Russia Economic Report From Recession to Recovery 1. RECENT ECONOMIC DEVELOPMENTS 2. THE OUTLOOK FOR THREE YEARS: GROWTH PROSPECTS ARE MODEST 3. RUSSIAN REGIONS AND THEIR RESPONSES DURING THE CRISIS YEARS This report is produced twice a year by World Bank economists in the Macroeconomics and Fiscal Management Global Practice. The team that prepared this edition was led by Apurva Sanghi (Lead Economist for the Russian Federation, asanghi@worldbank.org) and consisted of Olga Emelyanova (Research Analyst), Mikhail Matytsin (Research Analyst), Katerina Levitanskaya (Senior Financial Sector Specialist), Yohei Okawa (Economist), John Baffes (Senior Economist), Charl Jooste (Economist), Artavazd Hakobyan (Senior Agriculture Economist) and Irina Rostovtseva (Research Analyst). William Dillinger (Consultant) and Galina Kurlyandskaya (Consultant) under the guidance of Apurva Sanghi authored the focus note on subnational fiscal management based on a World Bank paper titled Russia: Subnational Governments’ fiscal response to the economic downturn. Peer reviewers included Kevin Carey (Lead Economist) and Christos Kostopoulos (Lead Economist). The report was edited by Christopher Pala (Consultant). The team would like to thank Hans Timmer (Chief Economist of the Europe and Central Asia Region), Andras Horvai (Country Director for Russia), Maria De los Angeles Cuqui Gonzalez Miranda (Practice Manager, Macroeconomics and Fiscal Management Global Practice), Gabriel Di Bella (Resident Representative, IMF), Sergei Ulatov (Director for coordination, Eurasian Development Bank), for their advice and support. The team also would like to express their gratitude to the Department for Research and Forecasting of the Central Bank, Department for Macroeconomic Forecasting of the Ministry of Economic Development and Department for the budget policy and strategic planning of the Ministry of Finance for the collaboration. This report went to press on May 23, 2017. TABLE OF CONTENTS ACRONYMS AND ABBREVIATIONS.............................................................................................................................IV EXECUTIVE SUMMARY ................................................................................................................................................ V PART 1. RECENT ECONOMIC DEVELOPMENTS ............................................................................................................ 1 1.1 Growth: a er almost two years of recession, Russia entered a path to recovery ......................................................... 2 1.2 Balance of payments: stable despite substan al external vola lity .............................................................................. 6 1.3 Labor Market and Poverty Trends: unemployment is stable and wages are recovering, but economy-wide unit labor costs are increasing faster than the OECD average and they vary across sectors ........................................ 9 1.4 Monetary Policy: gradual monetary easing amidst an uncertain and vola le external environment ......................... 11 1.5 The Financial Sector: the banking system has largely stabilized, but has not yet fully recovered and credit growth remains stalled .............................................................................................................................. 14 1.6 Government Budget: important ac ons have been taken in prepara on for a new fiscal rule .................................. 16 PART 2. THE OUTLOOK FOR THREE YEARS: GROWTH PROSPECTS ARE MODEST .................................................... 21 PART 3. RUSSIAN REGIONS AND THEIR RESPONSES DURING THE CRISIS YEARS ............................................... 31 Func ons ........................................................................................................................................................................... 33 Financing ........................................................................................................................................................................... 34 Fiscal Performance ............................................................................................................................................................ 36 Prognosis ........................................................................................................................................................................... 38 Short-term measures......................................................................................................................................................... 39 Long-term measures ......................................................................................................................................................... 40 REFERENCES .............................................................................................................................................................. 40 LIST OF FIGURES Figure 1: Global growth is strengthening. ............................................................................................................................... 2 Figure 2: China: actual and targeted growth in line ................................................................................................................ 