Documentof The WorldBank FOR OFFICIAL USEONLY Report No. 37901-RU INTERNATIONALBANK FOR RECONSTRUCTIONAND DEVELOPMENT INTERNATIONAL FINANCECORPORATION MULTILATERAL INVESTMENT GUARANTEE AGENCY COUNTRY PARTNERSHIPSTRATEGY FOR THE RUSSIANFEDERATION FORTHE PERIODFY 2007-2009 November20,2006 RussianFederationCountry ManagementUnit Europeand Central Asia Region International Finance Corporation MultilateralInvestmentGuaranteeAgency This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwisebe disclosedwithout World Bank authorization. DATE OF LAST CAS PR (February 15,2005) CURRENCYEQUIVALENTS Currency Unit =Ruble (Rb) US$ 1.00= Rb 26.83 (market rate, October 26,2006) Rb 100= US$3.72 WEIGHTS AND MEASURES Metric System ABBREVIATIONSAND ACRONYMS AAA - Analytical and Advisory Activities I C A BEEPS - Business Environment and Economic ICT -- Investment Climate Assessment Informationand Communication Productivity Survey Technology BRIC - Brazil, Russia, India, China CAS - Country Assistance Strategy IFC ---International Labor Organization International Finance Corporation CAE Country Assistance Evaluation I L O CEM -- Country Economic Memorandum MDG Millennium Development Goals CFAA - Country Financial Accountability M I C - Middle Income Countries Assessment MIGA - MultilateralInvestment Guarantee Agency CIDA - Canadian International Development NGO -- Overseas Development Assistance Non-Governmental Organizations Agency ODA CIS - Community of Independent States OECD - Organization for Economic Cooperation and Development CPAR - Country Procurement Assessment PEP Report PIU -- Private EnterprisePartnership Project Implementation Unit CPS Country Partnership Strategy PPP - Public Private Partnership DFID -- Department for International SIDA - Swedish International Development Development Agency EBRD - European Bank for Reconstructionand SME - Small and MediumEnterprises Development TA - Technical Assistance EU European Union TB FDI Foreign Direct Investment UES -- Tuberculosis Unified Energy System FIAS --- Foreign Investment Advisory Service USAID - United States Agency for International Development FSAP - Financial Sector Assessment Program VAT - Value Added Tax GEF Global Environment Facility WHO - World Health Organization GDP -- Gross Domestic Product GRP - Gross Regional Product Goskomstat -Russian State Statistical Agency HIV/AIDS - HumanImmunodeficiency Virus IBRD - International Bank for Reconstruction and Development IBRD IFC MIGA Vice President: Shigeo Katsu Edward Nassim Yukiko Omura, Exec. Director: Kristalina Georgieva Jerome Sooklal Frank Lysy Team Leader: John Litwack Lisa Kaestner Mario Marchesini TABLE OF CONTENTS EXECUTIVESUMMARY ............................................................................................................................ i COUNTRY CONTEXT ................................................................................................................................ 1 COUNTRYBACKGROUND ............................................................................................................................ 1 ECONOMICDEVELOPMENTS ........................................................................................................................ 1 Regional Dimensions ............................................................................................................................. 6 The Social Context and Poverty Reduction ........................................................................................... 5 THEPOLITICAL CONTEXT........................................................................................................................... 7 KEYDEVELOPMENT CHALLENGES .............................................................................................................. 8 A) Sustaining rapid growth.................................................................................................................... 8 B) Public governance ............................................................................................................................ 9 10 D ) Russia's Global Role and Integration into the World Economy..................................................... C) The Social Sector and Social Services............................................................................................ 10 THEMEDIUM-TERMSOCIAL-ECONOMIC PROGRAMOFTHERUSSIANGoVERNMENT............................... 11 THE WORLD BANK GROUP'SPARTNERSHIPSTRATEGY .......................................................... 13 PASTBANKASSISTANCE AND LESSONS THEPREVIOUSCAS FROM .......................................................... 13 THERATIONALEFORFUTURE COOPERATION........................................................................................... 16 PRINCIPLESOFENGAGEMENT AND MODALITIESCOOPERATION OF .......................................................... 17 STRATEGIC PRIORITIESFOR THE CPS ........................................................................................................ 23 Sustaining Rapid Growth..................................................................................................................... 24 Improving Public Sector Management and Peqormance.................................................................... 26 27 Enhancing Russia's Global Role ......................................................................................................... Improving the Delivery of Social and Communal Services ................................................................. 29 FOCUS ON REGIONS ............................................. ..................................................... 30 EXPECTEDBANKGROUP FINANCING VOLUMESANDPRINCIPLES............................................................ 30 FIDUCIARY ENVIRONMENTFORBANKLENDING ....................................................................................... 31 PARTNERSHIPS .......................................................................................................................................... 32 RESULTS MONITOR~G .............................................................................................................................. 33 CREDITWORTHINESS AND RISKS ...................................................................................................... 34 RISKS ........................................................................................................................................................ 35 CREDITWORTHINESSAND BANKEXPOSURE .............................................................................................. 34 TABLE OF ANNEXES ANNEX 1: GROWTHSCENARIOS FOR2006-2009 ANNEX 2: DEVELOPMENTCHALLENGES AND REGIONALISSUES ANNEX 3: WORLDBANK GROUP:COMPARATIVEADVANTAGES ANNEX 4: RUSSIA: COUNTRYPARTNERSHIPSTRATEGY RESULTSMATRIX ANNEX Al: RUSSIANFEDERATION. KEY ECONOMICS & PROGRAMINDICATORS. CHANGE FROMLAST CAS ANNEX A2: RUSSIANFEDERATIONAT A GLANCE ANNEX B2:RUSSIANFEDERATION.SELECTED INDICATORS*OFBANK PORTFOLIO PERFORMANCEAND MANAGEMENT ANNEX B3:RUSSIANFEDERATION.IBFWIDA PROGRAMSUMMARY ANNEX B3:RUSSIANFEDERATION.RUSSIANFEDERATION-IFCAND MIGA PROGRAM ANNEX B4: SUMMARY OF NONLENDING SERVICES-RUSSIANFEDERATION ANNEX B5: RUSSIANFEDERATION SOCIAL INDICATORS ANNEX B6: RUSSIANFEDERATION. KEY ECONOMIC INDICATORS ANNEX B7: RUSSIANFEDERATION. KEY EXPOSUREINDICATORS ANNEX B8: RUSSIANFEDERATION OPERATIONSPORTFOLIO (IBRD/IDA AND GRANTS) ANNEX B8: RUSSIANFEDERATION STATEMENT OF IFC'SHELD AND DISBURSED P0RTF0LIO ANNEX C: CAS COMPLETIONREPORT EyO3-06 MAP # IBRD 33470R LIST OF TEXT TABLES TABLE 1: SELECTEDMACROECONOMIC INDICATORS ..................................................................... 3 TABLE 2: EASEOF DOINGBUSINESS INBRICS (2006) ........................................................................ 4 TABLE 3: OVERVIEW OF BANK INSTRUMENTS BY CLIENT CATEGORIES ................................. 21 LIST OFTEXT BOXES BOX 1: RUSSIA AND THE MILLENNIUM DEVELOPMENT GOALS ................................................... 6 BOX 2: RECENT SURVEYS SHOW MIXEDPOPULARPERCEPTIONSOF GOVERNMENT EFFECTIVENESS .......................................................................................................................................... 7 BOX 3: THE JOINT IFCBANK SUB-NATIONALDEVELOPMENT PROGRAM ............................... .20 BOX 4: WBI CAPACITY-BUILDINGACTIVITIES ................................................................................. 22 LIST OF TEXT FIGURES FIGURE 1:REALGDP GROWTH ............................................................................................................... 2 FIGURE2: POVERTY REDUCTION ........................................................................................................... 2 FIGURE 3: INFLATION ................................................................................................................................ 2 FIGURE4: REALEXCHANGERATE ......................................................................................................... 2 FIGURE5: PUBLIC DEBT TO GDP ............................................................................................................ 2 FIGURE6: FISCAL BALANCE .................................................................................................................... 2 FIGURE7: INFLOWS OF FOREIGNDIRECT INVESTMENT (USDMILLIONS) .................................. 3 FIGURE 8: RUSSIA:TRENDS INPOVERTY 1997-2002(HEADCOUNT INDEX IN%) ........................ 5 FIGURE9: CPS STRATEGIC OBJECTIVES ............................................................................................. 23 FIGURE 10: SHARE OFPUBLIC DEBT INGDP ...................................................................................... 34 FIGURE 11:EXTERNAL DEDT AND FOREIGNRESERVES ................................................................ 34 EXECUTIVESUMMARY i. Thelast WorldBank CountryAssistanceStrategy (CAS)for Russiawaspreparedin 2002 for cooperation along three main pillars: (a) improving the business environment and enhancing competition, (b) strengthening public sector management, and (c) mitigating social and environmental risks. Inretrospect, this appears to have been an appropriate choice of pillars, and World Bank Group cooperation with the Russian government was substantial and productive throughout the CAS period. ii. DuringtheCASimplementationperiodtheeconomicandpoliticalcontextfor World Bank Group cooperation with the Russian government changed considerably. Since the preparation of the CAS, Russia has experienced five years of strong economic growth and poverty reduction. Furthermore, sharp increases in the prices of Russia's main export commodities, most particularly oil and gas, have filled the coffers of the federal government, and provided for the accumulation of over US$300 billion in monetary and fiscal reserves. Russia's global role as G-8 member, re-emerging donor, and provider of world energy has expanded notably. Accordingly, recent years have witnessed the beginning of a major transition in the nature of cooperation between the World Bank Group and the Russian government. The Country Partnership Strategy (CPS) for 2006-2009 outlines a plan for completing this transition to a qualitatively new and no less productive relationship that is based on new modalities of cooperation. iii. ThisCountryPartnership Strategy reflects a strong commitmentby both the World Bank Group and the Russian government to continue a close and productive relationship that is suitable to the new conditions. While the federal government no longer needs the financial support of the World Bank, it still values highly World Bank knowledge, experience, and project management skills. New borrowing by the federal government will be quite limited over the period of this CPS, whereas the use of guarantees, subnational borrowing and new fee-for-service arrangements for investment and policy advice are likely to grow. IFC and MIGA operations will remain substantial (Russia i s IFC's and MIGA's largest exposure). The successful full transition to new modalities of cooperation with the Russian government will depend on strong coordination among IBRD, IFC and MIGA. iv. Remaining developmental challenges in a large number of Russian regions suggests an enlarged role for the Bank Group in direct assistance at the subnational level. This i s particularly the case for the period of this CPS, as most far-reaching structural reforms will likely take the form of regional initiatives or pilots. Russian regions exhibit an enormous amount of economic, geographic, and ethnic diversity. The federal government has encouraged the Bank Group to deepen its direct involvement in the regions. Correspondingly, a central theme of this Strategy i s the focus of Bank Group activities in select regions, including economic analysis (growth and business environment diagnostics), regional development strategies, and related investment projects. v. This CPS envisions a partnership with the Russian governmentfor the realization of four primary objectives: (a) sustaining rapid growth, (b) improving public sector management and performance, (c) improving the delivery of social services, and (d) enhancing Russia's global i role. The first three pillars correspond closely to the pillars of the previous CAS, and channel support directly toward the development challenges and policies elaborated in the government's Medium-TermEconomic Program, with a particular focus on the regions. The fourth pillar forms the basis for a new area of assistance, and concerns Russia's integration in the world economy and donor community. vi. Sustainingrapid growth (pillar 1)will require reducingthe current high dependence of the economy on energy prices. It will also depend on sustained macroeconomic stability, a business climate consistent with more competition and ease of doing business, higher rates of private investment, and measures to ensure adequate infrastructure and qualified labor supply. The Bank Group will offer a wide range of potential assistance products under this pillar, including support for macroeconomic policy, reserve management, supporting key state investments and PPPs for growth and diversification, identification and alleviation of barriers to growth at the regional level, investment and technical assistance to support the development of financial markets, and direct support to the private sector. vii. Reforms in the public sector (pillar 2), most particularly in government administration at federal, regional and local levels, remain high priorities in the government's agenda. Despite enormous progress since 1999, the most recent experience in Russia in the battle with corruption and administrative barriers to business has been rather mixed. The Bank will continue on-going cooperation for modernizing key public sector institutions, and for reforming the government apparatus and budgetary framework. It will also step up cooperation in judicial reform and could become more involved in local self-government or national anti-corruption initiatives. viii. The development of effective social services in health, education, housing and utilities, and social assistance (pillar 3) has lagged behind economic growth in Russia. This poses an obstacle to sustaining rapid welfare increases and poverty reduction in the country. The improvement of social services i s therefore a major focal point of current budgetary reforms and priority National Projects in Russia. As the responsibility and initiatives for improving social services lies at the regional level of government, they are a natural focus of Bank regional work for developing effective systems of social assistance, health care, and education. Housing and communal services is another possible area of Bank involvement through a national project implemented inthe regions. ix. Working with Russia as a donor (pillar 4)forms a new areafor cooperation. Russia is in the process of developing its ODA strategy. The Bank can support this process by providing access to its development expertise and knowledge of the new aid architecture, as well as through the use of Bank instruments for channeling Russian developmental assistance. In addition, the Bank Group is a partner in the fulfillment of Russia's international obligations related to global public goods. The latter includes significant potential opportunities inthe carbon market. x. Possible instruments of cooperation consist of direct support to the private sector (IFC and MIGA), a small number of loans to the federal government with a high share of co- financing, subnational loans without sovereign guarantees, grants, partial risk guarantees, conventional and reimbursable TA or project management (fee-for-service), carbon finance, and asset management (provided by the Bank's Treasury Department). Given Russia's healthy financial position, overall Bank lendingwill be modest over the 2007-2009 CPS period. xi. The CPS is very much in line with the major tenets of the Bank Group's recently approved strategy for engagement with Middle Income Countries, as reflected by (i) flexible, demand driven nature of the CPS; (ii) primary focus on providing global knowledge to Russia with active involvement of local academia and think tanks; (ii) development of a business model 11 for fee-based services and TA implementation; (iii) selective use of IBRD financial services in support of critical institution building and piloting of investment finance frameworks at federal and regional levels; (iv) increasing emphasis on sub-national financing without sovereign guarantees; (v) engagement with Russia as a G8 member and emerging donor in support for global development; and (vi) enhanced Bank Group synergies though closer Bank-IFC collaboration on investment climate assessmentsand sub-national financing. xii. The proposed strategy faces some implementation risks. The significant strengthening of Russia's economic and debt position has greatly reduced macroeconomic risks at the federal level, and the financial risks in many regions. However, the full shift toward new modalities of cooperation, and the expansion of programs at the subnational level, present significant challenges. New modalities imply the need for a number of procedural adjustments for both the Bank and the Russian government. In order to generate a significant impact, and create opportunities for scaling up, the Bank will need to concentrate its limited resourcesprimarily ina small select group of carefully chosen regions. If Russia's economic and political conditions limit the use of traditional Bank instruments faster than anticipated, the time for developing effective new modalities of cooperation could prove insufficient. As the procurement environment for Bank projects in Russia remains complex, the Bank will need to pay close attention to safeguarding its operations. Finally, Russia's quest for economic diversification points toward some potentially controversial areas of economichndustrial policy that will require careful attention. xiii. Theperiod covered by this CPS is one of great opportunityfor Russia. Macroeconomic performance has never been stronger. Fiscal and monetary reserves are accumulating at a rapid rate. Increasing integration with world markets i s visible. Political stability and cooperation within the government and regions have reached unprecedented levels. The Russian government now has both the financial and political means to boost economic policies and reforms to new levels in tackling the still formidable developmental challenges for the country. Movement to new modalities of work and the realization of the proposed program present a number of strategic, logistical, and technical challenges to the World Bank Group and the Russian government. Yet, the progress that has already been achieved i s sound evidence of the possibility of success. xiv. Board members may wish to discussthefollowing questions: 0 I s the Russia CPS consistent with the Bank Group's emerging strategy for engagement in MIC countries? Are the CPS strategic pillars chosen appropriately, given Russia's current development challenges, policy priorities, and the Bank's comparative advantages? Does the CPS strike an appropriate balance between federal level and regional level engagement? 0 Does the CPS appropriately addressthe risksand possible obstacles to completing a transition of the Russia programto new modalities of operation within the CPS period? ... 111 COUNTRY CONTEXT Country Background 1. Russia is an exceptionally large middle-income country which has undergone a dramatic transition from a centrally planned to a market economy. Russia's gross national product in2005 amounted to US$764 billion (US$5,342 per capita), placing it in the mid range of middle income countries. Fromvirtual complete state ownership inthe Soviet period, roughly 80 percent of all enterprises in Russia now operate in the private and corporate sector, and roughly 70 percent of the housing stock has become privately owned. The territory of the country is vast and accounts for 13 percent of the world's land mass. The Russian Federation i s divided into 88 regions (Subjects of the Federation), which display very different socio-economic, climatic and geographic conditions. Russia's population of about 143 million people includes 140 recognized nationalities and 40 ethnic groups. Russians comprise the overwhelming majority of the population (80 percent), but a number of non-Russian ethnic groups dominate on a regional basis inrepublics and districts (Okrugs) of the country. The enormous regional and ethnic diversity in Russia complicates the task of ensuring an efficient and harmonious development of the entire country. 2. Owing to its rich resource base, Russia plays a crucial role in global energy and resource markets. Russia has almost 30 percent (47 trillion cubic meters) of the world's proven natural gas reserves, and proven oil reserves of 60 billion barrels. Russia currently accounts for 22 percent of the world gas market, is one of the two largest oil producers (along with Saudi Arabia), and is the fourth largest producer of electricity. Russia also boasts significant wealth in coal, uranium ore, iron-ore (around forty percent of world reserves), copper, gold, tin, nickel, platinum, tungsten, molybdenum. Inaddition, Russia is exceptionally rich innon-metallic mineral resources. Russia's forests contain an estimated quarter of the world's timber. Economic Developments 3. Most of thepositive macroeconomictrends in Russia identified in the 2002 CAS have continued and strengthened. Russia is in its eighth year of robust economic growth; GDP expanded by an estimated 48 percent between 1999 and 2006. Growth resumed following the sharp depreciation of the ruble and hardening of budget constraints inthe wake of the 1998 crisis. It has been subsequently sustained by large terms-of-trade gains, responsible macroeconomic policy, and some key structural reforms. High oil revenues and export growth have led to large and growing current account surpluses (over 10 percent of GDP in 2005). Prudent macroeconomic policies and active debt management can be associatedwith highfiscal surpluses and the achievement of investment grade creditworthiness ratings since 2004. 1 Lure 1:Real GDPgrowth igure 2: Poverty Reduction GDP Growthand OUPrice Powrty(shareofpope IiGinghloarukirtancelewl), inprcent / 11 35 I 5 : 1997 1998 1999 2000 2001 2002 2003 2004 2005 1 1996 I997 I998 1999 1000 2WI 2001 1003 1004 ZWS 7igure4: Real Exchange Rate RealExchange Rate (Index) 160 - 110 - 1.0. I W m - igure 6: Fiscal Balance w - General Government Overall Balance w . -- -hYircbU(r prc.oldCDP) 80 . imrorp.uiraa(rrrrrntdcDPi 70 I 60 I 50 . 40 --- . 30- 20 . LO . 0 1 , 4. The strong recent performance of the Russian economy owes to a number of factors. In the immediate aftermath of the crisis, the combination of an exceedingly weak ruble, substantial excess industrial capacity, and cheap energy resources supported an industrial recovery and expansion that was broadly based across Russian regions. Inthis context, many of the poorer Russian regions exhibited the highest rates of growth. As the ruble appreciated steadily in real terms and production costs increased, growth rates in industry, and in the economy as a whole, began to decline in 2001 and 2002 (Table 1). A number of enterprises that had become profitable under conditions of a weak ruble and excess capacity began to struggle, thereby raising questions about the sustainability of the economic expansion. 2 Table 1:Selectedmacroeconomic indicators 1999 2000 2001 2002 2003 2004 2005 2006e GDP growth, % 6.4 10 5.1 4.7 7.3 7.2 6.4 6.8 Industrialproductiongrowth,y-0-y, % 10.9 11.9 4.9 3.7 7 8.3 4.0 4.3 Fixedcapitalinvestment growth, y-0-y, % 5.3 17.4 8.7 2.6 12.5 10.9 10.5 11.0 Federalgovernmentbalance, % GDP -1.1 1.4 3 2.3 1.7 4.2 7.5 8.0 Inflation (CPI), y-0-y, % change 36.5 20.2 18.6 15.1 12 11.7 10.9 9.3 CurrentAccount,billion $ 24.6 46.8 35.1 32.8 35.9 60.1 86.6 95.0 Reserves(including gold)billion $, end-o-p 12.5 28.0 36.6 47.8 76.9 124.5 182.2 276.4 Realdisposableincome index, (1999 = 100) 100.0 112.0 121.7 135.3 155.4 170.8 185.8 204.0 Share of populationlivingbelow subsistence, % 28.4 28.9 27.3 24.2 20.6 17.8 15.8 n/a 5. In 2003, Russia received another impetus to growth from sharp increases in the prices of its commodity exports, most notably oil and gas. The oil sector responded to higher market prices with an initial rapid expansion, although capacity constraints and policy uncertainties have slowed growth in oil output since the second half of 2004. Nevertheless, higher oil and gas prices have continued to stimulate domestic demand, which has recently become the primary driving force of economic growth. At the same time, the huge oil and gas revenue inflows have placed strong upward pressure on the Russian ruble, thereby further increasing competitive pressures on the tradable and manufacturing sectors of the economy. Since the second half of 2004, economic growth has become increasingly concentrated in trade, construction, and services, while many sectors of manufacturing have exhibited much slower growth. 6. Responsible macroeconomic policy has supported Russia's impressive accomplishments. The accumulation of fiscal surpluses has been a critical factor in maintaining overall macroeconomic stability and a slower pace of real currency appreciation. The Russian government and Central Bank have shown notable restraint in macroeconomic policy, and have avoided potentially destabilizing fiscal expansions, both during the economic crisis in the late 1990s and during the period of huge surplus oil revenues since 2003. The tightening of macroeconomic policy following the crisis hardened budget constraints, and was the catalyst for pullingRussia out the "virtual economy" syndrome of escalating arrears, debt, and mutual offsets. While federal budgetary revenues have soared to well over 20 percent of GDP since 2004, federal expenditures have remained lower than 18 percent of GDP. Significant improvements are also visible in budgetary practices at the federal and subnational levels, including the elimination of non-cash operations and most unfundedfederal mandates. 7. Although domestic and foreign direct investment are still somewhat low relative to Russia's needs, investment has been growing even more rapidly than GDP in recent years, and has become an investment (USD increasingly important source of economic growth. From a very low base in the late 1990s, fixed capital investment has grown at any average rate of 9 percent since 2000, as compared to 6 percent average GDP growth. A large share of investment (27 percent) i s concentrated in energy and pipelines. But substantial investment has been important in some other sectors as well, and can be associated with substantial restructuringin many service industries,the food industry and some areas of machine- building. Inflows of direct foreign investment have picked up notably in recent years, reaching an estimated US$13 billion in2005. 