2 Figure 3: Global industrial produc on supported recovery in trade growth .......................................................................... 2 Figure 4: The economy bo omed out in the first quarter of 2016 (GDP growth, percent, y/y and q/q, sa) .......................... 4 Figure 5: Posi ve momentum appears to have rolled over to 2017 (IP, agriculture and cargo turnover growth, percent, y/y) ............................................................................................................................................... 5 Figure 6: Net exports contributed posi vely to GDP growth in 2016 (Contribu on to GDP growth by components, pp) ................................................................................................................................................. 5 Figure 7: Tradable sectors became main driver of economic growth (Contribu on of tradable sectors to GDP growth, pp) ...................................................................................................................................... 5 Figure 8: Output growth was not supported with investment growth in many manufacturing sectors (percent, y/y) .......... 5 Figure 9: Growth in manufacturing industries (percent, y/y).................................................................................................. 6 Figure 10: Export growth rates (percent, y/y) ......................................................................................................................... 6 Figure 11: Nega ve contribu on of non-tradable sectors to GDP growth decreased substan ally, compared to 2015 (Contribu on of non-tradable sectors to GDP growth, pp) ..................................................... 6 Figure 12: Prices for the major commodi es exported by Russia rebounded in the beginning of 2016, (ln) ......................... 7 Figure 13: In the second half of 2016, imports of goods picked up on stronger ruble and incipient economic recovery ...... 7 Figure 14: Improvement in the deficits of services and labor-income accounts could not compensate for the worsening trade balance (percent of GDP) ................................................................................................ 7 Figure 15: Russia’s external debt decreased, US$ billion, e-o-p ............................................................................................. 8 Figure 16: Russia’s 5-year CDS spread was lowered substan ally ........................................................................................... 8 Figure 17: LFP and employment rates are near maximum, (percent) ..................................................................................... 9 Figure 18: Unemployment rate is close to minimum, (percent) ............................................................................................. 9 Figure 19: Real wages started to grow, (percent year on year) ............................................................................................. 10 Figure 20: Real incomes con nue to decline, (percent year on year) ................................................................................... 10 Figure 21: The central bank cuts key policy rate gradually.................................................................................................... 12 Figure 22: Infla on expecta ons follow the downward path, but stay elevated .................................................................. 12 Figure 23: Mone za on of the economy increases ............................................................................................................. 12 Figure 24: Structural liquidity deficit narrowed ................................................................................................................... 12 Figure 25: Money market rates remained close and slightly above the key rate .................................................................. 13 Figure 26: Infla on slowed down (CPI index and its components, percent, y-o-y) .............................................................. 13 Figure 27: Oil prices remained the important driver of the ruble exchange rate (changes in oil prices and the nominal exchange rate, logarithmic scale).............................................................................................. 13 Figure 28: Key credit and performance risks remained unchanged ...................................................................................... 14 Figure 29: Corporate credit growth, (y-o-y, percent) ............................................................................................................ 14 Figure 30: Household credit growth,(y-o-y, percent) ............................................................................................................ 14 Figure 31: SME loans experiencing the sharpest decline. ..................................................................................................... 15 Figure 32: Outstanding SME loans(% of GDP, 2013).............................................................................................................. 15 Figure 33: Outstanding mortgage loans(% of GDP, 2013) ..................................................................................................... 15 Figure 34: The federal budget deficit widened but remained contained (% of GDP)............................................................ 16 Figure 35: Federal budget primary expenditures decreased in real terms in 2016, (percent, y/y) ....................................... 17 Figure 36: The economy is expected to grow in 2017-2019 at a modest rate (real GDP growth, percent) .......................... 24 Figure 37: Growth projec ons remain sensi ve to oil prices (GDP growth, percent) ........................................................... 25 Figure 38: The poverty headcount is likely to decline in 2017 and further (in percent) ....................................................... 25 Figure 39: Social sectors together account for just over half of total subna onal expenditures .......................................... 33 Figure 40: Shared taxes are the largest source of subna onal government revenue ........................................................... 34 Figure 41: Trends in subna onal deficits: subna onal governments seem to be weathering the ongoing slowdown in the economy fairly well ................................................................................................................... 36 Figure 42: Trends in subna onal revenues: aggregate subna onal revenues declined significantly between 2013-16 ....... 36 Figure 43: Trends in subna onal expenditures: the adjustment occurred mostly on the expenditure side ......................... 37 Figure 44: Short-term loans account for over one-third of the subna onal debt ................................................................. 37 LIST OF TABLES Table 1: Poverty rates increased slightly in 2016 .................................................................................................................. 10 Table 2: Federal budget deficit expected to decrease over me (percent of GDP)............................................................... 18 Table 3: Projected GDP growth by component, percent, y/y and contribu on to GDP growth, pp ..................................... 24 Table 4: Major macroeconomic indicators ............................................................................................................................ 25 Table 5: Recovery is expected to be broad-based: projected growth by sector.................................................................... 26 Table 6: Per capita revenues of regions vary widely ............................................................................................................ 35 LIST OF BOXES Box 1: Varying implica ons of an oil price shock: Russia had adapted well compared to other oil exporters........................ 3 Box 2: Unit labor costs (ULC) are increasing significantly in Russia and affec ng compe veness, despite the ruble deprecia on ................................................................................................................................... 10 Box 3: How do Russia’s government expenditures compare to those of other countries? .................................................. 17 Box 4: The government plans to introduce the new fiscal rule in 2020 ................................................................................ 19 Box 5: The Russian oil sector: Increasing produc on and exports despite headwinds ......................................................... 22 Box 6: Produc vity in pork produc on and dairy arming: revenues, profitability and labor produc vity increase, but opportuni es remain to improve land and capital produc vity .......................................................................... 26 Box 7: Russia’s poten al GDP and TFP revisited: declining produc vity trends ................................................................... 27 Box 8: Russian federalism in the interna onal context ......................................................................................................... 32 Box 9: Subna onal fiscal performance is not affec ng the federal government much ........................................................ 37 Box 10: Federal controls over subna onal deficits ............................................................................................................... 38 ACRONYMS AND ABBREVIATIONS Bbl Oil barrel CBR Central Bank of Russia CDS Credit-Default Swap CES Constant Elasticity of Substitution CIT Corporate Income Tax CPI Consumer Price Index DIA Deposit Insurance Agency EMDE Emerging Market and Developing Economies EU European Union GDP Gross Domestic Product HIF Health Insurance Fund IEA International Energy Agency IP Industrial Production LFP Labor Force Participation M2 Money Supply NPL Nonperforming Loan OECD Organization for Economic Cooperation and Development OPEC Organization of the Petroleum Exporting Countries PIT Personal Income Tax PPP Purchasing Power Parity REER Real Effective Exchange Rate RER Real Exchange Rate ULC Unit Labor Cost WDI World Development Indicators y/y Year-on-year SAAR Seasonally Adjusted Annualized Rate iv Russia Economic Report | № 37. May 2017 EXECUTIVE SUMMARY Global growth started to strengthen at the end of the recession it entered in 2014. In 2016, Russia’s 2016. After a slowdown of growth to 2.3 percent in GDP contracted by 0.2 percent, y/y, compared to a 2016 driven by weak investment and trade, global 2.8 percent contraction in 2015, with the economy growth started to improve at the end of 2016 (Figure bottoming out in the first quarter of 2016 (Figure 3.a). 