3 8. Private sector development has benefited from far reaching tax reforms and the reduction of some administrative barriers to business. Among a number of structural reforms that have improved the business environment in Russia in recent years, tax reform stands out as a key accomplishment. The complexity, instability, and excessive formal burden of the Russian tax system created major problems for business development throughout the 1990s. The consistent and determined pursuit of tax reformhas decreased the number of taxes, lowered the overall tax burden considerably, and greatly alleviated (although not yet solved) the problem of perceived instability in the business environment. Russia was one of the first countries to pioneer a flat income tax of 13 percent, and has been steadily reducing the rates of some of the other major taxes. The unified social tax was reduced from 35.6 to 26 percent in 2005, and the profit tax rate declined from 35 to 24 percent. The VAT rate was reduced from 20 to 18 percent, and its further reduction i s currently under discussion. In addition to taxation, surveys of entrepreneurs confirm positive results from a campaign since 2001 to target "administrative barriers to business" in registration, licensing, inspections, customs, and other areas. Many indicators of Russia's investment climate have improved inrecent years, and Russia now compares favorably with other transition and BRIC countries by some of these indicators. Table 2: Ease of Doing Business inBRICs (2006) ' (Rankings of the capital cities of 175 countries) Dealing with Licences ProtectingInvestors 60 83 33 60 Closing a Business 135 75 133 81 9. Expanded profit opportunities, structural reforms, and harder budget constraints have further accelerated the development of market institutions in Russia. One of the most notable changes has been the emergence of an active market in corporate control, and a corresponding strong shift in ownership of the majority of Russian firms from employees to outside shareholders. A number of sectors of the economy, particularly the food industry, have attracted significant investment, undergone major restructuring, and achieved rapid productivity growth. From the verge of collapse in 1998, the Russian banking sector has rebounded and is growing rapidly, although levels of financial intermediation remain low relative to Central Europe. A number of larger Russian firms have become increasingly interested in tapping international markets, and have thus pursued a higher degree of openness and transparency. The number of recent Russian IPOs is impressive. In 2005, Russia witnessed a surge of IPO activity in both volume and value terms: 11 IPOs took place in 2005 raising total capital of US$4.9 billion. 10. Assuming that the Russian government sticks to its basic economic policies, the Russian economy should continue to exhibit healthy growth throughout the CPS period. Oil prices presentthe primary source of uncertainty for both the pace and nature of growth inthe near future. Inthe mediumterm, capacity constraints may increasingly limit the pace of the economic expansion while overall growth prospects continue to depend greatly on economic policy. Particularly important are the maintenance of macroeconomic stability, development of infrastructure, key social sector reforms (in education, healthcare and social services) and measures to further improve the climate for private investment, competition, and entrepreneurship. Growthprospects also depend on external factors other than oil. But as most foreign inflows come from oil and gas, Russia's macroeconomic position i s not as vulnerable in 4 the short term to changes in investor sentiment about emerging markets relative to most other countries in the region. Annex 2 provides macroeconomic simulations for the Russian economy during the period of this CPS under alternative oil price assumptions. Inall of these scenarios, average GDP growth i s projectedto fall inthe range of 4.5-6.8 percent The Social Context and Poverty Reduction 11. Growth since 1999 has been strongly pro-poor, and can be associated with rapidly rising income, declining unemployment, and falling poverty rates. Real incomes of the population have been increasing faster than GDP, expanding by an estimated 86 percent between 1999 and 2005. The unemployment rate ( L O definition) continues to fall, reaching an estimated 7.6 percent in 2005 - down from over 12 percent in 1999. The recent World Bank Poverty Assessment noted a reduction in the poverty headcount from 41.5 to 19.6 percent between 1999 and 2002, and subsequent official data suggests that these trends have continued through 2005. 12. Following the halving of poverty rates between 1999 and 2002, the government Figure 8: Russia: Trends in Poverty 1997-2002 stated an objective to halve the poverty rate (Headcount Index in %) ;; again between 2002 and 2007, and this objective seems within reach. From 24.6 percent in 2002, the estimated share of the Russian population living below the official poverty line fell to 17.6 percent in 2004. 25 20 Although official data for 2005 have yet to be 15 10 announced, government officials have cited a 5 preliminary figure of 15.8 percent (Figure 8). 0 1997 1998 1999 2000 2001 2002 2003 2004 The World Bank Poverty Assessment of Russia employed a consumption-based poverty line +Official SubsistenceMuurnurn W RecommendedWB methodolow measure according to which poverty increased I faster in official figures during the economic crisis of the late 1990s, but then declined muchfaster in subsequent years. Estimates according to the World Bank methodology do not yet exist beyond 2002. Figure 8 shows the development in both the official and World Bank estimated poverty lines for Russia. 13. The World Bank poverty monitoring confirms that economic growth and the associated creation of higher-paying jobs have been the primary factors behind success in poverty reduction. Indeed, working families with children have the highest incidence of poverty in Russia. In addition to higher-paying jobs created by growth, increases in wages in the budgetary sphere have had a positive impact on poverty reduction. However, it will be difficult for Russia to maintain the pace of poverty reduction established since 1999. The initial period was a time of recovery from an economic crisis that had temporarily increased poverty rates. Although income inequality in Russia increased considerably duringthe first half of the 1990s, it has remained fairly stable in the last ten years, with a Gini coefficient of roughly 0.4. This i s considerably higher than inmost European countries, yet lower than inthe United States, Mexico, and Brazil. Regional differentiation in poverty rates i s quite large, estimated in the Poverty Assessment as ranging from 3.1 to 55.6, and recent trends in economic development suggest that disparities in regional poverty rates, and consequently income inequality, could grow significantly (See Annex 2). Many areas of policy and reform are important here, including measures to increase the mobility of the population, social reforms ineducation and health, and a revampingof the current system of social benefits for targeting the poor. Headcountindex measuresproportionof the populationliving below the selectedsubsistence minimum. 5 14. Russia has made progress toward achieving the Millennium Development Goals. As a middle income country with well-developed public education and low child mortality, Russia has already achieved or i s close to achieving some of the Millennium Development Goals. The primary areas of concern for meeting the MDGs in Russia are inthe spread of infectious diseases and environmental sustainability. A summary i s given below (Box 1). Box 1.Russiaand the MillenniumDevelopmentGoals The status of Russia achieving the Millennium Development Goals can be summarized as follows: On the eradication of extreme poverty and hunger, Russia reduced absolute poverty (below US$2 a day) to 6.3 percent in 2002 at the time of the Poverty Assessment. I t has most likely declined even further since then. Universalprimary education has already been virtually achieved in Russia with 97-98 percent of the population receiving primary education. On gender equality and the empowerment of women, Russia boasts indicators for education, health, and social services that are comparable to those of OECD countries. Still, discriminatory attitudes toward women inthe labor market are still problematic. Child mortality fell to an estimated 11 per 1000 births in 2004, and maternal morbidity i s also declining and well on track to meet the MDGgoals. HlV/AlDS is not yet widespread in Russia, but is nevertheless expanding at a rapid rate. The number of reported cases of HIV quadrupled between 2000 and April, 2006, moving from less than 80,000 to a reported 342,500 cases. The number of cases of TB more than doubled during the same period. In addition, TB remains a serious challenge, and a high priority for the government. Environmental degradation is increasing in many areas inRussia along with economic growth. Russia's new policy priorities and National Projects in the social sphere may have a positive impact on remaining MDG challenges. Half o f the spending for the National Projects is devoted to health, and contains a specific HIV/AIDS-TB component. Yet a stronger national campaign will most likely be necessary to contain these epidemics. Environmental issues have not numbered among the government's primary priorities in recent years, but will no doubt require more attention as problems accumulate. A number of serious social problems in Russia are not fully reflected in the usual MDG breakdown. Although average poverty rates have declined, concentrated pockets of severe poverty remain. While child mortality has fallen, pre-mature adult mortality i s extremely high for a country of Russia's income level. Average male life expectancy inRussia i s only 59 years, as opposed to 72 for women. Thus, adult health in Russia can also be considered a gender issue. The education system suffers from a number o f weaknesses for a country of Russia's income level. See Annex 2 for a discussion of these and other critical social issues. RegionalDimensions 15. The 88 regions of the Russian Federation exhibit considerable geographic, ethnic, economic and political diversity, and challenges in regional development are becoming increasingly important. The factors that supported regionally broad-based growth since 1999 (a weak ruble, cheap energy and labor, excess productive capacity) have now essentially disappeared. Strong differences among Russian regions, reflecting the Soviet legacy of 6 settlements that bear little relation to economic comparative advantage, suggest that regional inequality will likely become an increasingly acute problem. These problems are spelled out in detail inAnnex 2. The Political Context 16. The 2000s have witnessed a significant consolidation of power in Moscow. In this context, an unprecedented degree of political stability and cooperation between the federal government, Parliament, and regional administrations has replaced the former environment of sharp political conflict and impasse. A trend toward the devolution of power from Moscow to the regions in the 1980s-1990s has been reversed. Since 2000, the government has pursued initiatives to bring subnational legislation and policies in line with federal laws and priorities. The most significant such measure was probably the introduction of the direct presidential appointment of regional governors in 2004. While enhanced political stability and the role of the federal government offer advantages and opportunities for Russia, these developments can also be associated with concerns in some circles that the growing political centralization and government participation in the economy may be becoming excessive. Recent popular surveys show a mix of both support and skepticismabout current directions of economic development and policy (see Box 2). Box 2: Recent surveys show mixed popular perceptions of government effectiveness According to recent surveys, approval for President Putin i s very strong, with a current approval rating over 70 percent. I t quickly recovered from the slight decline in early 2005 in the wake of an unpopular social reform (the monetization of in-kind benefits) among other issues. On the subject of recent economic developments and public governance, opinions are much more reserved. Half o f the Russian citizens believe that the current economic situation is very mixed at best, and 59 percent hold the view that it is impossible to run a "clean" business in the country. Similar doubts exist regarding the capability of the government to make good use of the windfall o f oil revenues and tackle corruption in the public sector Source: ROMIR Monitoring Report 2006 17. While the appetitefor national reforms has weakened at the federal level, there is increasing interest in launching major structural reforms as pilots or local initiatives in selected regions, particularly in the area of public services. A period of relatively rapid structural reform followed the 1998-99 financial crises. Subsequently, the rapid growth of the Russian economy, high oil prices, and the virtual completion of many "first generation" reforms have understandably slowed the pace of structural reform. An increasingly cautious attitude toward reform in Moscow was reinforced by social unrest that followed the monetization of social benefits in early 2004. On the other hand, there remains political momentum behind some previously launched national reforms, including local self-government, public administration, budgetary reform, and electricity sector. Interest in Moscow for launching reforms at the subnational level has been increasing. The appointment of regional governors has eased fears on potential conflicts of interest in the delegation of authority. The pre-election environment also creates a premium for shifting responsibility for difficult social reforms to lower levels of government. Finally, as the 2005 monetization reform made apparent, Russian regions are sufficiently heterogeneousto suggest that a single unified national approach to every reform may not be optimal. 18. Russia has assumed a more prominent international role. It hosted the G-8 in 2006, has completed the vast majority of bilateral negotiations for WTO entry, has ratified the Kyoto Protocol, and has been assuming increasing international obligations as an emerging donor. Russia has recently joined the Multilateral Debt Reduction Initiative, and plans to write off US$700 million of debt in 16 enhanced HPIC countries in 2006. Part of this debt write-off is to 7 be directed toward high priority programs through a "debt for development swap", in partnership with various beneficiary countries in Africa and the World Bank. Russia has also agreed to contribute to several international development partnerships, including the Avian FluTrust Fund, Education For AllEast Track Initiative, and the Global Village Energy Program. Russia has also placeda strong priority on greater integration and cooperation within the CIS. Key DevelopmentChallenges 19. Despitethe many recent positive developments in the Russian economy, the country's developmental challenges remain formidable. The investment climate in Russia still suffers from uncertain property rights enforcement, inadequate competition, barriers to migration, and problems in public governance. These problems find reflection in still low private investment levels and a marked slowdown in the growth of manufacturing in recent years. Their solution becomes increasingly critical to maintainingrapid growth as capacity and labor supply constraints increasingly bind in high growth regions and the ruble appreciates. Russia's high dependence on oil and gas, coupled with relatively low average productivity in manufacturing, complicates the realization of diversified growth and the effective integration into world markets. 20. A successful development strategy needs to address a highly complex set of challenges. They include remaining hurdles in economic transition to a market economy (judiciary, regulatory institutions, etc.), issues common to developed market economies (such as aging population, eradication of poverty), problems stemming fiom the dominance of extractive industries and the effects of "Dutch Disease," and Russia-specific tasks (more efficient development of its vast multi-ethnic territory, of which a large part functions under harshclimatic conditions). 21. Russia'sprimary development challenges are described in detail in Annex 2. Below i s a summary of key issues grouped into four categories: sustaining rapid growth; public governance; provision of social services; and integratingRussia inthe world economy. A) Sustainingrapid growth Maintaining macroeconomic stability in the context of large foreign inflows. Macroeconomic stability remains critical for economic growth, and depends on sterilizing a large part of the current large foreign inflows through reserve accumulation. Yet political and social pressures are mounting for a fiscal loosening. Diversification. The economy remains highly dependent on oil prices, economic growth i s slowing notably in most "tradable" sectors of the economy, and Russia has yet to develop distinct comparative advantages in manufacturing. Continued upward pressure on the real exchange rate from resource exports complicates the development of these comparative advantages. Investment climate. The investment climate remains difficult, which particularly hinders investment growth, the development of entrepreneurship and a dynamic, diversified, and knowledge-based economy. Although fixed capital investment has been growing notably, it is still low (18 percent of GDP) relative to other dynamic emerging market economies. On the one hand, recent World Bank surveys indicate that, according to a number of business climate indicators (registration, taxation, customs, inspections) in Russia have reached, or even surpassed, levels achieved in China and India. Nevertheless, despite progress made in some areas the Russian business climate still suffers from weak competition, a weak judiciary, the common capture of markets at the regional level, problematic access to land and premises, remaining uncertainty over property rights, and 8 various other administrative barriers. While Russia made rapid progress between 2000 and 2003 in improving the investment climate, the results have been much more mixed in more recent years. Russia's rankings in the World Economic Forum Global Competitiveness Report and Transparency International also declined notably in 2006 relative to 2005. Infrastructure needs. Over the transition period, Russian infrastructure has deteriorated and suffered from underinvestment. Transportation bottlenecks are becoming increasingly acute and there i s a growing concern about the availability and reliability of electricity supply. Strong economic growth has also created a rapidly growing demand for infrastructure services. Shortages of housing infrastructure limit migration flows that are essentialfor sustaining rapid growth and poverty reduction Labor supply. As the population shrinks and ages, labor supply, particularly skilled labor supply, i s becoming an increasing constraint on economic growth. Training and vocational education are inadequate. The dependence of future growth on substantial external migration poses difficult political and economic questions with respect to current migration policy and its enforcement. The government has adopted a number of recent measures to promote and regulate effectively migration flows. Financial intermediation. Russia's banking sector remains small, dominated by state- owned banks, and potentially vulnerable to external shocks. Despite the impressive growth of Russia's banking and financial sectors in recent years, external financial constraints for Russian firms continue to form important limiting factors to Russia's continued rapid expansion. Environmental degradation. Inrecent years, environmental issues have not received top political priority in Russia. As a result, accumulating environmental problems may present growing threats in many areas. Both changes in federal administrative arrangements and further decentralization of environmental management can be associated with increasing regional differentiation in the quality of environmental oversight. The current industrial expansion, increases in vehicle ownership, low energy efficiency, and insufficient attention to the sustainable use of Russia's vast natural resources, represent important environmental challenges that cannot be neglected... The government i s now voicing concerns over the current lack of clarity in arrangements for naturalresource protectionand broader environmental oversight. B)Public governance Public administration. During the transition period, Russian civil service has suffered from the Soviet legacy of low pay, weak economic (performance based) incentives, and an administrative apparatus riddled with inefficiencies and redundancies. The reform of public administration and the civil service has been a top priority for the government in recent years, although progress has thus far been limited and mixed. Intergovernmental fiscal relations. The Russian system of intergovernmental fiscal relations can be associated with distorted incentives and inefficiencies at lower levels of government. Reforms in fiscal federalism and local self-government are currently being implemented inRussia, tackling a set of important remainingchallenges. Judiciary. The Russian judiciary still suffers from low trust of the population, corruption, and limited capacity. Judicial reform has justifiably received more attention from the government inrecent years. 9 Anticorruption Efforts. Recent studies (including the Bank's BEEPS survey) suggest that the declining trend in corruption registered between 1999 and 2002 has been reversed. A sharp increase in public revenues and in public investments at least partially contributes to such trends, as in other countries with similar resource windfalls. The issue of corruption is recognized as a priority at the highest levels of Government and a number of anticorruptionmeasures are being put inplace. Anticorruption efforts are also an important segment of the administrative reforms agenda of the Ministry of Economic Development and Trade and reflected inthe Government's Mid-TermProgram. Inclusion and civil society involvement. Civil society institutions are not fully developed, and this presents a challenge to the process of civil engagement in decision- making, and in ensuring public accountability for all levels of government. The realization of the current reform of local-self government could play a critical role in creating a foundation for the development of grass roots civil society. C) The Social Sector and Social Services Poverty and social services at the subnational level. The responsibility for most social policy has been delegatedto the regional and local levels. Yet huge regional inequalities, regressive social assistance, and limitedgovernment capacity poses major challenges. Extremely unfavorable demographic/health indicators and trends. For a middle income country, Russia has exceptionally high indicators of mortality and morbidity. The threat of AIDS and tuberculosis epidemics continues to grow. An ageing population places an increasing burdenon the pension and healthsystems. Education. The public education system in Russia i s in need of modernization and a greater orientation toward the needs of a modern market economy to improve the quality of school education and student's learningoutcomes inRussia. Access to social services for the poor. Rapidly growing formal and informal costs of quality health and education services place a particular burden on the poor. The Bank's recent Poverty Assessment and other studies show Russia's social assistance systemto be one of the most regressive among transition countries. Better measurement of poverty and its structure at the regional level will be key tasks in movingforward. Housing and communal services. Poorly developed markets in housing and communal services represent barriers to welfare improvements and much needed migration. Housing and communal service markets in Russia suffer from inadequate competition and various regulatory distortions. 0)Russia's Global Role and Integration into the WorldEconomy WTO accession and free trade agreements. Russia stands to profit significantly from deeper integration into the world economy. In addition to the direct benefits from gains from trade, rapid integration into the world economy offers the potential for rapid institutional development, the improvement of corporate governance and other standards, and benefits from competition. Emerging donor and G-8 member. Russia's growing economic strength has boosted its importance, and created a need for developing capacity, in its global roles as emerging donor and G-8 member. The 2006 G8 Presidency granted Russia a unique opportunity 10 for active involvement in the policy dialogue on important global and regional issues, for providing major inputs, and for taking the lead on specific themes and agendas. Russia's environmental significance on a global scale. Russia's environmental resources are of national, regional, and global importance. Addressing issues like illegal logging, biodiversity conservation and reduction of carbon emissions can provide local and global benefits. The Medium-TermSocial-EconomicProgramof the RussianGovernment 22. Russia's 2006-2008 Mid-term Program, approved in early 2006, addresses many of the country's most important development challenges. It encompasses the main objectives of "improving the welfare of the population and reducing poverty through dynamic and sustained growth and higher competitiveness." The program embodies the strategic goal of doubling GDP and cutting poverty in half in ten years as set by President Putin and endorsed by the Russian Parliament. It reflects intensive debates over the right mix between building market institutions and stimulating growth through public investments. The final mid-term program i s consistent with the basic reform orientation of the first years of Putin's Presidency. It advocates a combination of measures to promote private sector development and competition, the improvement of social services, and specific commitments to state investments in infrastructure and diversification, including public-private partnerships, state investment funds, state development banks and support for special economic zones and IT parks. Subsequent to the adoption of this program, President Putin's annual address to the Federal Assembly placed emphasis on some additional priorities, most notably reversing the problematic demographic trends. 