1.a). Investment and exports are gaining momentum, The incipient positive momentum appears to have albeit muted by still feeble private consumption. spilled into 2017. In the first quarter of 2017, GDP grew An upturn in the US and steady growth in the Euro by 0.5 percent, y/y. In the first four months of 2017, Area and Japan are supporting the upward trend. industrial production expanded by 0.7 percent y/y. In In China, strong public and state-owned companies’ the first quarter of 2017, agriculture also grew by 0.7 infrastructure spending slowed the rebalancing percent, y/y, and PMI indexes for both manufacturing trend from investment to consumption, although the and services pointed to expansion (Figure 4.a). structural shifts from manufacturing to services and Growing macro-stability driven by the government’s from external demand to domestic demand continued. policy response package of a flexible exchange rate policy, expenditure cuts, and bank recapitalization Global trade also recovered, and global financing – along with tapping the Reserve Fund – has helped conditions for emerging economies remained benign facilitate this adjustment. Box 1 in the report highlights in early 2017. From its low point in 2013, trade growth the varying implications of the oil price shock on oil recovered in the second half of 2016, supported exporters, and how Russia has adapted well compared by improved industrial activity (Figure 2.a). Global to others. financing conditions were favorable in early 2017. While the U.S. long-term yield increased by 50 basis Headline Russian economic and financial trends and points and currencies in many emerging markets indicators are improving. A moderately tight monetary depreciated after the U.S. elections of November 2016, stance helped reduce the average inflation rate from the increase was not accompanied by a sustained re- 15.6 percent in 2015 to 7.1 percent in 2016. Headline pricing of risk and of emerging-market assets. Capital inflation almost reached the end-year target of 4 inflows to emerging and developing economies were percent as early as April 2017, falling to 4.1 percent, y/y. robust in the first half of 2017. (Figure 5.a). Recognizing that several one-off factors supported the reduction in headline inflation, the Bank Amidst weakening external headwinds, rising oil of Russia pursued a cautious approach to monetary prices, and growing macro-stability, the Russian easing as inflation expectations, although following a economy showed encouraging signs of overcoming downward trend, remained elevated. Employment and Figure 1.a: Global Growth is strengthening Figure 2.a: Global Industrial Production is growing Percent. Percent, yoy yoy Global Global AE AE EMDE EMDE В % к предыдущему кварталу, %, урс 3m-on-3m, с учетом saar сезонных колебаний Industrial production Промышленное производство 2003-08 average 2003-08 среднее 8 6 2011-16 2011-16 average среднее 5 7 4 6 3 5 2 4 1 3 0 2 -1 Jan-2012 Apr-2012 Oct-2012 Jan-2013 Apr-2013 Oct-2013 Jan-2014 Apr-2014 Oct-2014 Jan-2015 Apr-2015 Oct-2015 Jan-2016 Apr-2016 Oct-2016 Jan-2017 Jul-2012 Jul-2013 Jul-2014 Jul-2015 Jul-2016 1 0 2011 2012 2013 2014 2015 2016 Source: World Bank. AE = Advanced Economies. EMDE = Emerging Markets and Source: Global Monthly, World Bank. Developing Economies. Series are seasonally adjusted. Russia Economic Report | № 37. May 2017 v Execu ve Summary Figure 3.a: The Russian economy bottomed out in the first Figure 4.a: Positive momentum appears to have rolled over to quarter of 2016 (GDP growth, percent, y/y and q/q) 2017 (IP, agriculture and cargo turnover growth, percent, y/y) 110 70 2 108 60 106 1 104 50 102 40 0 100 30 98 20 -1 96 94 10 -2 92 0 Apr-16 Apr-17 Feb-16 Sep-16 Feb-17 Jun-16 Jul-16 Mar-16 Mar-17 Dec-16 Aug-16 Oct-16 Jan-16 Nov-16 Jan-17 May-16 -3 -4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Industrial Production Cargo 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 Agriculture PMI services (RHS) SA q/q y-o-y PMI manufacturing (RHS) Source: Rosstat, Ministry of Economic Development. Source: Rosstat. labor force participation rates were still near maximum (Figure 8.a). In terms of income and labor dynamics, historical levels, while unemployment was close to the while real wages started to grow with decelerating minimum (Figure 6.a). The banking sector showed inflation, disposable income continued to decline signs of increased stability and a return to pre-crisis in real terms, driven primarily by non-wage income profitability levels. Key credit risk and performance components. The continued contraction of disposable indicators remained largely unchanged (Figure 7.a), incomes also slightly increased the poverty rate by 0.2 signaling that the worsening trend may be over. Capital percentage points in 2016 over 2015. The incomes of adequacy remained stable at around 13 percent. 