23. The Government's Program targets the key problems of the absence of incentives and opportunitiesfor the development of human capital, low efficiency of state governance, low levels of competitionand a high share of the %on-market economy," weak diversification, problems in the mobility of factors between regions, a low level of integration of Russia in the world economy, infrastructure constraints, and an uneven record in reform at the subnational level of government. Special priorities in the program are: The realization of the four National Projects in health, education, housing, and agriculture. These projects will allocate a planned 382 billion rubles (US$ 14 billion equivalent) in additional government money to these areas. The project in health accounts for roughly half of this spending, to be directed toward salary increases, modernization of equipment, and creation of new health facilities. Additional resources devoted to education will go mostly toward pay increases, including incentive pay for teachers, and grants for promising students. Much of the national housing project offers assistance to families for purchasing housing, either through redeemable certificates, subsidized mortgages, or guarantees. The agriculture program also has a strong social orientation, and consists largely of various subsidies for farmers. Increasing the efficiency of social policy, services and assistance. The Medium Term Program also targets a number of structural deficiencies in health, education, housing, and social assistance. Priorities include developing performance-based budgeting to measure and improve service delivery, increasing incentive pay for doctors and teachers, reallocating resources toward preventive and primary care, reforming health insurance, modernizing programs in education, expanding relevant professional training, facilitating the entry of private business in housing and communal services, developing targeted social assistance, and realizing (revitalizing) pension reform. 11 The continuation of reforms in government administration and the civil service. The new wave of administrative reform expands the program to the regional level of government. The primary current focus i s the introduction of best practices in basic organization, standardization, elimination of redundancies, performance-based pay, as well as measuresto limit the unwarranted interference of state bodies in economic affairs, fight corruption, and disclose more information to the public. Concerns over corruption have motivated more recent attention to this area. A comprehensive review i s underway of Russian legislation with an eye to correcting loopholes for corrupt practices. Promoting competition, entrepreneurship, and diversification through measures to strengthen market institutions, improve the business climate, and alleviate barriers to the movement of capital between sectors. Specific measures concern the strengthening of property rights (disclosures, court protection), corporate governance (improving standards, protection of minority shareholders, disclosures), banking sector (improved monitoring and tighter prudential norms to force mergers of smaller banks), land and real estate (cadastre, registration, privatization of land under enterprises), taxation privatization (requiring subnational governments to sell unitary enterprises and other property), competition policy, and integration with the world economy. Realizing the knowledge-based potential for growth and innovation in Russia. The Program emphasizes a number of policy directions aimed at igniting the "innovation economy" in Russia, including a greater state commitment to research and development, better protection and enforcement of intellectual property rights, and the formation of IT parks and state venture funds. Alleviating infrastructure constraintsto growth. The government i s increasing its own financial commitment to building infrastructure, particularly in transportation, but also plans to rely increasingly on Private Public Partnerships. Realizing a transition in regional policy away from equalizing growth potential to supporting points of economic growth. Government assistance in infrastructure and finance will prioritize areas with the potential to become or expand as growth points in the economy. This includes the placement of Special Economic Zones in high growth areas. The welfare implications of unequal regional development will be met to a larger degreethrough policies to promote migration to areas of growth agglomerations. Zmplementing effectively the ongoingfar reaching reforms in inter-budgetary relations and local self-government. The former delegate a much greater degree of expenditure autonomy to regions and localities, while leaving the determination of the revenue side of subnational budgets quite centralized. The latter reform promises to transform local municipalities into genuine budgetary entities with well-defined autonomy, responsibility, property ownership, and electoral responsibilities to the population. 24. Problems in demography and migration are receiving particular attention. This became a primary point of emphasis in President Putin's address to the Federal Assembly of May 2006. President Putin announced a plan that would substantially increase state child and maternity support for families with two or more children and also called for measures to facilitate legal migration to Russia from the former Soviet Union. The Medium-TermProgram contains proposals for simplifying registration and other procedures for legal migrants, as well as for attracting highly qualified workers from abroad. 12 THEWORLD BANK GROUP'SPARTNERSHIPSTRATEGY Past Bank Assistanceand Lessons from the Previous CAS 25. The World Bank Group's relaiionship with Russia has transformed over time, as the Bank developedfrom a partner of necessity to a partner of choice. Russia joined the Bank in 1992, soon after the dissolution of the Soviet Union and at the outset of economic transition. Broadly, the Bank's focus has been on helping build the institutions of a market economy, developing the private sector, and mitigating the social costs of transition. Since 1998 crisis, Bank assistance moved towards support for public administration reform and anti-corruption, budget management`, tax collection; federal-regional fiscal relations; improvements in the business environment; private sector investments; and rehabilitation of education and health systems with efforts to address the tuberculosis and HIV/AIDS crises. By the time of the 2002 CAS, the Bank's relationship with Russia was already changing considerably. As the government no longer required budget support and was more interested in the Bank's knowledge and technical expertise, the 2002 CAS included a shift in emphasis toward more analytical and advisory activities (AAA). At the same time, IFC and MIGA increased their involvement considerably in line with growth of the private sector. The attached CAS Completion Report offers a more complete assessment of the experience and lessons of the implementation of the previous CAS. A summary i s given below. 26. The design and implementation of theprevious CAS closelyfollowed thepriorities of the Russian Government, which strengthened ownership of the Bank program. In line with Government's medium-termprogram, the 2002 CAS focused Bank support to Russia along three strategic pillars: (i)improving the business environment and enhancing competition, (ii) strengthening public sector management; and (iii) mitigating social and environmentalrisks. The CAS also projected seventeen investment projects in support of the three CAS pillars for a total amount of about US$1.8 billion. Given much higher government revenues due to rising oil prices, the actual lending volume was less than projected - ten projects totaling US$1.2 billion. These projects, together with AAA and TA, helped the government realize key objectives in budgetary reform (particularly at the regional level), land cadastre and registration, customs, public administration, infrastructure, education, health, environment, and capacity building. 27. The Bank contributed to progress under each of the three strategic CAS pillars, although its role was not equally strong in all areas. On the first CAS pillar, improving the business environment and enhancing competition, Bank instruments appropriately emphasized AAA rather then lending, while World Bank Group direct support to the private sector expanded. The Bank made considerable analytical contributions to economic development and investment climate monitoring. While the accomplishments in these areas were significant, the structural reform agenda for improving the business climate is far from complete; administrative barriers to businessand investment remain significant, participation of SMEs inthe economy continues to be low and progress in the area of natural monopolies has been limited. The Bank's contribution to the second CAS pillar, improving public sector management, has been significant. AAA focused on federal functions where there was appetite both for reform and Bank support (tax, treasury, customs and fiscal federalism). A relatively small volume of lending resulted in a significant scaled up impact. The goals of the third pillar, mitigating social and environmental risks, were expansive in scope and address issues that are long term in nature - health care, education, institutional care of children, poverty reduction, and the Soviet environmental legacy. The 13 Bank's efforts were more successful when focused on policy analysis and consensus building, or responded to a clear government request such as in child welfare, adult health, HJY/AIDS, poverty assessment and forestry studies. 28. A QAG review noted the very significant impact of the Bank's AAA work during the CAS period. As noted, the CAS placed increased emphasis on AAA, which included a Country Economic Memorandum, a Poverty Assessment, investment climate assessments (Administrative barrier monitoring by FIAS, Business Environment and Economic Productivity Survey (BEEPS), a study on the potential impact of AIDS, fiduciary reports, policy notes, and sector reports. The Bank also launched a regular publication, the Russian Economic Report, which made significant contributions to the policy dialogue and public debate in Russia. A QAG assessment acknowledged the high quality of the Bank's independent judgment and perspectives, and its success in bringing global knowledge to Russia. According to interviews with clients, many changes in legislation, policies, design of institutions, and practical measures reflected the positive impact of Bank analysis, advice or facilitation. QAG rated the strategic relevance, internal quality, and dialogue and dissemination of Bank AAA inRussia as highly satisfactory. 29. Portfolio management has improved. The Bank portfolio as of end-FY06 consists of 22 projects totaling US$1.9 billion in net commitments. Important steps were taken during the CAS period to improve portfolio management and coordination, which focused on closing older projects and improving quality at entry and exit (improving the "disconnect" on final project ratings). A Bank-Government Joint Working Group (JWG) now regularly reviews portfolio and project performance, including proposed project extensions, and decides on actions to address significant problems and accelerate implementation. A number of portfolio monitoring tools have been createdto track implementation of "next steps" agreed in missions' aide-memories for both ongoing projects and projects under preparation. Most recently an on-line procurement monitoring system has been introduced that rates projects based on the timeliness of procurement steps under procurement packages. The Bank has strengthened supervision efforts through the further decentralization of operations, increasing communication with implementing agencies, PIUs and relevant Government agencies. As a result, the share of satisfactory projects has improved and currently stands at 95 percent; well above the 77 percent satisfactory rating at the start of the CAS. Project implementation pace has picked up and the disbursement ratio improved from an average 11percent over the last 6 years to 15.7 percent inFY06. 30. At the same time, portfolio management in Russia remains a challenging and management-intensive task. Projects often require lengthy Government consideration prior to approval and still take significantly longer to implement in the Russian context - the average project age now stands at 4.8 years. Despite improvements, the disbursement pace trails the Bank-wide and ECA averages of 24.0 and 17.1 percent respectively in FY06. An action plan for further strengthening portfolio quality includes: re-focusing the Bank-Government JWG on outcomes and strategic decisions, including management of closing dates; holding a strategic country portfolio performance review; holding an annual review of project Implementation Status Reports with an emphasis on outcomes; moving further towards ministry-based project implementation for new projects that leaves PIUs only with administrative and fiduciary functions; and improved supervision practices. Further discussions are underway to simplify the government grant approval procedure. On its side, the Bank i s also committed to continue its efforts in expediting project preparation, decentralizing its operations, raising to the extent possible the financial threshold per procurement methods and prior review thresholds, and responding inan effective way to client's needs. 31. ZFC significantly increased its activities in Russia. IFC's average commitment level for the CAS period reached US$588 million per year, almost six times the FY00-02 average. Russia is now IFC's largest country exposure, with a committed portfolio of almost US$2 billion 14 as of end-FYO6. Investments in financial institutions represented by far the largest share - about half of new commitments. This reflects the objective stated in the previous CAS to increase effective financial intermediation and opportunities for entry and growth of new firms. In line with the diversification objectives of the CAS, manufacturing and services remained a significant area of focus with 26 percent of new commitments. In infrastructure, transport became a significant new sector for IFC in Russia with nine investments in private companies (all Russian- owned), operating inrail, sea, and air transport. The remainder of new commitments went to the oil, chemical and mining sectors, agribusiness, and IT/media, and funds. In general, a significantly increasing portion of IFC's financing went to fundingRussian-owned companies. 32. ZFC continued providing technical assistance through the Moscow-based Private Enterprise Partnership (PEP) to promote the development of Russia's private sector. During the CAS period, IFC completed a large program in corporate governance, through which it supported 2,000 companies in improving their corporate governance practices. On the national level, the program worked with Russia's Federal Securities Commission to draft and disseminate Russia's first national corporate governance code and with the Russian Parliament on different laws and regulations related to corporate governance. This work was done in coordination with the Bank, OECD, and the Global Corporate Governance Forum. The program also sought to raise public awareness of the importance of good corporate governance and the protection of shareholders' rights and worked with educational institutions to introduce corporate governance topics into law and management courses. 33. The Foreign Investment Advisory Service (FZAS), ajoint unit of ZFC and the World Bank, increased its specialized assistance in monitoring the investment climate of Russia. Following a series of comprehensive diagnostics of administrative barriers for business start up, locating and operating procedures in 12 regions of Russia which demonstrated that the most important constraint was related to access to commercial land and real estate, FIAS focused on strengthening of transparent and defensible property rights for immovable assets for businesses. On the national level, FIAS i s assisting the Ministry of Economic Development and Trade in drafting the law on privatization of plots of land under privately-owned buildings. On the sub- national level, assistance is being provided to the 12 regions and municipalities covered by FIAS aimed at lowing barriers inland and real estate transactions. 34. MZGA has also increased its activities in Russia. Russia i s currently MIGA's largest country exposure. As of June 30, 2006, the Agency's gross exposure in Russia was about US$536 million (equivalent to 10.0 percent of MIGA's gross portfolio), and its net exposure amounted to nearly US$211 million (about 6.4 percent of total net exposure). As of June 30, 2006, MIGA's outstanding portfolio in Russia consisted of 15 contracts of guarantee in the financial, water supply, mining, manufacturing and agribusiness sectors. The Agency also supported various regions in strengtheningtheir investment promotion capacity. 35. A number of lessons emerge from the implementation of the previous CAS, with implicationsfor design and implementation of the new strategy: (i)in view of Russia's large fiscal surplus, the Bank's value added i s not in providing financial support but rather in helping Russia gain access to global knowledge and skills through analytical and advisory support and through bringingtogether different stakeholders and parts of government in forging consensus on key policy issues; (ii)given Russia's rapidly changing environment, the Bank should continue to move towards a partnership approach with a strong demand-orientation in design and delivery of assistance and flexibility in adjusting the Bank's program and modalities of assistance to client needs, making full use of the Bank's flexible arrangements for well performing MICs and spearheadingnew instruments of assistance which also draw on increased collaboration with IFC and MIGA; (iii)with the growing gap between prosperous and lagging regions, the major challenge for the Bank i s to address the development challenges at the sub-national and regional 15 levels; (iv) given Russia's enormous size, measures to increase the Bank's impact through enhanced dissemination, outreach and scaling up will be important; (v) recent progress in improving portfolio quality and speeding up implementation has been encouraging, but both the Bank and the Russian authorities will need to be diligent in staying the course given Russia's difficult operating environment (bureaucracy, slow decision making); (vi) Russia will continue to be a high cost country in which to operate, which reflects Russia's size, the significant time taken to build consensus on future policies, and the slow pace of government decision-making involving multiple reviews of new projects and delays in project implementation. At the same time, Government counterparts often prefer long-term Bank engagement on projects to prolong the use of Bank skills on project management and technical expertise; and (vii) decentralization has improved both the quality and timeliness of the Bank's work in Russia and should be sustainedinfuture operations - particularly as our work inthe Russian regions intensifies. The Rationale for Future Cooperation 36. The World Bank Group's current relations with Russia are unique. It has been a partner to Russia in its gaining a more prominent global role as emerging donor and G-8 chair. The Bank has also been coordinating and implementing substantial donor programs in poorer regions and elsewhere in Russia. The reasons for the unique and special relations lie in both the history of Bank-Russia engagement, and in Russia's rapidly changing economic conditions and growing global role. The Bank continues to be viewed by the government as an important credible and neutral partner in economic development. The Bank Group's programs in Russia, despite many challenges in implementation, enjoy a high degree of ownership. While the strong fiscal position of the federal government limits its borrowing needs, the country's immense regional diversity and remaining development challenges speak for the expedience of maintaining cooperation with the Bank in many areas. The Bank i s also uniquely positioned to facilitate Russia's growing role in the donor community. As the private sector in Russia has expanded, so have the opportunities for constructive engagement by IFC and MIGA. 37. The rapidly evolving economic and political situation in Russia has necessitated a transition to new modalities of cooperation. No longer needing external financing, the federal government i s demanding new and more diversified services in accordance with its status as one of the most sophisticated MIC clients of the Bank Group. The success with which the Bank and the Russian government can deepen relations on the basis of new modalities of operation have significance not only for the Russia program, but for the overall emerging strategy of the Bank for work in middle income countries. Russia is an example of a middle income country that has major significance for the entire ECA region, and can provide many lessons of value for developing and transition countries throughout the world. 38. Relations between the World Bank and Russia are already in transition, and this transition will continue throughout the CPS period. Consistent with current trends in the Bank's operations in Russia, future relations will be built primarily upon (i)the Bank's independent "on-time" policy advice on important issues facing the country; (ii)assistance in management of projects or public investments in priority areas without high lending amounts; (iii)continued strong levels of financing to the private sector, and increased financing to regional governments without sovereign guarantees, and (iv) the development of fee-for-service arrangements for the provision of technical and analytical work. The strategy of this CPS i s designedto support the completion of the current transition. 39. The government recognizes that the World Bank has comparative advantages in many areas that have high relevancefor Russia. During its 13 year history of engagement in Russia, the Bank has developed a significant capacity for bringing extensive knowledge and experience to bear in the country. This includes analytical work that places the Russian 16 experience in international perspective, institutional development in the private sector, public sector governance, and project management skills that remain valuable in the country at a time when the government itself is just beginning to develop capacity for multi-year project development, finance, and implementation. As a source of experience and knowledge, the World Bank engages in regular extensive monitoring of structural issues, and holds the most extensive databases on investment climate issues, governance, and private-public partnerships. The Bank has enormous relevant experience inthe design and implementation of infrastructure projects, and in building governance and budgeting capacity at the central and subnational levels of government. Finally, the Bank plays a leading role worldwide in the donor community, as well as in addressing global challenges as climate change, biodiversity, and infectious diseases. Annex 3 describes the Bank's comparative advantages inmore detail. Principlesof Engagementand Modalities of Cooperation 40. Bank support will be demand-driven and flexible within a strategicframework that reflects the government's medium-term program, and also builds on the Bank's agenda for well-performing MZCs.' Accordingly, key principles that will drive the orientation of Bank programs in Russia over the coming years are: (i) a strong demand orientation and flexibility of the Bank program in response to Russia's evolving needs; (ii) support for priority activities addressing Russia's key development challenges in accordance with the CPS strategic framework; (iii) use of the comparative advantages of the three parts of the World Bank Group (IBRD, IFC and MIGA), while further increasing their collaboration; (iv) support for systemic solutions with lasting impact on institutional capacity and potential for scaling up; (v) balancing federal level cooperation with selective, but increasingly deep, engagement with a small group of Russian regions and municipalities; (vi) leveraging scarce Bank resources with Russia's own budgetary resources, particularly as Bank lending volumes decrease; and (vii) effective partnerships with Russian institutions, including the private sector, think-tanks and civil society organizations, as well as with external partners (EBRD, OECD, the UN system, and bilateral donors with active programs in Russia). The Bank's lending and non-lending activities will be assessed as part of an annual consultation process with government in the context of government's budget formulation process which also sets out Russia's borrowing program for the coming year. Selection of activities for Bank support will be guided by government's demand for Bank services, the above key principles for Bank engagement, and the Bank's capacity to respond to new assistance demands. 41. The current dynamics of the Bank's program is characterized by a gradual shift towards new modalities of operation and instruments. Without introduction of such new modalities and instruments, given Russia's ample fiscal surpluses, future Bank lending, would be highly limited. At the same time, a program based on developing new modalities of cooperation as envisaged inthe CPS can expand and compensate for a shrinking traditional core program. As the Bank and the Government work towards resolving issues currently impeding wider application of proposed new instruments as discussed below, the Bank program in Russia would evolve into an "expanded" scenario. In this scenario, the Bank program would be shifting towards greater use of "new instruments", which in turn could form the new core of Bank activities in the post-CPS period. Thus, the CPS offers a flexible, yet cautious approach for Bank operations, mainly focusing on traditional instruments for a core program of activities in line with the planned available resource envelope for Russia, while investing limited resources into developing new areas of cooperation under the new instruments. * 1The CPS supports the major tenets of the Bank's recently approved strategy for engagement with Middle Income Countries entitled "Strengthening the World Bank's Engagement with IBRDPartner Countries", September 2006. 17 42. The IBRD program for the period of the CPS can be viewed as a combination of certain (shrinking) core activities that would be maintained even under a "low case" scenario of engagement, and expanded activities that depend on new business opportunities and modalities. The degree to which new business opportunities substitute for traditional lendingto the federal government over the period of the CPS will depend on the political and economic environment in the country. In the event that this environment will be less conducive than expected to the creation and expansion of new modalities of operation, core activities will shrink over the period of the CPS, and the post-CPS role of the IBRD could be reduced primarily to servicing Russia as an emerging donor and shareholder; At the same time, IFC and MIGA will continue their significant engagement in support of the private sector and foreign investment. 43. The CPS builds on the important adjustments already made to the Bank's program in Russia tofacilitate a full transition to new modalities of operation. Recent projects with the federal government have involved a higher share of Government financing (e.g. Hydromet, Cadastre), while other such projects are in preparation. Bank activities have been moving increasingly to the regional level. The Bank has begun a special program of assistance to the Southern Federal Okrug. The focus of much of the Bank's TA and AAA work, including the Country Economic Memorandum, has shifted to the regional and local levels. The first sub- national project without a sovereign guarantee, developed in cooperation between IFC and the Bank, was recently approved for the Chuvashia Republic. A fee-for-service TA assignment for a PPP highway project was implemented with the city of Saint Petersburg. A special AAA Advisory Council was created in 2005, consisting of the leaders of prominent Moscow and Saint Petersburgthink tanks. This Council gives advice on, and critical evaluations of, the Banks AAA work, and facilitates the establishment of joint projects. The Bank has conducted a significant restructuring of its Moscow office, including a realignment of skills, further decentralization of decision-making, enhanced multi-sectoral cooperation, and the introduction of an internship program for graduate students from Russian universities. To support its enlarged program, IFC has increased capacity in the field to improve client responsiveness and has organized the Moscow office along sectoral lines to ensure a comprehensive view on each sector of interest. 44. Focused engagement in selected regions and high eo-financing in federal projects also provide opportunitiesfor scaling up and maximizing the impact of the Bank's resources. Successful cooperation at the regional level though integrated programs that includes general analysis, diagnostics, and operations would provide models that can be expanded to other regions at a later date, with or without the direct participation of the Bank. In some areas the assistance that the Bank can offer the regions already represents a scaling up of lessons and experience of Bank cooperation at the federal level. Also, high co-financing of federal projects allows for their expansion beyond what Bank resources alone would deliver. Recently, the government has increasedits co-financing of a number of on-going projects as a means of scaling up the project's scope or range. 45. The Bank's AAA work aims to ensure continued capacity to contribute to important policy debates in the country, both in regards to domestic issues and Russia's global role. The Bank has successfully served as a depository of international experience for the highest level of government on various issues. The government has profited from analytical work in many areas, and has referred to the Bank for advice (in,the form of both in-depthdiagnostic reports and brief notes) on issues ranging from implications of various tax policies, establishment of domestic development institutions, and arrangements for donor funding. Providing high quality advisory services will be essential to the Bank's value to Russia in a time when the government and Russian think tanks are demanding more specific and nuanced international expertise. As such inquiries are expected to continue, the Bank aims to maintain a minimum program of core diagnostic AAA along the lines of economic monitoring (Russian economic report, poverty work, strategic sector dialogue), and advisory services in low-income regions to the extent possible. 18 Regional AAA is expected in developing regional strategies and local investment climate assessments, especially for regions where the Bank Group may be expanding its lendingservices. Inthe interest of strengthening government capacity, "staff secondment" arrangements to engage Russian experts more actively in the Bank's work in other client countries and international events are envisaged. Inaddition, WBIwill continue to support Bank work with specific capacity buildingactivities inthe regions (see below). 46. As in other well-performing MICs, AAA work is expected to move increasingly towards reimbursablefee-for-service arrangements. To continue delivery of a comprehensive analytical and advisory program, the Bank will work with federal and regional authorities in moving towards a more streamlined approach in developing such fee-for-service arrangements along the lines of developments in other well-performing MICs, including the signing of a framework agreement between the Bank and government that would include principles of cost recovery. Under this instrument, the Bank reaches agreement with a non-commercial entity to deliver analytical work on a fee-for-service basis. The assistance would include knowledge transfer in the interest of developing local capacity. The Bank would only offer such services if the requested expertise i s not available in the market. A large part of reimbursable TA provided by the Bank in various countries has involved consultative services for large-scale infrastructure investments, especially those based on private-public partnerships. The first such experience in Russia was with the City of St. Petersburg for construction of the high-speed diameter ring-road. Initial discussions with various regions suggest interest in other types of work in addition to public investment projects, including diagnostics of regional growth and economic competitiveness, investment climate monitoring and benchmarking, reforms in the social sector, and asset management services. The scope of the Bank's "reimbursable TA" program in Russia could reach about US$1million per year towards the second half of the CPS period. 47. Along the same lines, the Bank and the government are developingan instrument to allow the application of the Bank's project design and management skills to federal projects without Bank lending. While projects in the current pipeline are being developed with a high share of financing by the Russian government, even this approach has important drawbacks in the current Russian political context in the light of huge fiscal surpluses. Given the Government's interest in tapping the Bank`s skills in project design and management, a new instrument i s being jointly considered that would provide such skills for government financed programs and projects on a fee-for-service basis. It would allow Bank advisory support in a larger number of government programs - either at the federal level or in regions on the basis of federal funding. Such instrument must accommodate the Bank's fiduciary policies and preempt possible reputation risks. In general the Bank and the government will continue discussions for developing additional instruments that can both exploit the Bank's experience and knowledge without muchreliance on federal borrowing. 48. The World Bank Group intends to maintain current levels of finance for the private sector and expand regional lending without sovereign guarantees. IFC and MIGA will maintain strong support for private sector development by focusing on priority areas aligned with overall Bank Group strategy, in particular investments in financial institutions, infrastructure, and services and production where Russia has a competitive advantage, or where investment will contribute to the diversification of the economy. IFC will continue to emphasize the development of good corporate governance in it investments, and an increasing area of focus in both investment and advisory work will be environmental sustainability. In addition, it is expected that the new joint IFC/Bank Sub-National Development Program will finance 1-3 projects (about US$25-100 million) per year in support of mainly infrastructure investments in creditworthy regions and public utilities. Care would be taken that such sub-national projects are in line with federal priorities and fiscal considerations, and based on prior consultations with federal 19 authorities for each such proposed transaction. Box 3 provides further details on the IFC/Bank Sub-National Development Program. Box 3: The Joint IFC/BankSub-NationalDevelopmentProgram The joint IFC/Bank Sub-National Development Program offers a new financial instrument: sub-national loans without sovereign guarantees. The Bank Group responded to the demand for such new sub-national financial products in 2003 by establishing a Municipal Fund within IFC. In June 2006, the Bank's Executive Director approved a Joint IFCBank Sub-National Development Program that builds on the experience of the Municipal Fund and similar initiatives of other IFIs. The Program taps into the comparative advantages of IBRDin supporting reforms o f local government, utilities, investment planning, and public expenditure management, and IFC's experience in managing a diverse set of financial instruments and investment operations. Thus, the Program provides technical assistance for financial management, support of reforms, public investment through provision of guarantees, loans, or equity finance, mainly in local currency. The Program has been approved for a three-year pilot period, coinciding with the CPS, with commitments of US$800 million for financing and US$6 million for technical assistance. The Program is to be managedjointly by the IBRD and IFC. A first sub-national operation in Russia has been approved, and a number of other proposals from regions are currently under discussion. It i s expected that lending from the Program in Russia will amount to about US$25-100 million per year during the CPS period. The highest demand for sub-national financing would be for capital investments in municipal or rural infrastructure and utilities, with some regions interested in other sectors, such as tourism or forestry. 49. The administration of grants and development of the carbon market could also become important parts of the Bank's activities in Russia, provided processing at the federal level can be accelerated. With the introduction of the GEF Resource Allocation Framework in 2006, Russia could access a country allocation of about US$50 million in the climate change focal area and US$lO-20 million in the biodiversity focal area during the 2006-2010 GEF replenishment period, as well as additional funds for other areas. The Bank's Post-Conflict Grant Facility also offers development opportunities to conflict-affected territories (e.g. the Northern Caucasuses). Federal processing of such grants has been slow, and will require more efficient procedures for preparation, approval, and monitoring of grants at the national level, along with mechanisms for joint implementation and supervision of grants by federal and regional authorities. Russia has significant potential opportunities for tapping into the carbon market, both in the use of its existing carbon allocation and through a "green investment scheme" for expanding its allocation. Lending to regions and the private sector could be combined with carbon finance revenues, which would make Bank financing even more attractive and provide incentives for the adoption of low-carbontechnologies for increasing energy efficiency. Bank Instruments by Clients 50. There are four main "constituency" groups for Bank assistance in Russia: (i) the federal government, sectoral ministries and agencies, which value the Bank's overall assistance, including that in global affairs and the support of Russia's expanding donor role; as well as the Bank's sectoral knowledge both in regards to formulation of important policies and implementation of long term public investment programs; (ii) regional governments, which want to cooperate with the Bank on both developing their reform agendas and accessing the Bank's financing products; (iii) the private sector, which receives financial and technical assistance from IFC and guarantees from MIGA for expanding operations in Russia and abroad; and (iv) Russian think tanks, experts, and NGO community, which highly value the Bank's independent opinion on important policy and reform processes in the country, and access the Bank's international knowledge and experience. The Bank's program over the CPS period will seek to address key needs of these groups of Russian clients by using a broad array of instruments as shown in the 20 following table and elaborated below. In the course of current discussions between the Russian government and the Bank, additional new instruments could also materialize duringthe period of the CPS. ClientdBeneficiaries BankInstruments agencies ReimbursableTA 0 Bank's TF Mechanisms 0 Grants Asset Management WBI capacity building activities IBRDLoans 0 Partial Risk Guarantees 0 Carbon Financing Regional Governments Analytical and Advisory Activities Carbon Financing Private Sector 0 Analytical and Advisory Activities IFC Financing 0 MIGA Guarantees Carbon Financing Civil Society & Academia Joint Analytical and Advisory Work Reimbursable TA (i)Analytical and Advisory Activities Conventional AAA: Continued analytical work in partnership with local think tanks to the Government and ministries on the state of the economy; important policy and sector issues; and on priority areas for poor regions. Reimbursable TA: Additional analytical work and technical assistance can be provided by the Bank on reimbursable basis including preparation of strategies and sector analyses for regions; technical support for specific investment activities (e.g. PPPs in infrastructure, projects supported by the Investment Fund, etc.). Special reimbursable TA arrangements are foreseen to provide Bank advice on project design and management for investment projects fully funded by the Federal and regional governments. Assistance to the Government in transformation to a donor country: Includes short notes in the framework of G8 process, and TA on exposing Russian experts to the international aid architecture and instruments. IFC technical assistance: Primarily through FIAS and the Private Enterprise Partnership (PEP), IFC will continue to support improvements to the business enabling environment, the introduction of new products in the financial sector (e.g. housing finance and securitization), the promotion of socially and environmentally sustainable development (e.g. through work to support occupational health, community and SME development around large investments, financing of energy efficiency, and cleaner production). 21 (ii) Financing and Guarantees Conventional IBRD loans with large share of Government co-financing: Limited number of IBRD Loans with high-level of co-financing by the government. The focus will be on piloting innovative mechanisms that can be later scaled up using federal funding and for supporting priority operations inregions with weaker financial performance. IFC and MIGA support to the private sector: IFC and MIGA will continue their strong levels of investment and guarantee operations, with increased focus on regions beyond Moscow. IFC will support the increased deepening of the financial sector through support to the development of other sources of financing, including municipal bonds, securitizations, and increased local currency financing. Partial Risk Guarantees: A few IBRD PRGs are expected, especially in the infrastructure sector. Subnational Loans: One to three subnational projects a year could be developed without sovereign guarantees, primarily focusing on regional infrastructure. Sub-sovereign lendingby the Bank Group's Sub-National Development Program will be aimed at creditworthy regions. Grants: One to three GEF, Post Conflict, or other grants during the CPS period could be prepared for Federal or regional governments for meeting global commitments (a grant request for US$20million for a Renewable Energy project i s under preparation). Carbon Finance: A number of carbon finance projects could be prepared a year benefiting private businesses, utilities, or municipalities for improving energy efficiency and meeting global commitments under the Kyoto protocol. (iii) Special Services WBI capacity-building activities: WBI's programs will combine learning programs and training courses with TA programs designed and delivered together with the Russia country team. Box 4 provides further details. Asset Management: The Bank's Treasury can provide its technical assistance on asset management for better management of Russia's oil revenues on federal or regional levels, basedon introduction of appropriate legal instruments. Bank's Trust Funds Mechanisms: The Government plans to use the Bank's TF mechanisms for delivery of its aid commitments as Russia's donor role expands. Box 4: WBI capacity-buildingactivities During FYO7-09, W B I expects to maintain an active demand-based capacity building program in Russia. WBI's programs will combine learning programs and training courses with T A programs designed and delivered together with the Russia country team. Programs will be multi-year and closely aligned with the analytical work of the Bank and TA activities of FIAS and IFC. Provision will also be made to allow for rapid response to emerging areas of key strategic significance, identified jointly with the Country Director and country team. Design and delivery of WBI's programs benefit from excellent Bank and local partner relationships. Insupport of the Banks focus on regions, WBI i s already paying closer attention to capacity building in the Southern Okrug, working with the various levels of government and with broad sections o f the society, including local and international partners. WBI will continue to play an important role in supporting dissemination o f Bank reports and in creating a platform for policy dialogue, reform and consensus building in important areas such as increased governance in the public sector particularly at the Imunicipal level, support to SME development, trade and the WTO agenda, and improving competitiveness and investment climate inRussia. I 51. In order to fully utilize the various instruments described above, the Bank and Government need to take a number of actions, including (i) synchronization of the Banks and government's procedures for preparation and implementation of IBRD loans and grants, (ii) 22 clarification of procedures for preparation and approval of subnational loans and of the Banks advisory services on a reimbursable basis, and (iii) the establishment of a regulatory framework for the implementation of Kyoto-related mechanisms. A process i s in place to address these issues, engaging the relevant Russian authorities and representatives of the Bank. The speed and scale of resolving them will have implications for the size and composition of the program. Strategic Priorities for the CPS 52. The World Bank Group's program for the coming years will be guided by the priorities of Russia's medium-term program, and be directed at areas where the Bank's comparative advantages can help in addressing Russia's outstanding development challenges. Accordingly, the strategic priorities for the CPS correspond closely to the pillars of the previous CAS in supporting Russia's overall goal of improving the well being of its population and decreasing poverty, which will be realized primarily through dynamic and sustained economic growth and a more competitive economy. In support of this overall country goal, the bulk of World Bank Group activities in Russia over the coming three years will be directed to achieve progress infour areas: (i) sustaining rapid growth (including diversification) (ii) improving public sector management and governance; (iii)improving the delivery of social and communal services, and (iv) enhancing Russia's global role. The World Bank Group's involvement inall of these areas would correspond to its specific comparative advantages, as noted above (also see Annex 3). 53. Given the needfor significantflexibility in Bank cooperation in Russia, the Country Partnership Strategy outlines a broad menu of activities that may become focal points of the program during 2006-2009 at both the federal and sub-national levels. Not all of these activities or operations will likely be implemented during the CPS period. The actual program will depend on how demand for and supply of Bank skills and services correlate, as well as on progress inaddressingcurrent constrains on both sides inthe development and application of new instruments. The broad strategic framework for Bank involvement is in the following Figure. Bank involvement in each of the strategic pillars is discussed below. As shown, the Bank's growing activities in the regions would be guided by the first three pillars of the strategic framework which also apply to the Bank's federal level involvement. The indicative outcomes of this involvement are set out inthe attached results matrix (Annex 4). Figure 9: CPS Strategic Objectives Overarching Country Objective I Sustainedimpiovementsinthe well-beingof the populationanddeclines inpoverty 1I Sustainingrapid Strengtheningpublic Improving delivery EnhancingRussia's performance communalservices t t RegionalFocus:Strengtheninggrowth, governanceand service delivery 23 SustainingRapid Growth 54. The World Bank Group will assist Russia in various ways in meeting the challenges of sustaining rapid growth. This includes active participation in macro-policy debates, monitoring the investment climate, supporting public investment and PPPs for growth and diversification, working with regions to identify and overcome barriers to growth, supporting investments in priority areas at the regional level, and providing direct assistance to the private sector: Macroeconomic policy and the effective management of Russia's large external inflows: The Bank will contribute to the macro-policy debate in Russia through the Russian Economic Report, on-demand policy notes and knowledge sharing. Advisory services can include training and impact monitoring activities related to WTO accession. In addition, there is strong interest in the Bank's technical assistance in advising on alternative uses for the windfall oil revenues, including the development of an institutional framework for the effective management of a growing diversified portfolio of foreign assets. The World Bank Treasury has experience and expertise that can be valuable to Russia in this area and has held initial discussions with the authorities on possible support. Investment climate monitoring and policy advice: The Bank will continue periodic BEEPS surveys, regional investment climate assessments, and administrative barriers studies undertaken by FIAS for interested regions. The Bank and MIGA can work at the regional level on capacity building and the development of investment promotion programs for attracting FDI, similar to the initiative currently underway in Rostov Region. WBI will continue capacity-building activities related to investment climate assessments. Supporting Government investment and PPPs for growth and diversification: Two separate projects in support of developing Special Economic Zones and IT Parks (both in FY07) have the goal of promoting the diversification and the agglomeration of economic activities in Russia. A microfinance infrastructure development project (FY08) focuses on financial cooperatives and their integration into the financial system of the country. On-going investment projects support land registration and the development of a national cadastre for securing property rights and the development of land markets. Possible partial risk guarantees of the Bank to the power sector could help attract investment to the electricity sector for modernization and substantial increases in capacity. And another partial risk guarantee instrument may be used to support the construction of an aluminum complex (SUAL) in Russia's Komi Republic, possibly alongside an IFC investment in the aluminum complex. Other areas for possible IBRD projects relevant to sustaining rapid growth include support for science and technology development, modernization of the chemical sector, and forestry. In addition, regular and reimbursable TAs will support development of PPPs across sectors. Working with regions to identifv engines of growth, develop growth strategies, and remove barriers to growth: The Bank will continue thematic Country Economic Memorandum focused on relieving barriers to growth at the subnational level and on questions of regional agglomerations. The development of fee-for-service arrangements with the regions would provide another promising avenue for supporting preparation of 24 regional investment strategies and growth analyses, and provision of other analytical services. Supporting investments in priority areas at the regional level: The IFCBank Sub- National Development Program will support important regional public investments. The government i s particularly keen on developing this financing mechanism further, as it involves direct lending to well-performing regions and municipalities without sovereign guarantees. One to three such sub-national operations per year are contemplated over the CPS. Infrastructure is also an important area of IFC investments. This concerns primarily transport and logistics, but also includes municipal infrastructure. MIGA can play a role in supporting foreign direct investment in infrastructure at the sub-sovereign level, including inthe water and solid waste sectors. Providing direct support to the private sector: IFC will continue to support Russia's private sector growth agenda through a combination of financial and advisory services to promote the growth of the private sector and the diversification of the Russian economy. IFC will finance projects (1) with important spill-over effects to other companies, such as infrastructure and financial markets, (2) in sectors where Russia may have a comparative advantage, for example the processing of natural resources and those that promote the knowledge economy, and (3) those increasing the range and quality of products and increasingly look for opportunities to participate in equity financing. Inthe real sector -- services available in the Russian market, particularly outside of Moscow. IFC will including infrastructure, extractive industries, manufacturing, high-tech, media./IT, and agribusiness -- IFC will continue to support mid-sized local companies without other access to long-term financing. Even with larger corporates, IFC has a role in selected projects where there are key environmental and social issues and scope to improve corporate governance practices. Much of IFC's activities will remain concentrated in the financial sector, where priorities will be: building long-termrelationships with medium-sized independent private regional banks, so as to increase competition and the range of services available to the population. IFC financing, provided in the form of long-term senior loans and, in selected cases, subordinated loans, will help to strengthen the banks' balance sheets, reach new clients (including SMEs), attract more depositors, and consolidate their position as leading regional banks; supporting the introduction of specialized banking products, including mortgage financing, consumer finance and leasing; supporting the process of privatization of state-owned banks, as and when requested by the Russian Government; and supporting development and use of new financial instruments, such as partial guarantees of local currency bonds and securitization. Continuing I F C advisory work through the Private Enterprise Partnership and FIAS: This technical assistance will address the following objectives: (a) increasing the development impact of investments through strengthening local suppliers and engaging in community development work around large investments; (b) building the capacity of private banks to deliver new product lines, such as mortgage finance and financing for energy efficiency; and (c) improving corporate governance and environmental sustainability through work with banks and real sector clients, including IFC investees. FIAS will continue to work with select regions to improve the business climate by assisting in implementation of policies/instruments to kick-start functioning markets of land and commercial real estate. Other opportunities for FIAS to support improvements in the business climate include: mainstreaming Doing Business indicators in Russia on 25 the sub-national level; piloting Municipal Scorecards; land and real estate monitoring; regulatory and administrative simplification activities, including on a fee-for-service basis in better-off Russia's regions; and implementing market-based Corporate Social Responsibility activities in sectors of global importance (e.g., promoting sustainable forest managementby assisting inintroduction of voluntary certification schemes). MZGA will continue to supportforeign investors through theprovision of political risk guarantees: Supporting foreign investment in infrastructure, in close coordination with the Bank, will remain an important area of MIGA's activity in Russia. In the financial sector, the Agency will continue to explore opportunities to support capital markets transactions, including asset-backed securitizations. MIGA may also continue to promote the role and assist inthe expansion of foreign banks inthe Russian banking sector. Areas for potential further involvement in Russia include the manufacturing, agribusiness and services sectors. Improving Public Sector Management and Performance 55. Public sector management has been a particular area of strength of World Bank work in Russia, which will be further deepened in coming years. The Bank will remain engaged in supporting programs for modernizing selected public sector institutions, improving government administration, the judiciary, local self-government, and budgetary management at federal and sub-national levels. The Bank will expand its engagement inregions inthese areas, in accordance with the federal priority for improving public sector performance at the subnational level. Modernizing selected public sector institutions: The completion of on-going projects, together with a new project in the pipeline, will contribute to the modernization of public institutions and improved public services. These include tax modernization, customs development, cadastre and registration, fiscal federalism, performance-based budgeting, treasury development, and a statistical development project (FY08). Supportingthe governmentprogram in administrative reform: The Bank will continue its close engagement with the government in the area of administrative reform at the federal and subnational levels, including the coordination and implementation of substantial donor funds. The primary goal will continue to be bringing Bank and international expertise to bear on the implementation of the government's program for administrative reform, which currently places a strong emphasis on encouraging initiatives at the subnational level. So far, the Bank has concentrated subnational work in the Southern Federal Okrug and regions in the North-West. A possible project could be also developed to promote administrative reform in lagging regions. 