19.8 million people, or 13.5 percent of population, still remained below the subsistence level. In the However, headline indicators hid disparities. A banking sector, though there were no signs of further continued fall in consumer demand on the back of a deterioration, nonperforming loans remained high protracted fall in real incomes kept domestic demand by historical levels at nearly 10 percent. And the SME depressed in 2016 (-2.4 percent y/y). Fixed capital segment will take time to adjust to new conditions. investment also remained subdued, decreasing by This is a priority sector for the Russian government 1.2 percent in 2016 compared to 2015. And although that was hit the hardest by the recession as SME loans export-oriented production – thanks to a weak experienced the sharpest decline compared to other ruble – played an important role in the expansion of market segments. These, and other related disparities, tradable sectors, output growth was not supported are discussed in detail in the report. by investment growth in many manufacturing sectors Figure 5.a: Inflation has slowed down (CPI index and its Figure 6.a: Employment and labor force participation rates components (percent, y/y) are high (percent) 25 71 70 20 69 68 15 67 10 66 65 5 64 63 0 62 Dec-14 Dec-15 Dec-16 Oct-14 Oct-15 Oct-16 Aug-14 Aug-15 Aug-16 Apr-14 Apr-15 Apr-16 Apr-17 Jan-14 Nov-14 Jan-15 Nov-15 Jan-16 Nov-16 Jan-17 Feb-14 Sep-14 Feb-15 Sep-15 Feb-16 Sep-16 Feb-17 May-14 May-15 May-16 Jun-14 Jul-14 Jun-15 Jun-16 Jul-15 Jul-16 Mar-14 Mar-15 Mar-16 Mar-17 2011 2012 2013 2014 2015 2016 2017 Core inflation CPI inflation Food inflation LFP rate Employment rate LFP rate, MA Empl. rate, MA Non-food inflation Services inflation Source: CBR and Haver Analytics. Source: Rosstat, Haver Analytics and World Bank staff estimates. vi Russia Economic Report | № 37. May 2017 Execu ve Summary Figure 7.a: Key credit risk and performance trends are Figure 8.a: Output growth was not followed with investment holding steady growth in many manufacturing sectors (percent, y/y) Capital adequacy ratio NPLs to total loans Transport and transportation equipment Loan loss provisions to total loans Electro-technical and optical Return on assets Machines and equipment 15 Metallurgy and metal products Return on equity Other nonmetal products Rubber and plastic 10 Chemicals Coke and oil products Paper, pulp and polygraph Wood processing 5 Leather Textile Food products 0 -50 -30 -10 10 Dec-15 Dec-16 Oct-15 Oct-16 Aug-16 Apr-16 Apr-17 Jan-14 Jan-15 Jan-16 Nov-16 Jan-17 Feb-16 Sep-16 Feb-17 May-16 Jun-16 Jul-16 Mar-16 Mar-17 Investment growth in 2016, % Production growth in 2016, % Source: CBR. Source: Rosstat. The federal fiscal deficit grew in 2016 but remained deficit rose to 2.8 percent of GDP from 2.6 percent contained. The primary deficit grew from 1.7 percent of the previous year. Extra-budgetary funds registered a GDP in 2015 to 2.7 percent of GDP in 2017 on the back marginal deficit of 0.2 percent of GDP, and imbalances of lower oil and gas revenues. It was contained primarily in the pension system increased. Federal government by consolidating expenditures and mobilizing some transfers that covered the Pension Fund deficit grew revenues (including from the privatization of Rosneft). to 2.4 percent of GDP from 2.1 percent of GDP in 2015, Compared to 2015, primary spending decreased by reflecting a substantial dependence of the Pension 2.6 percent in real terms (Figure 9.a). Pensions were Fund on the federal budget. indexed below inflation, and civil servant salaries and the savings pillar of the pension system were frozen. There are significant variations in the quality of the In real terms, government spending decreased across regional budgets and concerns related to the growing all categories except for social security, environmental role of federal government loans. The consolidated protection and national defense (the latter largely due regional budget registered a primary surplus of 0.2 to the redemption of the debt of military enterprises at percent of GDP in 2016. And as Part 3 of the report the end of the year). discusses in detail, Russian regions have weathered the slowdown in the economy fairly well in the recent past Figure 9.a: Federal budget primary expenditures decreased – showcasing low deficits and broadly moderate debt in real terms in 2016 (percent, y/y) levels. However, the structure of the local debt presents 20 challenges, as it is mostly made up of short maturities 10 and subject to rollover risks. The significant part of 0 -10 subnational debt (39 percent) shown in Figure 10.a -20 takes the form of short-term loans from commercial -30 banks. In addition, some local governments are highly -40 indebted. -50 -60 Adjustment in Russian regions has happened through massive expenditure cuts as opposed to revenue mobilization, with social sectors and capital spending hit the hardest. Better debt management (reducing rollover risks; mobilizing more revenues and cutting Source: Federal Treasury of the RF. expenditures where it makes sense) will be key to unlocking the growth potential at subnational levels, The general government’s fiscal stance also worsened as will improving the public-sector efficiency of moderately. In 2016, the general government primary subnational governments. Russia Economic Report | № 37. May 2017 vii Execu ve Summary Figure 10.a: Short-term loans account for over one-third of Figure 11.a: Federal budget deficit expected to decrease the subnational debt over time (percent of GDP) 3 000 Bonds constant Rbs Bns of 2015 2 500 Bank loans 2 000 Federal loans 1 500 1 000 500 - 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Federal Treasury of the RF. Source: Ministry of Finance. In early 2017, the federal government balance expenditure categories would decrease over three strengthened on the back of increasingly robust oil years except for environmental protection. Social policy revenues. Compared to January – March 2016, oil and expenditures would decrease by 2.5 percent in real gas revenues in the federal budget rose by 2.2 percent terms in 2019 compared to 2016, which would require of GDP to 7.6 percent of GDP on the back of higher oil increased targeting of these expenditures. The fiscal prices. Federal budget primary expenditures increased consolidation will also be supported by some revenue by 0.2 percent of GDP to 18.6 percent of GDP. The mobilization efforts: the government projects to raise federal government balance consequently registered a 1.1 percent of GDP in 2017-2019 predominantly from primary deficit of 0.5 percent of GDP in January-March the transfer of dividends of state-controlled companies 2017 compared to -2.4 percent of GDP deficit in the and by increasing tax revenue from the energy sector. same period last year. However, the federal non-oil As Box 3 in the report and Figure 12.a shows below, primary deficit worsened marginally to 8.0 percent Russia’s expenditures as share of GDP are low compared of GDP in January-March 2017 on the back of higher to other countries, suggesting more emphasis could expenditures, compared to 7.9 percent of GDP in the perhaps be paid to mobilizing revenues in addition to same period last year. expenditure cuts. With an eye to the proposed introduction of the new Against these dynamics, we expect the economy to fiscal rule, the government passed a three-year federal go from recession to recovery. Consistent with our budget law and introduced currency interventions projections in the previous Russia Economic Report in the domestic market. The three-year budget law (November 2016), we expect the Russian economy to covering the 2017-2019 period provides for substantial grow 1.3 percent in 2017 and 1.4 percent both in 2018 fiscal consolidation, mainly through expenditure cuts and 2019 (Figure 13.a). The positive terms-of-trade and limited revenue mobilization efforts. The budget effect from rising oil prices, coupled with more stable law is based on an oil price of US$ 40/bbl for the 2017- macroeconomic conditions, are expected to drive 2019 period (Figure 11.a). this recovery. And as Box 5 in the report elaborates, being among the top three oil exporters in the world, Expenditure consolidation – more than revenue the Russian oil sector has demonstrated resilience, mobilization – is the central plank of the three-year increasing production and exports despite headwinds, federal budget law. Compared to 2016, federal budget thanks to increased production by small- and medium- primary expenditures would decrease by about 7 size producers (including Gazpromneft, Novatek, percent in real terms (deflated by CPI) over three years Tatneft, Russneft, and Bashneft). Moreover, total oil and by 3.6 percent of GDP, almost evenly distributed, production is expected to increase to 11.38 mb/d in with the biggest expenditure cuts proposed in national 2017 and peak at 11.54 mb/d in 2018, as new projects defense, the national economy and in housing and will more than offset brownfield declines. communal services. In real terms, all federal budget viii Russia Economic Report | № 37. May 2017 Execu ve Summary Figure 12.a: Russia’s expenditures as % of GDP are low Figure 13.a: The economy is expected to grow in 2017- compared to other countries’. General government spending 2019 (real GDP growth, percent) as percentage of GDP and by function: Russia vs. EU-28 and OECD average for 2015 2015 Social protection Education Recreation, culture and religion Health Housing and community amenities Environmental protection Economic affairs Public order and safety Defense General public services TOTAL 0 5 10 15 20 25 30 35 40 45 50 OECD average (27 countries) EU-28 Russia Source: OECD, Federal Treasury of the RF, Eurostat. Source: Rosstat, World Bank. Consumption is expected to drive growth in 2017- fueled by inventory restocking and deferred demand 2019 with investment playing a supporting role for investment imports. Table 1 shows the projected (Table 1.a). We expect headline inflation to continue overall growth, growth in its expenditure components, moderating, falling slightly below 4 percent at the as well as the components’ contribution to projected end of 2017 and stabilizing around 4 percent in 2018- growth. 