0 Stepping up engagement onjudicial reform: Assistance onjudicial reform also involves the coordination of donor funds and special cooperation at the regional level. A new project is currently under development for judicial reform (FY07) with a focus on improving dispute resolution, the enforcement of laws, and the transparency of information Supportfor budgetary reforms: The Bank will continue to respond to the demands of the federal and some regional governments for assistance in budgetary reform and the development of performance-based budgeting. In addition, the Bank will remain a partner to the government in the continued scaling up of the Fiscal Federalism Project (now financed by the Russian government) and its expansion to the municipal level. 26 Supporting the reform of local self-government: The Bank will continue its dialogue with the government in this area, and in brining international experience to bear on this vital area of reform in Russia. A study has been launched for monitoring and assisting the development of local-self government in rural areas in the Perm, Penza, and Adygeya regions. The Bank will seek to engage directly with regions and municipalities in this area on the basis of new modalities, including a discussion of replicating the positive experience of the Fiscal Federalism Project model for buildingcapacity at the municipal level. Investments in municipal development: On-going and possible future regional projects have significance for overall municipal development and the quality of municipal services. This includes the current Kazan and Saint Petersburg municipal development projects, a housing and communal services project under preparation (FY07, also see below), and possible regional projects on water and heating system upgrades. Supporting anti-corruption initiatives: As a coherent national-level anti-corruption program may begin to take shape, the Bank will explore avenues of possible constructive contributions to such anti-corruption initiatives. Improving the Delivery of Social and Communal Services 56. In addition to continued general cooperation with the federal government, the Bank will concentrate much of its support for improving social service delivery at the subnational level. As noted above, the Government has prioritized the social sector and social services in its medium-term program. Given that the primary responsibilities and initiatives for reform in the area of social and communal services will be at the subnational level, the Bank will concentrate its focus on the regions. Main activities include the continuation of work in the areas of poverty, education, and health in cooperation with the regions. Additional activities include the monitoring of social trends and service delivery quality (joint with USAID) and special employment-related activities in the Southern Federal Okrug (the development of decentralized employment services, and labor integration of youth). Another critical area for improving living standards is provision of housing and communal services. The government places high importance on improving the performance of the housing and communal services (HCS) sector and on the delivery of high quality services by communal enterprises, and closely links service provision with improving the quality of life. In this context, modernization and reforming of HCS was included inthe recently approved Medium-Term Government Programfor 2006-2008. Continuation of thepoverty work: In addition to continuedcooperation with Rosstat and federal ministries, the emphasis of the Bank poverty work (in cooperation with DFID) has moved to the regional level. The Bank i s working, and will continue to work, directly with regions on monitoring poverty and improving social assistance programs, including labor market policies. Regional social protection strategies for Tver, Tomsk, Kalmykia and three other regions will be developed with Bank assistance. Successful models of cooperation can be scaled up to similar regions. Zmproving the health of the population: The Bank will continue its engagement with the government on adult health, and the development of a national strategy to improve the health of the population, with the goal of reversing the strongly negative trends in premature mortality and morbidity. As a follow up to earlier child welfare efforts and jointly with international donors the Bank will assist in design and implementation of practical mechanism for family support, preventive social welfare and child care at federal and regional level. Additional advocacy, public awareness and information sharing efforts jointly with government leaders, public figures, private sector and NGOs 27 will be undertaken in support of critically needed government policies in this area. Another priority i s to advise federal and regional authorities on appropriate risk pooling, insurance, and sustainable health financing. IFC will continue working with private companies on programs for occupational health, including HIV-AIDS issues. The Bank will implement on-going projects in the health sector and offer to scale up or modify existing models at the subnational level as a service to regions. The development of public-private partnerships in the health sector could be supported jointly by TA from the Bank and direct financing by IFC to PPPs and/or purely private providers. Lessons from the TB/AIDS project could be applied through more focused interventions in interested regions through subnational projects and TA. A few regional projects could be supported for removing environmental hotspots and addressing other environmental concerns posingmajor health risksto population. Modernization and improvement of the education system and vocationaltraining: The Bank will complete current projects in education designed to modernize the system and improve vocational training. As i s the case for the area of health, the Bank will seek to meet demands of regions for special support at the subnational level for education reform. Regional TA and possible projects could focus on improving systems for professional and vocational education, accompanied by parallel assessments of local labor markets with an eye to improving the quality of local professional labor supply. The recently completed Youth Strategy by the Bank provides recommendations for improvements in youth policies, with possible applications to Russia for forwarding the dialogue on youth policies inthe area of education and training. Improvement in the provision of housing and communal services: The Bank's support in the sector of infrastructure will largely focus on improving quality of utility services and housing. The Bank has a large portfolio focused on improving heating, water, electricity, and other municipal services in selected regions. This includes the current Kazan and Saint Petersburg municipal development, municipal heating, municipal water and electricity reform projects. A housing and communal services project (FY07) in support of reforms and investments in HCS on grant basis allocated to regions on a competitive basis, and an electricity generation guarantee (FY08) will continue Bank efforts on improving quality of utilities and housing services. Also, a large share of sub- nationallending i s expected to focus on improving these services. Housing finance and energy efficiency through ZFC's PEP program: IFC's PEP program i s currently focusing its work on two new product platforms in Russia: Housing Finance and Energy Efficiency, both of which are complemented by IFC investments in this area. The Primary Mortgage Development Project is working to streamline the mortgage lending process in Russia at two levels: first, the project works to consolidate the efforts of key industry stakeholders to improve the legislative environment for mortgage lending and to develop a set of standardized products for use across the industry; second, the project works with 8 financial institutions to assist them in improving internal operational practices. IFC's Sustainable Energy Efficiency Program in Russia combines IFC's advisory and investment capacity. The project makes credit lines available to banks for on-lending for energy efficiency projects, and provides technical assistanceto banks and private companies in order to raise the lendingvolumes available for energy-saving projects. The program has already disbursed its first credit line to Center Invest Bank in Rostov, and currently has a US$60 million pipeline of potential deals across all regions of Russia. IFC also runs a number of additional programs in Russia, including support for corporate governance in the banking sector, for improvement of forestry management practices inthe Northwest, and for development of local suppliers to the mining sector inthe remote region of Magadan. 28 Enhancing Russia's Global Role 57. The Bank has a strong commitment to support Russia's increasing global role, and assist the country infulfilling its global commitments. The Bank will continue cooperation with the Russian government in support of its emergence as an international donor and active member of multilateral organizations. Inaddition, the Bank will assist inestablishment of mechanisms and implementationof specific actions arising from Russia's global engagements, such as the Climate Change and Biodiversity Conventions, and pandemic diseases initiatives. During the CPS period, the Bank will also seek to share with Russian experts its analysis (and advocacy) that i s currently directed towards the traditional DAC donors. Specific areas for Bank's engagement inRussia are: Assistance in the formulation of an ODA strategy for Russia as emerging donor: The Bank will continue to assist Russia as an emerging donor, and will cooperate on the design of Russia's development aid strategy and the establishment of a national ODA system. Specific Bank support includes trainingbapacity events, information sharing, and advisory services. The Bank will remain engaged with Russia on international policy initiatives developed under Russia's G-8 presidency, including on Russia'a priority themes for international assistance - quality of education, energy poverty, and the spread of infectious diseases. Providing access to the Bank's instruments for channeling Russian developmental assistance: The Bank will help in arranging an Africa debt-for-development swap, the establishment of an Avian Flu Trust Fund, the implementation of the Education For AllEast Track Initiatives and Russia's participation in the Global Village Energy Partnership. It will also facilitate expanding Russia's role in IDA. Beginning with a high- level Emerging Donor Meeting in April 2006, the Bank i s assisting Russia in organizing development aid seminars and international events. The Bank will also seek opportunities for increased engagement of Russian experts in development policy debates, their participation in the Bank's work in other countries, and "staff secondments" for building capacity within the Russian Government for aid allocation and management. Fulfilling international obligations related to global goods: The Bank will assist Russia in developing procedures and mechanisms for implementing specific activities in the framework of the Climate Change and Biodiversity Conventions. TA is currently being provided on the introduction of low-carbon technologies and climate change mitigation. If the government moves ahead with the introduction of financial instruments for low-carbon technologies in Russia, the Bank would be ready to support the preparation and implementationof a number of carbon-finance projects. There are three GEF projects in the Bank's pipeline awaiting the establishment of a legal and institutional framework for their introduction at the regional level with federal oversight. Additional projects on biodiversity and climate change could also be prepared. The Bank will continue participation in the Ministerial Conference on Forest Law Enforcement and Governance in Europe and North Asia. Linking Russian companies to global markets: IFC and MIGA activities are also relevant to the expansion of Russia's global role. In keeping with its global strategic objective to encourage investment across emerging markets (South-South investment), IFC will continue to actively support strong, reputable Russian clients in investments elsewhere in emerging markets. Consistent with its strategic objective to support South-South investments through the provision of guarantees, MIGA will continue to proactively engage Russian companies planning to invest inemerging markets. 29 Focuson regions 58. A greaterfocus of the Bank's work on the regions requires a concerted approachand coordination. The Bank has ongoing activities and projects ina large number of Russian regions, involving close cooperation with the federal government. The number of regions in the Russian Federation is too large for effective coordination and funding of Bank activities inregions across the entire country. More effective collaboration at the sub-national level requires deep local knowledge and a strong mutual commitment. To both interest Russian regions and have an impact, the Bank will need to offer an integrated package of analytical and advisory work combined with financing where feasible. A deeper regional engagement during the CPS period therefore makes it imperative that the Bank focus its attention on a more limited number of regions where it can concentrate its work. Such a more focused approach would also allow the scaling up of successes achieved inparticular regions to other regions. 59. Based on the above principles, the Bank is working with thefederal government, in identifying a small sub-set of 6-10 regions that may become the target of concentrated work programs with the Bank. Regions are being chosen from wealthier, middle income, and poorer areas. Important criteria for the selection of regions for Bank engagement are (i) the willingness and commitment of the regional administration to work with the Bank; (ii)a past history of successful cooperation; (iii)the reform-orientation and competence of the regional administration; (iv) strategic importance of the region for Russian development and the existence of other similar regions for possible scaling up of successful cooperation; and (v) the region's creditworthiness and potential interest in Bank operations (for wealthier or middle income regions). Following initial engagement of selectedregions, the strategic directions and modalities of cooperation with the Bank will be included in a joint Memoranda of Understanding, to be signed with the leaders of the focus regions. As noted, Bank involvement at the regional level would involve a combination of targeted AAA on diagnostics of the local economy and investment climate, and development of regional strategies, coupled with selected lending operations to address key challenges. 60. The World Bank Group intends to concentrate some work inpoorer Russian regions, which are often in most need of development assistance. The list of priority regions will include some such poorer regions. IBRD engagement in poorer regions that lack creditworthiness will depend significantly on opportunities for participation in federal programs or the coordination of donor funds. IFC will make special efforts to support private sector activities in poorer areas. For some poorer Russian regions which have achieved creditworthiness, potential opportunities exist for fee-for-service activities or subnational lending without sovereign guarantees. Discussions on the development of new instruments will give particular attention to facilitating Bank work inpoorer areas. ExpectedBankGroupFinancingVolumesandPrinciples 61. Annual IBRD lending projects and volumes will be determined in consultation with the Federal Government as part of the consultations on its annual borrowing program. In accordance with Government's preferences, all IBRD lending i s foreseen in the form of investment projects. Currently, there are eight Bank projects in the Government-approved borrowing program, of which six lending operations (Housing and Communal Services, Judicial Reforms, State Statistics Systems 11, IT Parks, Special Economic Zones, Microfinance Infrastructure) and two guarantees. A set of broad principles would be followed in the selection and design of future Bank projects: (i)finance priority activities in accordance with the CPS strategic framework; (ii)finance activities as part of the Government's medium-term fiscallexpenditure framework; (iii) provide support for systemic solutions with lasting impact on institutional capacity and potential for scaling up and replication; (iv) avoid design complexity; 30 and (v) mainstream implementation arrangements within existing institutions, while ensuring sound fiduciary safeguards for project implementation. Annex B3 provides details of the initial Bank lending program. While the IBRD lending volumes are expected to be very modest for a country of Russia's size and economic performance, somewhat reduced lending may be warranted in case of unforeseen severe adverse developments on the macroeconomic or policy front. In the event of significant changes to the proposed strategy, a CPS progress report would be prepared for discussion by the Board. 62. Zn addition, Bank Groupfinancing and guarantees will be provided by ZFC, MZGA, GEF and the Carbon Finance Facility. IFC's significant commitments in Russia over the CPS period are expected to be in the order of US$700 million per year. Expected lending from the Sub-National Development Program i s expected to be in the order of US$25-100 million per year. MIGA's portfolio is expected to remain high. Potential GEF allocations are US$lO-20 million per year (the Bank i s preparing a US$20 million renewable energy project), with Carbon Finance projects possibly reaching US$lOO-300 million depending on the regulatory framework Russia i s currently preparing. As indicated earlier, successful and timely preparation of projects will require streamlining the Government procedures for project approval. FiduciaryEnvironmentfor BankLending 63. The procurement environmentfor World Bank projects in Russia continues to be complex despite recent efforts to improve the legal framework. In the past, a vast amount of often uncoordinated procurement legislation and norms complicated the realization of many Bank projects. A long-awaitedmajor procurement law for the federal, regional, and municipal levels of government was finally passed and entered into force in January 2006. On the positive side, the new law: (i) regulates public procurement at all levels -federal, regional, and municipal- thereby providing the basis for a single economic space, (ii)substitutes a single legislative act for previous disperse, confusing, and sometimes contradictory regulations, (iii)provides for advertisement and full disclosure of all procurement processes by electronic means on official websites, and (iv) creates the basis for electronic procurement in the future. The Law also provides mechanisms of control and review of complaints. Yet, in an effort to make the Law ``corruption-proof" it also prescribes a series of rigid procedures that are at the expense of flexibility and competition and incontrast to international best practice. 64. The Bank will need to remain vigilant in safeguarding sound procurement in Bank- financed projects. Even more so, as Bank projects with the federal government will be carried out with increased co-financing. Inthis context, the Bank plans to maintain intensive supervision of procurement in Bank-financed projects. The Bank will also maintain a strong dialogue with Government in the interest of improving the national procurement system and giving careful consideration to the possibility of using acceptable features of current or modified national legislation on procurement. Due to remaining significant differences between the new procurement law and the Bank's procurement guidelines, insufficient practice under the new legal framework, and the upward trend in corruption in Russia, the use of the national procurement systemi s not yet an option for Bank operations inRussia. 65. Thanks to concerted efforts, financial management risk for most projects has been reduced. In 2001, the Country Financial Accountability Assessment (CFAA) assessed the fiduciary environment of the Russian portfolio as high risk and recommended maintaining ring- fencing arrangements for fiduciary functions. Since then, the Russian government has acceleratedthe pace of reforms inpublic financial management. Main achievements and ongoing reforms include: (i) inthe area of budget preparation, formulation of a three-year federal budget; strategic planning and gradual introduction of performance-based budgeting; (ii) progress in the introduction of a new GFS-basedchart of accounts, and (iii) persistent delays associated with the 31 manual clearing procedures are expected to be overcome with the full implementation of the Treasury Single Account mechanism and its related information system. In addition on the Bank side, risk mitigating measures in financial management (FM) have been incorporated into project design and implementation, including: (i) development of a risk management framework and adoption of a risk-based approach for FM work, which helps focus attention and resources on particular areas of vulnerability; (ii) close work with client agencies at the project preparation stage to identify measures to mitigate fiduciary risks, strengthen controls and develop borrower capacity; and (iii) at the project implementation stage, monitoring the continuing adequacy of the FMarrangements and satisfactory implementationof action plans and controls' performance. As a result, the FMriskfor most projects i s now considered to be moderate. 66. Additional actions are planned over the CPS period to further reduce FM-related fiduciary risks and improve portfolio quality, including: (i) tightening some core FM practices and increasing emphasis on quality and effectiveness of FMwork, especially on aspects that have significant bearing on anti-corruption e.g., more rigorous follow-up on audit reports and management letters, and more intensive review of internal control systems; (ii)enhancing supervision activities, including close monitoring of identified high risk areas; (iii) extending consultations with FM quality assurance on project design and supervision of projects with high corruption potential; and (iv) linking FM supervision plans and resources with FM risk ratings. The impact of the reforms on the fiduciary environment will need to be assessed before contemplating greater use of country systems in Bank-financed projects. Inaddition, as the Bank moves towards sub-national lending without sovereign guarantee there will be a need to gain and/or update knowledge of the fiduciary environments surrounding the flow of funds, including both the central and sub-national governments. 67. To improve governance in the corporate sector, we expect the Government may request a comprehensive Financial Sector Assessment (FSAP), which would be conducted jointly with the IMF. The FSAP would be complemented and preceded by a Report on the Observance of Standards and Codes (ROSC) in Accounting and Auditing. The ROSC will . support reforms in the country's accounting and auditing framework and practices. It i s expected to provide the recommendations to the Russian Government on: (i) facilitating transition to the international standards in accounting and auditing, which should support foreign direct and portfolio investment in line with the country development goals; (ii)allowing investors to evaluate corporate prospects and making informed investment and voting decisions; and (iii) enhancing professional accounting education and thus the quality of accountants inthe country. Partnerships 68. Russia has benefited from a range of assistancefrom its various external partners. International donors have been actively involved in assisting Russia in the transformation process. International experience was actively shared and assistance provided on a broad set of macroeconomic management and business development issues, fiscal and public administration, institutional and structural reform and social policies. International donors played a key role in developing civil society and Russian domestic NGOs. But the scope of international donor ' assistance i s becoming more limited and selective as Russia economic performance is improving. It i s concentrating now on issues of good governance, budget and municipal reform, health sector and infectious disease control, including HIV/AIDS, poverty reduction, child welfare and social services development. A strong regional focus continues to be important for major donors like EU, USAID, DFID, CIDA and SIDA, with emphasis on the regions of the Northern Caucases, NorthWest and Kaliningrad. 69. Given the absence of a program, the IMF's role in Russia has been reduced to a surveillance and advisory function. In this context, the IMF has continued an active dialogue 32 with the government on macroeconomic policy and the regulation of the financial sector. The Bank will continue to coordinate its work in these areas closely with the IMF with the goal of reaching consensus and consistency in policy advice. The IMF has also continued valuable analytical work on the macroeconomic situation in Russia, which examines changing risks and vulnerabilities, and opportunities for a medium-term fiscal adjustment. 70. The EBRD has continued its strong involvement in Russia, primarily in the private sector. Since 2002, the EBRDhas maintainedannual investment levels in Russia of over EUR 1 billion, 80 percent of which has gone to the private sector. The EBRD has been particularly active inthe financial sector, energy, infrastructure, manufacturing, and, through the Russia Small Business Fund, the SME sector. Like IFC, the EBRD has been introducing new financial instruments in Russia, including ruble-denominated bond issues and loans in 2005, and working increasingly with regional administrations. Enhanced work in Russia is consistent with EBRD's general strategic goal to commit a larger portion of its work to the East and South of the ECA region. Infrastructure and PPP-related projects will be an increasing priority in the near future. The EBRDremains a vital working partner for the World Bank Group, particularly for IFC. To date, IFC and EBRD have jointly supported more than 20 projects in Russia. Most of these projects are in financial markets, general manufacturing, and private equity funds. This cooperation i s particularly valuable with larger projects, where neither organization can absorb the full exposure needed, and with local partners, where both can play a role in developing the company's capacity. 71. The Bank developed close working relationships and partnerships with various donor organizations in support of Russia's economic reform agenda. One prominent example i s the program on public administration and budget reformsupported by DFID, CIDA, SIDA, EU and a Bank-hostedjoint Donor Secretariat. The Bank has collaborated closely with the OECD on issues of tertiary education. The Bank and WHO jointly coordinated a partnership for work on improving governance in the Southern Federal Okrug, which included the active participation of USAID, EU, and DFID. A multi-sectorFinnishtrust fund is currently supporting a diverse set of regional development activities in the regions of the North West. DFID has also supported the Bank's poverty work in Russia. IFC's Private Enterprise Partnership in Russia i s currently funded by the Governments of Austria, Canada, Denmark, Finland, Switzerland and Saxony (of Germany) as well as by GEF. Meanwhile, USAID, EU, EBRD, DfID and SECO have supported FIASoperations inthe country. Results Monitoring 72. CPS results monitoring will be undertakenjointly with the Government. Monitoring will track progress towards achieving outcomes influenced by Bank interventions agreed to be undertaken as part of the CPS. Annex 4 shows an indicative results matrix based on agreed activities for initial Bank involvement. More specific results frameworks will be built into the individual Bank interventions. CPS results monitoring would be done jointly with the Government as part of the annual consultation process for assessing progress of the CPS and possible adjustments to the Bank program. These consultations would also provide inputs for updatingthe CPS results framework to reflect such adjustments. 33 CREDITWORTHINESSAND RISKS CreditworthinessandBankExposure 73. Russia's creditworthiness has improved significantly over recent years in tandem with a reduction in its external debt. The high oil prices of recent years have built up reserves, strengthened the fiscal position and by end-July 2006 allowed for the accumulation of US$67.2 billion in the Stabilization Fund. Russia became a net external creditor in 2004. In 2005 Russia paid off its outstanding US$3.5 billion to the IMF, as well as some US$20 billion in Soviet-era debt, includingUS$15.6 billion in prepayments to the Paris Club. This brought the total public external debt stock down to US$71.4 billion at the end of 2005 (or 9.4 percent of GDP), compared with US$97.4 billion (16.5 percent of GDP) at the end of 2004. In2006 Russia prepaid all of its remaining debt to the Paris Club (US 21.3 billion), which should bring Russian sovereign foreign debt down to 4.5 percent of GDP by the end of the year. The federal domestic debt stock is small, amounting to 4 percent of GDP at the start of 2006. The sovereign's commitment to pay its external creditors remains strong. By the end of April 2006, Russia became the fourth-largest holder of gold and foreign-currency reserves in the world. With oil prices expected to remain broadly at current levels over the forecast period, Russia would have no problems servicing its debt. es 74. At the sub-national level, the creditworthiness of Russia's strongest regions also continues to improve and offers expanding opportunities for lending without sovereign guarantees by the Bank Group's Sub-National Development Program .Higheconomic growth in industrially developed Russian regions and the service-oriented largest cities has led to increasing revenues. Inaddition, a series of tax, financial and legal reforms are reshaping Russian sub-national operational environment, influencing the financial profile and creditworthiness of regional and local governments. Standard and Poor's rates 11local and regional governments in Russia. The creditworthiness of Russia' strongest regions has improved over the past few years in line with that of the Russian federation, as evident by increased credit ratings (to "BB+" for Moscow and St Petersburg from "BB-" in 2002 and "CCC-" in 1998). But uncertainties associated with the implementation of the Russian inter-governmental reforms, the difficulties to sustain growth in industrial-based regions under the current circumstances (high oil prices and a strong currency), and the unevenrevenue growth across regions and local governments call for a cautious and selective approach for Bank Group lendingto regions without sovereign guarantees (suchlendingby the Sub-National Development Programwill be on IFC's books). 34 75. In line with the modest CPS lending scenario, IBRD's exposure in Russia's will continue to decline. IBRD's exposure inRussia is expected to fall from US$4.9 billion at end- FY06 to less than US$4.0 billion inFY09. Its share of the overall IBRDportfolio would decline from 4.7 percent to 3.8 percent over the period. Risks 76. Macroeconomic risks associated with Russia's oil dependency are considered low during the CPS period. The repayment of foreign debt and the rapid accumulation of reserves have insulated Russia to a significant degree from external shocks. A very sharp decline of oil prices could send ripples through Russian financial markets. Even in this event, government finances would be protected during the CPS period by the large accumulated fiscal reserve (Stabilization Fund). The Stabilization Fund (fiscal reserve) has accumulated resources to the point that it could sustain the government budget at current expenditure levels with oil prices under US$20 a barrel during the CPS period. Given that the Russia's dependence on foreign money concerns primarily sales of oil and gas, as opposed to inflows of foreign investment, its immediate macroeconomic vulnerability to changes in investor sentiment is lower than in many other emerging market economies. The immediate risks from a sharp fall in oil prices, together with a significant depreciation of the ruble, would likely be confined to the non-government financial sector in the short run, and could be contained through responsible macroeconomic policy and bank regulation. Simulations reported in Annex 1 indicate that significant economic growth and macroeconomic balances should be maintainedover the CPS period even in the event of low oil prices. A possible implication of Russia's high fiscal reserves for the Bank's program may be a further reduction of IBRD's lendingprogrambelow the already modest levels foreseen. Future Bank lending is focused on leveraging Russia's own funds through increased national co- financing. Ultimately, the Government will decide on borrowing from the Bank based on fiscal conditions and the alternative options for availing the Bank's value added, such as fee-for-service arrangements. 77. While macroeconomic risks are considered low, there are implementation risks related to the pace and the direction of economic reforms. Russia's political environment is currently stable. President Putinhas a strong mandate and enjoys a constitutional majority in the Duma. The executive branch has more leverage over regional and local governments than in the past. The next presidential election in 2008 i s not expected to lead to significant changes in policy. Nonetheless, there remains some uncertainty about the pace and the direction of economic reforms. While the current medium-term development program follows the general transition goals of the 2000 program, they also include more controversial areas of economic policy which have a mixed world experience. These include active state interventions along a `new industrial policy' which aim at stimulating diversification and the innovation economy. The Bank's involvement in areas such as the new economic zones and industrial parks help to bring best global practice to Russia for development of such policy areas. Differing views could also exist within the government on administrative and budgetary reform, particularly on the degree to which these reforms should or should not concentrate attention on increasing control of the federal center over sub-national bodies. Inthese areas, the Bank can play a valuable advisory role in transferring global experience and the state of knowledge on potential advantages and risks from the pursuitof one or another specific policy. 78. Finally, there are implementation risks in the Bank moving to a more regional approach and to the new modalities of operation. Some of the proposed modalities such as sub- national lending and the development of a fee-for-service advisory program are either relatively new for the Bank or limited interms of prior experience, and operational details are still evolving. To address these risks, the Bank will be selective in how it approaches the evolving work in the regions to ensure a critical mass and impact of its interventions. In moving to the new modalities 35 of operation, the Bank can build on the significant progress achieved with successful pilots already completed in many of the new areas. A complicating factor may be the recent public procurement and competition laws which appear not to exempt IFIs from competition with private market participants when seeking to provide paid services to all levels of government or direct sub-national lending. Consultations with the Government are underway to resolve this apparent bottleneck, through expeditious amendments to the laws and/or the execution of a stand alone framework agreement with the Government. 36 Annex 1 Page 1of 2 RussianFederation: Growth Scenarios for 2006-2009 1. Assuming that the Russian government sticks to its basic economic policy commitments, the Russian economy should continue to exhibit significant growth throughout the CPS period, although capacity constraints may increasingly limit the pace of expansion. For the CPS period, oil prices present the primary source of uncertainty for both for the pace and nature of future growth. Three scenarios considered below are projected for different oil price trajectories. In the medium and longer term, growth prospects will depend greatly on economic policy and reforms. This especially concerns the effective maintenance of macroeconomic stability, the development of infrastructure and energy, and measures to improve the climate for private investment, competition, and entrepreneurship. Growthprospects also depend on external factors other than oil. Higher international interest rates, for example, could deprive Russian enterprises of their current sources of relatively cheap finance, with implications for profitability and growth. As most foreign inflows come from oil and gas, Russia's macroeconomic position is not as vulnerable in the short term relative to most other countries in the region to changes in investor sentiment about emerging markets. 2. The table below presents base case, highoil price and low oil price projections for the Russian economy through 2009. In the base case, the oil price declines gradually from an average price of 65 dollars to 55 dollars a barrel by 2009. The high case scenario assumes an increase of the oil price to 95 dollars a barrel in 2009. Finally, a low case scenario assumes a significant decliningtrend inthe price of oil, down to 35 dollars a barrel by 2009. Table :Economic scenarios: 2006 - 2009 2005 2006 2007 2008 2009 lilprice,$/bbl 55 base scenario 65 60 56 55 high price 70 77 85 95 low price 60 50 40 35 3DP growth, % 6.4 base scenario 6.8 6.0 5.5 5.0 high price 6.8 6.5 6.5 6.5 low price 6.5 5.0 5.0 4.5 nflation(CPI), % 12.6 base scenario 10 8 6 5 high price 10 10 10 10 low price 10 8 7 7 3eneral government fiscal balance, % GDP 7.6 base scenario 7.7 6.2 5.2 5.0 high price 9.0 10.4 11.2 13.8 low price 6.7 4.7 2.8 0.9 hrrent account balance, % GDP 10.9 base scenario 9.7 5.2 2.9 2.0 high price 11.7 9.8 8.7 7.8 low mice 8.5 4.3 1.6 0.4 ource: World Bank estimatesandprojections. Annex 1 Page 2 of 2 3. All three scenarios are consistent with the continuation of economic growth, macro- stability, and both fiscal and current account surpluses. Yet, they pose different sorts of policy challenges. Under the low case scenario, fiscal and current account surpluses largely evaporate by 2009. This scenario would most likely also be accompanied by a substantial weakening of the capital account. Quite probably, such a decline in oil prices would shake up the Russian financial sector and create serious problems in some commercial banks. The Central Bank should manage to isolate these problems in a handful of problem banks with high oil price or foreign exposure, and thereby prevent a general financial crisis. In this low oil price scenario, the manufacturing sector of the economy would receive a much-needed boost in competitiveness, but might also find itself more liquidity constrained in the short due to the problems in the financial sector. Due to this factor and slower growth indomestic demand, economic growth would be lower. Inflation would be higher than in the base case oil scenario due in part to ruble depreciation and higher prices for imports. 4. The high oil price scenario presents a challenge in the form of even larger balance of payments inflows. In order to keep inflation under control (at still 10 percent) and protect tradable sectors of the economic from an extremely rapid real exchange rate appreciation, the government would be compelled to generate ever greater federal budgetary surpluses, up to 14 percent of GDP in 2009. Inthis scenario, economic growth accelerates slightly to 6.5 percent of GDP, but this would be accompanied by an even more rapid decline in employment in manufacturing, with the movement of labor and other assets to non-tradable sectors. Restrictive macroeconomic policy would be essential for maintaining macroeconomic stability and preventing the overheating of the economy. An extremely rapid accumulation of reserves (By 2009, US$ 690 billion in gross currency reserves and a Stabilization Fund of over US$ 600 billion) would challenge the government to minimize the opportunity costs of delays or inefficiencies inthe investment of this money in a diversified internationalportfolio. 5. Inthe base case scenario, the current account andbalance of payments moves gradually toward equilibrium, and pressure on the ruble subsides somewhat. Annual GDP growth continues at five percent through 2009, and inflation falls to 5 percent. Thus, of the three scenarios, relative stability inoil prices presents the best opportunity for reducing inflation. Annex 2 Page 1of 13 Russian Federation: Development Challenges and Regional Issues 1. Russia's rapid growth, increased wealth and political stability since 1999 provide opportunitiesfor tackling a unique and di,fficult set of development challenges. They encompass remaining hurdles in economic transition to a market economy (judiciary, regulatory institutions, etc.), issues common to developed market economies (such as aging population, eradication of poverty), problems stemming from the dominance of extractive industries and the effects of "Dutch Disease," and Russia-specific tasks (more efficient development of its vast territory, of which a large part functions under harsh climatic conditions). SustainingRapid Growth 2. While the Russian economy should continue to grow over a wide range of possible scenarios, maintaining or accelerating the current pace of growth will be a challenge. Current annual GDP growth i s projected to be 4.5 - 6.5 percent over the next 5 years. While this i s a very respectablepace for a middle income country, this average growth falls short of the 7 percent target necessary to double GDP in ten years in accordance with the government's objectives. Achieving and sustaining high growth requires that the Russian government maintains macroeconomic stability, while at the same time realizingkey structural and spatial policies. 3. Macroeconomic stability remains essentialfor growth. Strong commitment to budget discipline and huge surplus revenues associated with high oil prices have transformed the macroeconomic environment, facilitating the elimination of budget deficits, the accumulation of reserves, and a major reduction in outstanding debt. But windfall oil revenues also imply new challenges. They underpin the financial strength of the government, but also present two types of important macroeconomic risks: (i) upward pressures on inflation and the real exchange rate and (ii)riskofpotentialvolatilityduetothehighdependenceoftheeconomyandgovernmentfinance a on oil prices. With regard to thefirst risk, the Russian government has shown notable monetary and fiscal restraint at a time of heated domestic demand, primarily by generating high fiscal surpluses and accumulating windfall revenue in a Stabilization Fund. Even so, annual inflationhas remained rather high at over 10percent. With regard to the second risk, few experts expect a sharpfall in oil prices at thepresent time. Nonetheless, oil prices have historically been quite volatile and difficult to predict, and this is a source of risk to Russia. A sharp fall in oil prices, and an associated depreciation of the Russian ruble, would likely cause problems for a number of Russian banks, as well as for some Russian firms that have accumulated significant foreign- denominated debt. 4. Rapidly growing reserves place a new and increasingly important demandfor quickly developing asset management capabilities in the government and the Central Bank. In the context of high oil prices, Russia has been accumulating fiscal and monetary reserves at an extremely rapid rate. So far, the corresponding fiscal Stabilization Fund is simply held as an account by the government at the Central Bank. As the size of this fund increases, the opportunity costs of not investing these reservesin a diversified portfolio are mounting. The fact that the fiscal reserve i s not so invested also increases pressures to use it for domestic purposes, which carries a high inflationary risk and could undermine macroeconomic stability. To counter these pressures and ensure more effective use of the accumulated resources, the Government has decided to set up a fund for future generations by investing a portion of the Stabilization Fund in a longer-term diversified portfolio. The fund has the potential to grow into an important source of income for Russia, playing a major role in meeting future social obligations and creating a large diversified source of income that will protect the budget against volatilities in oil and gas revenues. To achieve Annex 2 Page 2 of 13 this potential, Russia will needto make an investment inthe next couple of years into institutions of oversight and governance for portfolio management in correspondence with best international practice. 5. Diversification occupies more and more of a prominent place in Russian policy debates, as economic growth in Russia has become increasingly concentrated in non-tradable sectors of the economy. The inherited Soviet economic structure offered Russia few initial opportunities for international competitiveness outside of resource-related industries. The exhaustion of temporary factors that supported broad-based growth in the immediate post-crisis period, along with much higher oil and gas prices, once again favor the development of resource sectors and non-tradables relative to manufacturing. The strong appreciation of the Russian ruble can be associated with domestic labor costs that are, for example, roughly double those of neighboring Ukraine, which has comparable labor productivity. The recent Investment Climate Assessment suggests that, by contrast, Russian productivity in manufacturing i s close to that of Ukraine, as well as to China and Indiawhere labor costs are many times lower. Figure :Average labor productivityand wages in manufacturing in BRlC Countries 14 6 12 5 Io$ 4 8 3 0 4 2 2 1 0 0 Russia India China Brazil Source: World Bank InvestmentClimate Assessments 6. Diversifcation and development of the knowledge-based economy can be critical to Russia's future prospects. While Russia's current development model as a major energy supplier with a thriving and profitable domestic market is consistent with continued growth and welfare improvements for the population, this model also poses significant risks and arguably constrains Russia's economic potential. A high dependence on oil and gas makes Russia highly vulnerable to changes to commodity prices. Natural resource supplies in Russia are also not unlimited. Increasing evidence from the recent experience in economic growth suggests major advantages for countries that succeed in developing highly competitive manufacturing and innovation industries. Russia has potential advantages from a generally high level of human capital. A strong ruble and, consequently, high labor costs in Russia relative to many other middle income countries, suggest a natural specialization in highly-skilled labor. Thus, the degree to which Russia can succeed in igniting a competitive innovation-based economy will determine much for its prospects for sustaining highrates of growth over the longer term. 7. While Russia has made some important strides in improving the investment climate, further improvements will be needed for realizing the ambition of a dynamic, diversified, and knowledge-based economy. The Russian business climate still suffers from insufficient competition, a weak judiciary, the common capture of markets at the regional level, problematic access to land and premises, and remaining uncertainty over property rights. While the World Bank Group's Doing Business Report and recent ICA Surveys confirm that Russia may have, for example, reached or surpassed India and China by many of basic investment climate indicators (registration, taxes, permits, customs, inspections), many problems remain. Concentration in Russia is high. Evidence collected in the Country Economic Memorandum of 2003 suggests that almost half of all sales in the economy in 2002 may have been associated with 22 large business groups. While more recent comparable data is not available, partial evidence suggests that the concentration in ownership has grown still further in the last few years. This i s particularly true for Annex 2 Page 3 of 13 the share of government participation in the economy, which has been the cause of some concern. The process of "creative destruction," involving high levels of entry and exist in fluid markets, which i s vital for "the innovation economy," will need to be fostered in Russia through reforms that improve incentives at the subnational level for good governance (see below) and a further strengthening of market institutions. In recent years, more Russian businesseshave been citing corruption and unfair competition as significant problems for their operations. 8. The share in employment of small businesses and individual entrepreneurs remains quite low in Russia (26 percent) by international standards. This appears directly related to problems in concentration and unfair competition discussed above. Many of the remaining administrative barriers to business in Russia fall disproportionately on small business. Resultsfrom the ICA survey suggest that firms in Russia facing the greatest degree of competition (including SMEs) also face the highest reported investment climate constraints. A recent FIAS study on Russia highlightsin particular problems in access to land and premises for entrepreneurs. 9. Increasing private investment rates is essential to maintaining rapid growth. Fixed capital investment has been growing at double digit annual rates, although from a very low base. But it remains low in absolute terms relative to Russia's development needs. Fixed capital investment amounts to roughly 18 percent of GDP in 2005, which can be compared to rates of over 25 percent in most emerging market countries that have sustained rapid growth over a number of years. Potential investment growth, includingFDI, suffered in the context of the Yukos affair and other mixed signals coming from the government concerning the appropriate role of private capital in the Russian economy. The year 2005 witnessed progress in the clarification of these issues, but regulatory and other problems continue to limit investment, particularly more risky investments in the manufacturing sectorsof the economy. 10. Higher investment is needed throughout the economy: in extractive industries, manufacturing, transportation, electricity, and the social sectors. Investments in manufacturing are critical for diversification, and yet they are particularly low. Only 17 percent of fixed capital investment currently goes to manufacturing industries in Russia, raising concerns over the ability of these industries to increase productivity at a pace that would ensure their future competitiveness. A primary source of productivity increases in industry in recent years has been labor-shedding. Yet this source may now be reaching its limits. While the oil and gas sectors have attracted a large share of Russian investment in recent years, the estimated needed investment for exploration and the exploitation of new deposits i s much larger. Infrastructure in transportation, electricity, and the social sectors has suffered from neglect and low investment throughout the transition period. The government now has both the will and the resourcesto increase investment in infrastructure. 11. Infrastructure is very importantfor Russia's economicdevelopment.There is a growing demand for infrastructure services such as new roads, urban transportation, electricity and heat supply. At the same time, the extensive networks of existing infrastructure - including power, telecommunications, communal services and transportation developed during the Soviet time -- have not been properly maintained duringthe transition, which i s leading to deterioration of service quality and growing liabilities for rehabilitation. According to federal government estimates, the one-time rehabilitation needs of the communal services sector amount to around US$33 billion. In this context, the government has been increasing infrastructure investment, and is also malung significant efforts to facilitate private-public partnerships in the provision of infrastructure services. Some recent examples include establishment of an Investment Fund to support PPP projects, the adoption of a concession law, the preparation of a conceptual framework and draft legislative package for toll roads and the development of a mechanism for guaranteeing private investments in electricity generation. 12. The problem of infrastructure development is related to a more general dilemma that makes economic transition and sustaining rapid growth in Russia much more complicated than in many otherformer socialist countries, namely the spatial misallocation of people and capital. As a legacy of Soviet planning, a substantial part of the Russian population and capital stock Annex 2 Page 4 of 13 remains in cold and isolated regions, where the costs of maintaining infrastructure and production are relatively high and the prospects for developing competitive industries are relatively low. In this context, the government will need to make difficult decisions on where to concentrate its resources to support infrastructure and growth, and where to focus instead on encouraging out- migration to more promising areas. The development of potential growth points is also currently constrained by infrastructure, particularly in housing for migrants and transportation. In larger cities, as increased prosperity brings increased car ownership, development of urban transport infrastructure, urban traffic management and integration of public and private transport systems are key challenges. 13. While Russia has made substantial progress in many areas of economic reforms, housing and communal services, gas, and, to certain extent, electricity reforms are still far from realizing their true potential. This poses significant impediments for creating market mechanisms for the delivery of housing and utility services. Currently, the most ambitious reform program i s in the electricity sector, with two distinct and equally critical parts: the structural and market reform on the one hand, and regulatory reformon the other. Structural reform - particularly, unbundling the regional utilities, is proceeding fast, representing the most advanced component of reform and have the potential to result in a more efficient and competitive market structure. Russia is one of the most energy intensive economies on the planet. In2004, Russia's economy had consumed about 0.9 kg of oil equivalent per one US dollar of GDP, measuredby purchasing power parity (PPP), while the same rate in developed and even developing countries stands at 0.1-0.2 kg of oil equivalent per dollar. 14. Both the growth potential and possibilities for increasing efficiency in the Russian natural gas sector are very large. The sector i s dominated by Gazprom, the state-controlled company (5 1% state-owned after the recent acquisition of shares by the Government) which controls the Unified Gas Supply System (UGSS) and holds a monopoly for gas exports from Russia. Despite the remarkable growth in gas prices on international markets, Gazprom's productionlevels have been increasing at a much slower rate than the Russian economy as a whole (1.5% per annum over the last five years, as against an all-industry average of over 6.7%.). Lack of investment in the development of new gas fields and related infrastructure i s a particularly pressing concern, given the growing demand for gas both at home and abroad. 15. As the Russianpopulation shrinks and ages, labor supply is becoming an ever greater constraint on economic growth. The most recent Investment Climate Assessment of the World Bank and Higher School of Economics confirms that inadequate labor supply, most particularly skilled labor, i s already a major problem for many firms. Furthermore, the training of labor in Russian firms appears to be inadequate, while both formal and informal education systems are not oriented toward skills to support higher productivity. Medium term demographic trends are particularly unfavorable. Over the medium term, the loss in worlung population will become even more acute. A recent World Bank report, "Dying to Young," emphasizes the relationship between labor supply issues and the acute problems in the poor health of the population and premature morbidity. Thus, improving the health of the population i s a primary challenge in this area. Migration, both external and between regions, i s a particularly critical economic and political question for Russia in the context of a rapidly ageing and declining population. In addition, the current and insufficient quality of migration legislation and its weak enforcement pose substantial political and other risks to the country labor supply in the future. The government has been giving increasing attention to migration recently, i s developing programs to provide incentives for the resettlement to Russia of Russians living abroad, has drafted a new law on the registration of migrants, and made changes to the federal law on the rights of foreign citizens living in Russia. 16. The Russian banking sector is still small relative to the needs of the economy but growing rapidly and in need of additional capital. The Russian banlung sector has recovered and .. grown at a very rapid pace since it teetered on the verge of collapse in 1998-1999. After this crisis, the Central Bank refrained from any significant recapitalization or refinance program. Instead, most banks were left essentially cut off from refinancing or government contracts, needing to fend Annex 2 Page 5 of 13 for themselves or shut down. Inthe absence of deposit insurance, commercial banks (other than the State Savings Bank) wishing to work with household deposits had to compete for the trust of the population themselves. Under these conditions, a number of Russian banks rose to the opportunities provided by growing demand for finance from profitable firms. Credit to the non- financial sector has grown from negligible levels in 1999 to over 25 percent of GDP. Consolidation has begun, yet important problems remain. Vulnerability to an oil price shock i s a major concern. Many Russian banks are poorly capitalized, and the correct monitoring of bank capital in the Russian context of large business groups with low transparency i s quite difficult. Also challenging in bank regulation is the introduction and enforcement of IFRS reporting to the Central Bank. Important weaknesses also remain in institutions and procedures of resolution for problem banks. Two years ago, a reform that introduced state deposit insurance for household deposits has made it imperative for the Central Bank to improve its monitoring capabilities. A very large share of commercial banlung in Russia remains concentrated in a few large state banks, and competition in the industry is limited although growing with the entry of foreign banks and the growth of some Russian banks. 17. Development of the rural and small-town economy presents a particular challenge. 27 percent of the population lives in rural areas and 10 percent are employed in agriculture. This compares with EU 15 countries where 22 percent of the population are rural but only 4 percent are employed in agriculture. Especially in the more densely populated areas, there are substantial opportunities for strengthening and diversifying the economy through the creation of more flexible land markets, improved access to financial services, enhanced landscape management, and improved provision of basic infrastructure and social services. In this context, small businesses could assume a more prominent role in production and the processing of higher quality, higher value added food and agricultural products. 18. The rural economy still largely depends on agriculture, which still faces major structural challenges. Since strong growth of agricultural output following the devaluation of 1998, the sector growth has since contracted, and has been growing at 2% to 3% over recent years. The food processing sector, largely privatized, appears to be undergoinga gradual transformation in response to the increasing competition caused by a relatively open trade policy, changing patterns of consumer demand, and changes in the prices and sources of raw materials. Yet, remaining challenges include slow liquidation of unprofitable farms and the transfer of their assets to more efficient enterprises, inefficient input subsidies for fertilizer, credit (interest rates), and machinery, and some regressive trade and price policies. These slow down the shedding of loss making enterprises from the sector and impede growth in output and productivity. Although the proportion of loss-making enterprises i s falling slowly, 37% of agricultural enterprises are still loss-making 15 years after reform began. Overall budget subsidies to agriculture and rural development are much lower in Russia than in OECD countries. However there i s substantial potential to reorient these programs to focus more on delivery of public goods rather than on market interventions. Removal of remaining trade barriers and production quotas, reform of the present machinery leasing arrangements, support to further development of land markets, and support to effective weather basedcrop insurance systems are also priorities. 19. Environmental degradation may present a growing threat to Russian development in many areas. Pollution declined over much of Russia during the 1990s, mostly because of the decline in industrial and broader economic activity. Economic recovery i s bringing a new and different set of challenges. While forest management is beginning to incorporate broader ecosystem approaches and expenditures on protected area management are increasing, fires and illegal logging are still a threat to longer term sustainability, and tourism development needs to incorporate landscape management. Water resource and water quality management remain inadequate, and agricultural land management does not always take sustainability approaches into account. Energy efficiency is still low in Russia. In recent years, environmental matters have not occupied a priority place inRussia's reform and policy agenda. (See Box below). Annex 2 Page 6 of 13 Box :The Environment: A Growing Concern Environmental matters have not occupied a priority place in Russia's recent reform and policy agenda. Changes in the administrative arrangements for environmental management at central level, and decentralization, have led to increasing regional differentiation in the quality of environmental oversight. Government i s now voicing concerns over the lack of clarity in regards to natural resource protection and management and broader environmental oversight. Environmental degradation presents a threat to Russian development in many areas. Pollution as conventionally measured declined over much of Russia during the 1990s, mostly because of the decline in industrial and broader economic activity. Economic recovery i s bringing a new and different set of challenges. Industrial pollution legacies remain, and impede effective urban and peri-urban development in some areas, although much new industrial development uses modem, less polluting technologies. Rapid urban redevelopment, with disorderly land-use planning and poorly functioning land markets, impedes the development of livable cities. While forest management is beginning to incorporate broader ecosystem approaches and expenditures on protected area management are increasing, fires and illegal logging are still threat to longer term sustainability, and tourism development needs to incorporate landscape management. Water resource and water quality management remain inadequate, and agricultural land management does not always take sustainability approaches into account. A clear, transparent system of environmental management i s a key element inRussia's transition to a modem, competitive economy. Going forward, Russia's growing international prominence on the one hand, and growing living standards of people on the other, will most likely place higher demands on the quality o f environment in the country and responsiveness over global goods. In recognition of this Russia has recently undertaken a number of important initiatives; most prominently it ratified the Kyoto Protocol in 2005. I t also hosted an international conference on forest law enforcement and governance. The Banks program in environment has focused on support to federal institutions, through a Forestry Project focusing on improving the sustainability of forest management, an Environmental Management Project focusing on pollution abatement, and the recent National Hydromet Modernization project, aimed at improving weather forecasting services. There have also been a number of T A initiatives, on forestry, water quality management in a river basin context, and environmental legacy issues and modernization of the chemicals sector. In the absence of substantial borrowing for environment by the federal government, the Banks program in the next years i s likely to focus on support to improving energy efficiency through carbon finance, and on global public goods activities supported by the GEF across a range of programs. Inaddition, as the Banks regional program expands, it i s likely that the Bank will work on addressing specific environmental priorities facing regions, where there is a very substantial and challenging agenda. Possible investment activities on a federal level could focus on projects dealing with environmental liabilities and industrial modernization. The Bank will stand by ready to provide its technical assistance and advice to important national environmental initiatives, if needed. Public Governance 20. Weak public sector governance remains a key impediment to accelerating Russia's growth and improving the provision of social services. To a large degree Russian civil servants still operate under distorted incentives in an inefficient system of government administration that was largely inherited from the Soviet Union. So far there have been modest results from efforts to implement a far-reaching public administration reform, aiming to reduce the interference of the government in the functioning of the economy, improve the quality of administrative services, and increase the accountability of civil servants to the public. There exits an abundance of evidence that problems in public administration and the judiciary continue to be major obstacles to improvements in the business climate. Intergovernmental fiscal relations have also been a primary source of distorted incentives for governmental officials and budgetary inefficiency. Correspondingly, they have been the subject of major reforms that are still in the process of implementation. Annex 2 Page 7 of 13 21. Russia has been working to build a modern civil service and government administration, although these reforms arefar from complete. Duringthe transition period, the Russian civil service has suffered from the Soviet legacy of low pay, weak economic (performance- based) incentives, and an administrative apparatus riddled with inefficiencies and redundancies. This has been a source of corruption and a thorn in the side of the business climate. Recent years have witnessed some improvements. In particular, the pay for federal and many sub-national civil servants has been increased closer to market rates, the organization of the federal government apparatus has been streamlined, and evaluation and recruitment processes have been transformed. A strong emphasis has been placed on a better articulation of goals and the measurementof results in the evaluation of civil servants. Part of the current stage of the administrative reform concentrates on the regional level. Recently, the Ministry of Economic Trade and Development conducted a competition among Russian regions and federal executive bodies for federal financial support of regional programs. 29 out of 46 participating regions, and 19 out of 22 participating federal executive bodies, were awarded financial support on the basis of the strength of their proposed programs. Yet, the transformation of government administration in Russia is likely to be a slow and complicated process. This was illustrated well in 2004, when an attempt at a rapid leap forward in the re-organization of the federal government proved very disruptive to government operations inthe short term. 22. Intergovernmentalfiscal relations have undergone major changes since the 1990s, and significant reforms are still at the implementation stage. The fiscal federalist system of the 1990s featured a high degree of both formal centralization and informal decentralization. Saddled with excessive federal expenditure mandates and lacking their own explicit revenue sources, subnational governments created "shadow budgets" on the basis of informal bilateral relations with firms operating on its territory, and well as through debt offsets and various money surrogates. A system of soft interbudgetary transfers gave weak incentives for responsible fiscal management or performance in the formal system. Reforms since 2000 have introduced a more rational formula- basedtransfer formula, greatly reduced unfunded expenditure mandates, created a clearer and more stable division of revenue and expenditure assignments among different levels of government, and delegated more expenditure autonomy to lower levels of government. A centralization of political power has granted the federal government greater leverage over many of the activities of subnational administrations. A very ambitious reform in local self-government has created 1000s of new municipalities in Russia, and aims to establish genuine budgetary institutions at the local (municipal) level of government. Many regions are also following the federal lead in developing a medium-term budgetary framework and performance-based budgeting. A number of regions are pursuing and obtaining international debt ratings. Nevertheless, survey evidence suggests that problems remain in funding imbalances, continued budgetary pressures in the form of informal mandates (as recommendations), and perceptions at the subnational level that improved budgetary performance will be inadequately rewarded by the federal center. The implementation of the local self-government reform has been particularly complicated, due in part to problems of inadequate local capacity and unforeseen imbalances inrevenues and expenditure responsibilities. 23. Judiciary reform remains central to building rule of law in Russia. Recent Bank work on Judicial Systems in Transition Economies highlights the fact that building a strong demand and capacity for an independent and effective judiciary system has been among the most difficult institutional reforms in most transition countries. Russia i s no exception. Although the judiciary has become increasingly important for resolving economic conflicts in Russia since the 1990s, it still needs to improve its credibility among the population. Serious problems remain in the competency, training, and compensation schemes for judges, and in the ability of courts to enforce decisions. Information disclosure on court cases is insufficient. The government has made information disclosure (including computerization of the judiciary network) and better conditions for judge's particular priorities inthe current stage ofjudicial reform. 24. The Russian government has demonstrated a concern over the new evidence of corruption. After a period of decline during 1999-2002, recent evidence from business surveys (BEEPS in particular) indicates that corruption has taken an upward turn and appears to be a Annex 2 Page 8 of 13 growing obstacle to business. While survey evidence suggests that levels of corruption in Russia are not extremely high relative to other middle income countries, there is evidence from a number of sources that progress in battling corruption in Russia may have stalled or even reversed in the last few years. The period from 1999 to 2002 witnessed important successes in economic reform in Russia, including comprehensive tax reform and campaigns to combat "administrative barriers to business." The reduction of corruption as a barrier to business appeared particularly strong in Russia. In 1999, roughly half of all Russian entrepreneurs inthe BEEPS survey cited corruption as a serious impediment to their business. By 2002, this average for Russia fell to 29 percent. By 2005, however, the frequency of citations of corruption as a significant impediment to business in Russia increased again to 39 percent. The causes of the apparent recent deterioration in indicators of corruption in Russia in BEEPS data, which is mirrored in a number of other recent surveys, are not obvious. In fact, some of the important measures taken by the government to combat administrative barriers to business date from the 2002-2005 period. Other measures during this time in the budgetary sphere have increased the fiscal transparency at the federal and subnational levels, as documented inthe 2004 ROSC of the IMF. 25. To address these indications of increased corruption, the government is putting in place a number of initiatives. An anti-corruptionprogram of sorts i s beginning to take shape. One initiative i s a comprehensive examination of existing legislation in many areas from the point of view of closing loopholes for corrupt practices. The President has recently initiated major administrative shakeups in the Customs Service and some regional administrations. The administrative reform, which had been stalled since problems in implementation emerged in 2004, has received some new momentumin 2006. The reform in local self-government also has potential importance for strengthening accountability to the public and civil society at the local level. Challenges in the Social Sector and Social Services 26. Russia's main challenges in the social sphere will be sustaining the momentum in poverty reduction under lessfavorable conditions, and improving the delivery of social services, particularly in health, education, housing, and social assistance. These two goals are closely related. An important dimension of Russian poverty i s an increasingly problematic access to quality social services for poorer segments of the population due to sharp increases in formal and informal costs. Russia's new strategic orientation toward the active support of growth points brings new challenges for ensuring minimal welfare and opportunities for citizens in less fortunate regions, while the feasibility of migration to wealthier areas depends on improvements in housing and other social services in high growth areas. The territorial concentration of poverty is expected to increase. Poverty is already significantly concentrated in the republics of the Southern Federal Okrug, where political and social instability is a critical problem. (In the republics of the Northern Caucusus, per capita GRP in 2004 was below US$ 1560, and unemployment rates are commonly in the range of 20 percent.) Unfavorable demographic trends place an additional burden on health and pensions. Russia still has far to go in developing a social safety net, providing effective social services, and assisting the resettlement and retraining of a large part of the labor force. Thus, the social sector has become a very high priority for the government in its current National Projects and planned reforms in the government Medium-Term Program. 27. Poverty and social services are particular challengesfor regional and local levels of government. The division of budgetary responsibility delegates responsibility for most of the social sphere to the regional and local levels of government. This can be associated with a basic financial tension, as richer regions typically have more resources for social support than do poorer regions. The government corrects this, to some degree, through a transfer system that gives special priority to the poorest regions. While federal programs are important for leading reforms in the social sphere, regional and local initiatives are, and will continue to be, critical for addressing poverty and improving social services. This is particularly true as the new reform in fiscal federalism gives regions and municipalities considerably more flexibility on the expenditure sides of their budgets. In this context, a number of regions are already forging ahead in social reform, Annex 2 Page 9 of 13 including Nizhnyi Novgorod, Samara, Tomsk, and Chuvashia. Federal reforms in the social sphere will most likely be increasingly focused on regional pilots, initiatives, and co-financing. 28. Russia's unfavorable demographic trends present threats to future welfare and the provision of social services in addition to the labor supply issues emphasized above. For its level of income and development, the Russian Federation still exhibits disturbingly low indicators of life expectancy and morbidity. Furthermore, these indicators have yet shown little improvement over the period of economic growth since 1999. New epidemics of HIV/AIDS and tuberculosis present major additional threats. An aging and declining population promise to place an ever greater burden on the already strained pension and healthcare systems. 29. Concern about the health system has led government to placing it among its major priorities. Major structural weaknesses in the health care system include an overemphasis on hospitals relative to primary care and disease prevention, poor monitoring of health risks and the quality of services, an inefficient distribution of health workers across geographic areas, low pay for a large number of medical professionals, a shortage of modem equipment, little budgetary flexibility at the municipal level, and an under-funded national insurance system. Indeed, increases inmortality and morbidity rates are particularly concentrated among the poor. Russia exceeds most other countries, includingthose of the EU, in per capita numbers of doctors, nurses, other hospital personnel, hospital beds, and average lengths of hospital stays. Yet it lags behind in most other areas, most particularly in health promotion and disease prevention. 30. Access to quality education may be decliningfor a large segment of the populationfor similar reasons to that of health care. The public education system in Russian i s burdened not only with insufficient funding in many areas, but with a largely out-of-date administration and structure inherited from the Soviet period. The government has so far created insufficient incentives and opportunities for improving and modernizing education programs. There i s still a specialized public education and the needs of the market. Government is also turning its attention to the need for improving the quality of school education and student's learning outcomes, and to evidence of a decline in quality education for poorer segments of the population. New government initiatives address such important issues as the social status of teachers and the introduction of ICT in education. Finance for education is growing. But the effect of the additional money will be limited if Russia does not succeed in modernizing its largely out-of-date administration and curriculum 31. The social assistance system remains regressive. The recent WB Russian Poverty Assessment and other studies based on new (Nobus) data reveal Russia's system of social assistance to be one of the most regressive among transition countries. The vast majority of benefits accrue to particular social groups of the population that have a rather low correlation to true relative needs in social support. First attempts to address this problem though the monetization of in kind benefits in early 2005 met with strong social resistance from the groups that had been receiving such benefits, most particularly pensioners. Thus, the creation of a more efficient targeted system of social assistance i s limited not only by technical, but by socio-political complications. Better measurement of poverty and the identification of the poor at the regional level are key tasks inthis regard. 32. Housing and communal services in Russia represent a complex web of subsidies, local government control, and entry barriers to private business. The quality of services i s often exceedingly low, and shortages of affordable housing appear to be a primary constraint to vitally needed migration to areas of high growth and potential. The massive privatization of individual apartments to occupants in the 1990s distributedenormous benefits to those living in modem urban areas and centers of economic growth. Yet those living in less attractive or promising areas are commonly trapped by the unavailability of housingelsewhere that is affordable to them. 33. While Russia stands well relative to many other countries with respect to gender equality, the most prominent political and professional positions in the country are still male Annex 2 Page 10 o f 13 dominated. Russia's accomplishments are particularly visible in education. As many Russian women today obtain a higher education as men. In the labor market, despite clear constitutional guarantees and other legal safeguards, women eam less, are concentrated in low paid sectors and under-representedin managerial positions. A recent comprehensive study of by the American Bar Association, supported by USAID, concludes that Russian women also still face a relatively high degree of domestic violence and harassment on the job. A new government initiative greatly expands guaranteed maternity benefits for women, although this could actually have problematic side effects for discrimination against women in employment. Russia's Global Role and Integration into the World Economy 34. Russia's prospects depend very much on its integrahon into the world economy. The recent world development experience strongly supports the notion that deep integration into world markets i s a key to achieving and sustaining rapid economic growth. The speed and degree of integration should have a direct effect on the pace of institutional development in Russia, particularly with regards to competition, the development of the knowledge economy, and the transparency and openness of business practices. Integration with world markets i s also a key condition for attracting foreign investment. The degree of integration of Russia in the world economy has grown considerably in recent years, and should continue to grow following the country's accession into the WTO, although the structure of Russia's integration in world trade i s still strongly skewed toward energy and metals exports. 35. Foreign competition has been a primary motivating factor for restructuring, productivity increases, and innovation in the Russian economy. Given the high domestic concentration of production, and limited domestic competition in many markets, a primary source of competitive pressure in Russia has come from foreign markets. In the 1990s, this pressure created a dilemma for many financial constrained and un-restructured Russian firms. Yet, the Investment Climate Survey confirms that Russia firms facing more competitive pressures,including foreign competition, are likely to be more productive and more innovative than other Russian firms. The knowledge-based (innovation) economy i s very much a global marketplace, where very high integration is world markets is a necessarycondition for success. 36. WTO accession is an important step towards integration. In recent years, preparation for WTO accession has been a primary motivating factor for Russia to align its legislation and standards with world requirements in many areas. The effect has already been quite positive on Russia's markets and integration with the world economy. A recent World Bank study estimates that benefits from pursuing and achieving WTO accession could amount to as much as US$ 19 billion dollars in medium term benefits. In addition to direct benefits, WTO accession is an important stepping stone toward free trade and other agreements that promise to deepen Russia's integration in world markets. 37. Zmproving corporate governance significantly depends on economic integration. Russia boasts generally progressive standards and laws in the area of corporate governance that mirror best international practice, and the improvement of standards and laws i s continuing. Nevertheless, Russia continues to suffer from problems in the openness of information, the protection of minority shareholder rights, and the overall transparency of business. Prospects for the greater integration of Russia in the world economy, and the related need for a favorable international business reputation, provide quite strong incentives for Russian corporations to improve their corporate governance practices, even above and beyond what i s prescribed by law and recommended national standards. 38. Russia's role as G8 member and donor is growing, and is in the process of developing capacityfor effective development aid. Improved economic performance and growing international concerns over energy security have elevated Russia's role as a G-8 member and emerging donor. The 2006 G8 Presidency has granted Russia a unique opportunity for active involvement in the policy dialogue on important global and regional issues, for providing major inputs, and for taking Annex 2 Page 11of 13 the lead on specific themes and agendas. Russia has participated in full in the HIPC initiative and announced additional debt reduction through Africa debt for development swap (in collaboration with the World Bank). It has made contributions to the Avian Flue Global Program, E F M Iand GVEP programs, and has made a commitment to scale up its development support. However, Russia i s still in the stage of determining its own strategic position in the donor community, and will continue to buildrelevant capacity. 39. Russia's size gives it a unique role in the global economy, including the management of environmental, energy and forest resources. Although Russia presently uses energy much less efficiently than most industrialized countries, it has ratified the Kyoto Protocol, thereby demonstrating its commitment to combat global climate change. There is great scope for Russia to reduce carbon emissions through efficiency gains and reduced energy losses, resultingalso in gains to the local economy. Russia accounts for 22% of the world's forest area. Russian forest policy states a commitment to balance conservation and development goals. Russia could profit significantly from an effort to increase transparency and reduce illegal activities in the forestry sector, and the government has articulated such goals. There are also opportunities for improved coordination with Western Europe and the timber importing countries of East Asia. Regional issues 40. The 88 regions of the Russian Federation exhibit considerablegeographic, ethnic and economic diversity. Poverty headcount rates vary from 3 percent of the population (Saint Petersburg) to 56 percent (Dagestan). Among the 88 Russian regions (Subjects of the Federation) as of 2004, 60 had gross regional product (GRP) levels that would qualify them for status as low- middle income countries, while 14 would have IDA-like status. Half of these IDA-like regions correspond to the ethnic republics of the Northern Caucuses. Poorer regions also include the non- Russian ethnic republics of Tyva (Eastern Siberia), Altai (Western Siberia), Marii El (Volga area), and Chuvashia (Volga area), as well as other agricultural or industrial regions in various parts of the country (such as Ivanovo, Penza, Kurgan, Pskov). While many of the poor ethnic republics of the Northern Caucuses have strong growth potential (agriculture, surplus labor, tourism) that is currently constrained by political and ethnic conflicts, other cold and geographically remote settlements in the North and East of Russia arguably face an even more problematic economic future. 41. Since the mid-I990s, the cities of Moscow and Saint Petersburg have emerged and strongpoints of growth and agglomeration, which has spilled over to some surrounding regions, most particularly to the Moscow and Leningrad oblasts. Other regions that have achieved GRP and income levels similar to Moscow and Saint Petersburg are primarily those rich in resources or major metals producers. The two richest regions in Russia are the oil and gas rich autonomous Okrugs of Khanty-Mansisk and Yamal-Nenetsk. Other leaders in GRP per capita include resource- rich Chukotka, Sakha (Yakuntiia), Sakhalin, Tomsk, and Komi, as well as steel-producing Vologda and Lipetsk. In recent years, while a number of regions have exhibited notable dynamism, no city has yet distinguished itself as an alternative growth agglomeration point to Moscow or Saint Petersburg. The emergence of other such cities will be an important milestone inRussian economic development. Annex 2 Page 12of 13 Figure :Russian regions by GRPper capita (US$2004) (excluding Chechen Republic, Tunien oblast, Khanty-Mansiysky A 0 -Yugra, Yamalo-Nenetsky AO) 42. The collapse of the Soviet Union in the 1990s led to enormous regional differentiation within Russia, but the initial period of economic recovery from the 1998 crisis favored rapid growth and poverty reduction in many poorer Russian regions. The huge decline in Russian industry of the 1990s brought substantial poverty and hardship to industrial regions, while those regions rich in natural resources fared much better. Following the 1998 crisis, however, a depreciated ruble, huge excess capacity, and cheap labor supported broad-based economic growth, particularly in the industrial regions that had experienced very rapid decline in the 1990s. Loss- making industrial firms with excess capacity suddenly became profitable. During this time, on average, poorer regions had even more success in poverty reduction than their richer counterparts. Many the poorest regions experienced average annual growth rates above 6 percent during the period 1998-2002. Figure : Regionalwealth and economic growth: 1998-2002 (Subjects of the Russian Federation) 18 0 _ - _ ~ 160 14 0 43. However, a strong trend toward regional inequality will likely resurface. The factors that supported this rapid and regionally broad-based growth (a weak ruble, cheap energy and labor, excess productive capacity) have now disappeared. Strong differences among Russian regions, reflecting the Soviet legacy of settlements that bear little relation to economic comparative advantage, suggest that regional inequality will likely become an increasingly acute problem. Annex 2 Page 13 of 13 Recent industrial production data confirm a rather unequal picture in this regard, and are consistent with possible growing regional disparities. While almost all regions experienced strong industrial growth during the period of economic recovery, 11of 88 regions experienced industrial growth of less than 1percent in 2004, and 9 of these regions showed negative industrial growth. In 2005, 23 regions reported industrial growth of less that 1 percent, and 15 Subjects of the Federation experienced industrialdeclines relative to the same period of the previous year. Figure :Annual industrialproduction growth by region: 2005 (% relative to 2004) 44. An emerging national strategy for regional development places emphasis on creating and supporting points of agglomeration and growth. The Russian government recognizes that achieving diversified growth will require the formation of growth agglomerations in urban areas other than Moscow and Saint Petersburg. Relative to other industrialized countries, Russia has too few large cities. Given the inherited Soviet legacy, the new strategy, as reflected in the Medium- TermGovernment Program, acknowledges that regionally equitable growth throughout the Russian Federation i s unlikely, and the facilitation of more rapid internal migration will be critical to the growth and welfare prospects of the country in years to come. Annex 3 Page 1of 5 World Bank Group: Comparative Advantages This Annex presents the particular comparative ~~ ~~ advantages of the World Bank Group for Russia MbdfBa& Organizationwith Global in knowledge, expertise, governance, and filling Knowledge and Experience gaps where market institutions remain weak. 1The World Bank i s a truly global institution During its 13 years history of engagement in with membership of 184 countries, 10,000 Russia, the Bank Group has developed a employees in headquarters and more than 100 significant capacity for bringing its extensive country offices. FY2006 operations were development knowledge and experience to bear conducted in 88-countries. on the particular case of Russia. This includes .IBRD lending in FY2006 was more than analytical work that places the Russian $14bln for 112 Projects, with additional experience in comparative international $10bln for 167 Projects by IDA in 88 countries perspective, institutional development in the in total; Cumulatively, IBRD and IDA have private sector, and project management skills issued more than 9,000 loans for more than $600bln. that remain valuable in the country at a time 1 The World Bank delivered 601 economic and when the government itself i s just beginning to sector work and 307 technical assistance develop capacity for multi-year project activities in FY2006 alone with products development, finance, and implementation. The ranging from country strategies, sector reports, progress and experience of World Bank Group investment climate and governance cooperation in recent years at the federal level in assessments, growth analyses and etc. areas such as governance, poverty, health, and 1 The World Bank's report database holds over education can now be applied to the regional and 15,000 free, downloadable documents, local levels where related needs in government including operational documents (project capacity are still quite strong. In infrastructure documents, analytical and advisory work, and evaluations), formal and informal research and budgetary reform the Bank Group has papers, and most Bank publications. already developed substantial experience at the 1 The World Bank Institute trained more than subnational level. Specific areas of the Bank 10,000 people in FY2006 alone, and supported Group's experience most applicable to the capacity building activities in 45 countries. Strategy are briefly described below. Bank spends more than $5Omln a year in supporting its global knowledge sharing initiatives such as Development gateway. Strategic Pillar One: Sustaining RapidGrowth CatalyzingInvestment in the Private Sector IFC and MIGA play important role in supporting private investments globally: in FY2006 alone, IFC committed $6.7bln for 284 Projects in 66 countries and MIGA issued $1.3bln in guaranteesfor 41 Projects and provided advisory services in 28-countries under 45-Projects. IFC has accumulated huge experience in Russia: IFC has invested more that $2.9bln in 130 Projects in Russia and its committed portfolio in Russia reached US$ 1.8 billion by June 2006 (largest IFC exposure). IFC mobilized an additional $583 million of financing to Russia through syndicated loans. In addition, IFC is able to provide a variety of structure finance products and introduce new financing mechanisms that bringin other sources of capital. IFC's global strategic priorities include private investment in infrastructure and social services and support to the development of financial institutions. IFC has leveraged expertise in these areas in Russia. For example, IFC has invested $1.8 billion in more than 90 housing finance deals in 35 countries and has strong in-house expertise. In Russia it is extending this expertise both through investment and TA to develop the primary market. PEP'S TA with banks has resulted in 10 new residential mortgage loan products developed by lenders as the result of Annex 3 Page 2 of 5 Project advisory involvement. PEP has also drafted legislation related to mortgage lending and securitization. Joint IFC/World Bank Foreign Investment Advisory Service (FIAS) carried out a series of comprehensive diagnostics of administrative barriers for business start up and operations similar to work done inmany other countries in 15 regions of Russia. MIGA has also gained experience in Russia and the country is MIGA's largest exposure with gross outstanding coverage of US$536 million as of June 30,2006. Rich Experience in SupportingBusiness and Investment Environment The World Bank is one of leading organizations supporting initiatives for improved business and investment environment in member countries through reports that can be used for country diagnostics as well as benchmarking progress with respect to other countries: such as Doing Business, the Bank Group's flagship product on the quality of government regulation (175 countries), WBI Governance Indicators (more than 200 countries); and Administrative Barrier Assessments (more than 50 countries), Database on ECA countries on business environment and enterprise performance. In addition, 35% of IFC's advisory projects globally are focused on improvements to the business enabling environment. Experience in Regional Development Experience with establishing resource allocation frameworks for regional development, in EU pre-accession and other middle-income countries, to ensure that resources reach the lagging regions basedon a set of objective and clearly understood criteria. Developing inclusive decision-making mechanisms at the regional level that help prepare and select projects that are responsive to the needs and priorities at that level. Project experience for supporting fiscal and administrative decentralization, building capacity at the local level to fully benefit from decentralization reforms. Experience in helping design local initiatives with annual IBRD lending to sub-national infrastructure projects with sovereign guarantees exceeding $5bln. Municipal Fundestablished in 2003 leveraged $800mln in investments, and now offers loans in 20 local currencies. Sub-National Development Programapproved in 2006 allocates $600mln for subnational loans; More recently, Bank work in China, Brazil, India, Pakistan, Mexico etc. has focused on subnational level analysis of growth, city development strategies, and assisted in preparation of Regional Development Strategy for Kazakhstan. Sub-national benchmarks on the quality of investment climate i s being created and monitored usingmethodology of "Doing Business" in 31states of Mexico and its Federal District, 9 states of India; and 4 provinces of Pakistan; similarly, 25 municipalities have been benchmarked for investment climate indicators under the Municipal Scorecard programdeveloped by IFC. Experience in Infrastructure Investments Infrastructure is an important part of the World Bank Group activities: with 30% of the IBRD lending in FY2006 committed for transportation, energy, and mining projects. Infrastructure i s 33% of the Bank's total project portfolio, or about $80bln. Infrastructure accounted for about 41% of MIGA's overall gross exposure, as of June 30,2006. The Bank's Public Private Infrastructure Advisory Facility (PPIAF) established in 1999 has since prepared more than 200 Public Private Partnership (PPP) reviews, strategies, and legal documents (ranging from railroads, SMEs in power generation, and solid waste); trained more than 15,000 people on various aspects of PPP around the world; advised 21 countries on reforms. Annex 3 Page 3 of 5 PPPIF manages a Database of 3,100 projects in 150 countries, which is a leading source of public-private participation in infrastructure trends. Analyses of these projects yields best practice lessonson cross-cutting issues. Infrastructure is a global priority area for IFC, as adequateinfrastructure i s a prerequisite for the growth of the private sector. Since the early 1990s when IFC first became active in infrastructure financing, private infrastructure deals worth nearly $4.8 billion have been arranged in more than 46 developing countries. In Russia, this has been a rapidly growing area of activity for IFC, primarily in transport infrastructure that supports businesses operating across the Federation's expansive territory. . GrowthDiagnostics and Policy Formulation The Bank has assisted many countries, including Indonesia, Ukraine, Brazil, Mexico, China, Poland, India, and Turkey in undertaking a careful analysis of the constraints to growth and the appropriate response policy. This work has covered analysis of macroeconomic volatility and risks, trade policy (especially impact of WTO accession), labor market demand and supply conditions, sectoral constraints in agriculture, industry and services, financial sector issues, role of public policies to promote growth, etc. . Fiscal Analysis As part of its broader mandate, the Bank has more than 50 years of experience in analyzing fiscal policies in member countries and unique in-house expertise on efficiency and equity of public expenditures and revenue generation, distributional implications of different types of taxes, the efficiency of systems of budget management systems, etc. . Asset Management The World Bank's Treasury manages more than $60 billion in global fixed income liquidity portfolios for the World Bank Group and other official institutions, and pension fund assets for World Bank Group staff. The Bank provides technical assistance to a number of countries on asset management, including management of oil surplus funds with objective to develop the country's own capacity for managing its reserveseffectively. The creation of a Fundfor Future Generations with a longer-terminvestment strategy is a key priority in Russiatoday. Strategic Pillar Two: Strengthening Public Sector Management and Performance Public Governance The World Bank is a leading institution for supporting reforms of the public administration with large and diversified analytical program across the world, supported by financial products - in IT2006 alone, public administration, law & justice loans made 22% of the lending portfolio, or $3.lbln. Over the last five year, the Bank has initiated over 360 lending operations inthis area, including over 70 operations inthe Europe andCentral Asia Region. The Bank developed specific analytical tools for measuring the performance of the public sector: GRICS (Governance Research Indicator Country Snapshot) published every two years for 204 countries measures quality and effectiveness of governance; BEEPS (Business Environment and Enterprise Performance Survey) of about 10,000 firms in 27 ECA countries, Public Expenditure and Financial Accountability (PEFA) Program of the Bank, IMF, EU, and other donors. 0 The Bank also supports public-sector governance at the local level, building the capacity of local authorities to manage resources, be responsive to citizens, engage in participatory Annex 3 Page 4 of 5 development planning, and develop "bankable" development projects. The Bank assisted with participatory budgeting in India, Indonesia, the Philippines, and Albania, and is supporting a pilot inrural Russia. Projectsfor Improving Public ServiceDelivery The Bank has developed investment projects in many countries to support the modernization of tax and customs administration, treasury development, internal and external audit, medium- term expenditure programs; performance based budgeting; intergovernmental fiscal system reforms. etc. Strategic Pillar Three: ImprovingDelivery of Social and Communal Services Education and Health The Bank has developed extensive experience in the design and implementation of projects in the social sectors during the last 30 years in 140countries, includingreforms of national health care and education systems, improvement of quality of health services delivery and primary education, linking higher education with the economic development agenda. The Bank's portfolio in the social sectors in Russia is $600mln in 7 projects, and successful lessonscan be further supported through subnational activities inmore regions. 0 IFC has increased its support for private investments in health and education around the world by 50% in FY2006, and in partnership with the Bank has a unique capacity to support PPP in these sectors. Poverty Diagnostics and Social Protection The Bank has a unique institutional focus on monitoring poverty indicators using its database and in-house slulls for evidence-based poverty analysis, cross country benchmarking, evaluation of anti-poverty programs, reforming social assistance, global knowledge on what works for poverty reduction, analysis of lagging/poorer regions and strategies to promote regional development, etc. Bank's tools on social protection and poverty include: poverty assessments (more than 120 countries), PRSP elaboration (more than 50 countries) and Poverty and social impact analysis (available since 2003 and used in 70 countries for assessment of reform impact for different social groups). The Bank has supported the implementation of reforms in social assistance and targeted investment programs in many countries including most of the transition countries as well as Brazil, Mexico, China, Vietnam etc. Bank's current social projects (90 projects in more than 60 countries) address social policy needs within realities of national fiscal and institutional frameworks and focus on targeted social assistance, social services for families, children and disabled at the regional and local levels. Social Inclusion The Bank is supporting implementation of innovative social inclusion initiatives in EU accession countries, (e.g. in Poland) helping design programs that address vulnerable groups that may not be adequately targeted by the existing social safety nets. Annex 3 Page 5 of 5 Strategic Pillar Four: Enhancing Russia's Global RoleDnternational Integration Aid Delivery Mechanisms, Credibility with Governments, Donors, and International . Organizations The Bank participates in 160 global partnerships in areas of common concern such as diseases, . environment, trade, infrastructure, Indigenous Peoples and migration, and committed $170mln to support them inFY2006 alone. InFY2006, the Bank managedmore than $10bln inTrust Funds and raised more than $5bln in cofinancing for its operation from other institutions. .. Participation in Conventionson Climate Change and Biodiversity; GEF Agency The World Bank Group has the largest portfolio of projects among the three GEFImplementing Agencies, with more than 1,700 projects inthe current portfolio. As the overall aggregated carbon market is estimated to reach $25bln in 2006, the Bank i s credited is being one of the pioneers and continuing to play an essential role in the market. It i s managing more than $2bln in several carbon funds, and has prepared more than 50 carbon . finance projects. Even more important role of the Bank is in-country capacity building and methodology development. Energy Efficiency i s one of priority areas, and the Bank has invested more than $6bln and mobilized more than $lOblntowards energy efficiency and renewable energy projects. 0 . 0 1 . . . . . a . . . a . . a . a . . . . . e e e e e e I v1 0 e e l e e e e e e I s . . . . 0 . Y A .. . . . I . . . . . 0 b b b b m - r j d " v ! ' " 4 x p " f - 4 n E hE h 3 d M 5 $ Annex A2 Page 1of 3 Russian Federation at a glance W Z 0 6 Eurclpe& Key Devebpment Indicators Russian Centntl Federstrwl ASia ram3 I Mail Female %pilaf#Wl, mid-yestr (mnilaOn5) 1432 473 Surfacearea ithausandsq km) 17,098 24.238 Populatmrigrwtht%) -05 0 1 YrtPan powahan(% of totalpopwlatronl 73 E4 GNI (Alae &hod, ussklllcHlSf 633 I 1,945 GNI per capita (AUasmtM,US$) 4,113 GNI percapite (PPP,ntematmal S: 14,460 O . W 3.142 GDPg m I%) 6 4 6 0 CDP per eaprtagrowth PA) 6% 5 9 (mastrecsnf estmafe, ZOO&NVS) PovertyheaOcount ratsoat 52 a day 1PPP K1 .cl 2 povertyheSC1counlramat 52 a day (PPP Kj 13 16 tne expectancy at blrn lyeen] 65 6Y InfantIn0mM.y (pef 1,mlive Lwrvls: 17 28 ChildmJnutrrtnx!(% d childnnunder 5) 6 5 Adiuk Wracy. male (%of @ea 15 and ol& lh? 98 Mui7bkracy.temsle(%of oges 15 ando&r) 99 L96 Grosswmty enrollment, maleI% of age group 123 105 Grossmaatyenrollment, twnale (%of age gmup' 123 102 Accessto an improvedwater source1%of wpwla+m: 97 92 Access to improvedsonitahmfacilrues PA of popblatonj e7 85 I I Net Aid Flow $980 1990 20w 2w5` 254 1565 1.313 Growth of GDP and GDP per capita (%) 26 e15 716 254 64 98 T 1 32 70 a0 011 6 0 2 ? 9 Long-Tern, Economic Trends Consumer pnces( a m 1% change: 874.6 20 8 127 GDP impiicndeflalcfi a m lY change) 15 9 37 7 193 Exchangerote (annus average,iocal per USS 00 28 1 28 3 Term of trade mden(2000 = fffOfD1 ?W 162 1330 1483 1463 143 2 516,414 259 708 763.73 (56of GDP) 166 6 4 5 6 -49 4 5 4+q 4 37 9 35 0 -7 1 6 1 17 6 17 9 35 0 55 6 56 4 -I 7 6 5 45 0 46 2 49 8 -0% 9 3 20 8 15 1 16 0 -2 2 1 5 301 83 7 20 3 -19 1 9 2 l e 2 44 t 353 5 8 9 6 17 9 24 0 21 5 -fi1 19 u 36 3 362 32 2 Annex A2 Page 2 of 3 Russian Federation Balance ot Payments and Trade moo 2005 I Governmeindicators.ZOO0 and 2004