2019. Lower inflation will support real wages that will be the main source of real income growth. These and Growth projections remain sensitive to oil prices. A improving consumers’ sentiments and better credit simulated decrease of 15 percent in oil prices reduces conditions are all expected to lead to a growth in private growth to 1 percent in 2017 and 1.2 percent for 2018 consumption of 1.8 percent in 2017 and 2.5 percent in and 2019 (Figure 14.a). A simulated increase of 15 2018 and 2019. Investment demand is also expected to percent in oil prices increases growth to 1.6 percent pick up in the forecasting period as businesses renew for 2017 and 1.8 percent for 2018 and 2019. Despite their stocks in 2017 and fixed capital investment grows policy efforts to reduce sensitivity, oil price volatility due to macro stabilization and improved investors’ would still affect consumer and producer sentiments. sentiment. The 2018 soccer World Cup could further We expect a slightly higher response of the economy to support public investment. The contribution of net the upper oil price variation due to improved investor exports to growth is expected to be negative in 2017 as sentiments. import growth is expected to outstrip export growth in 2017 because of an improvement in domestic demand Table 1.a: Projected growth is between 1.3 to 1.4 percent in 2017 - 2019 Projected Growth, y/y, percent Contribution to Growth, pp 2017 2018 2019 2017 2018 2019 GDP 1.3 1.4 1.4 1.3 1.4 1.4 Consumption 1.1 1.6 1.6 0.7 1.0 1.1 Gross capital formation 8.0 1.5 1.1 1.5 0.3 0.2 Gross fixed capital formation 2.0 2.5 3.5 0.4 0.5 0.7 Export 2.0 2.3 2.5 0.6 0.7 0.8 Import 10.0 4.0 4.0 -1.5 -0.6 -0.7 Source: World Bank staff calculations. Russia Economic Report | № 37. May 2017 ix Execu ve Summary Figure 14.a: GDP growth scenarios in 2017-2019 (percent) The poverty rate is expected to decrease because of decelerated inflation and recoveries in private 2 incomes and consumption. In the baseline oil price 1,5 scenario, the poverty headcount is projected to decline in 2017 to 13 percent from 13.5 percent in 2016, and 1 to continue declining to 12.3 and 11.6 percent in 2018 and 2019 respectively (Figure 15.a). Incomes will also 0,5 be supported by an increase in pensions that were 0 indexed by end-year inflation and are likely to increase 2016 2017 2018 2019 in real terms during 2017. Figure 3 also shows the -0,5 GDP growth (baseline) GDP growth low (-15%) GDP growth high (+15%) sensitivity of poverty projections to the minus/plus 15-percent change in oil prices (scenarios 2 and 3) Source: World Bank staff calculations. compared to the baseline. Figure 15.a: The poverty headcount is likely to decline in 2017 and further (percent) 14 14 0,422 13,5 14 0,420 13 13 0,418 12,5 13 0,416 12 12 0,414 11,5 12 0,412 11 11 0,410 10,5 11 0,408 10 10 0,406 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Poverty rate, % Scenario 1 (baseline) Scenario 2 (lower-bound) Scenario 3 (upper-bound) Gini (rhs) Source: Rosstat, World Bank staff calculations. The medium-term prognosis of the Russian economy fiscal framework and the introduction of an updated is favorable. Projected growth rates are between fiscal rule are expected to further improve economic 1.3 to 1.4 percent in the forecasting period of 2017- predictability. The projected strengthening of domestic 2019. Among factors driving this recovery, maintaining demand is also expected to support economic activity macro stability and high oil prices are the most in the non-tradable and tradable parts of the economy influential. Moreover, the return to the medium-term (Figure 16.a). Figure 16.a: Recovery is broad-based, with both Figure 17.a: TFP growth (by various measures) is Russia is tradable and non-tradable sectors to benefit: Projected low and declining growth by sector 12 CES 10 Structural Change Education and resources 8 6 4 2 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -2 Source: World Bank staff calculations. Source: World Bank staff calculations using WDI, Rosstat and ILO data. Note: CES = Constant Elasticity of Substitution x Russia Economic Report | № 37. May 2017 Execu ve Summary However, Russia’s longer-term growth prospects shrinking working age population, potential output remained constrained by its low productivity. Box 7 growth is modest at best (around 1 to 1.5 percent in the report discusses various methods and measures of GDP), thus limiting GDP recovery growth rates. of total factor productivity (TFP) growth in Russia, all Additionally, as shown in Figure 18.a below, over the which yield the same conclusion as summarized in past nine years, unit labor costs (ULC) in Russia have Figure 17.a: TFP growth in Russia is low and declining. been rising. And as discussed in Box 2, even considering For example, even in a relatively well-performing the recent ruble depreciation, high ULCs adversely sector like agriculture, as Box 6 in the report illustrates, affect competitiveness of the Russian economy vis-à- although revenues and profitability have increased in vis other countries. the subsectors of pork production and dairy farming, untapped opportunities remain to improve land Boosting productivity growth remains key to achieving and capital productivity. With low TFP growth and a inclusive, sustainable and fast-paced growth in Russia. Figure 18.a: Unit Labor Costs (ULC) increased significantly in Russia in recent years 280 250 220 190 160 130 100 70 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Agriculture Mining Manufacturing Transport&Communication Construction Finance Total Source: OECD, Rosstat, Haver Analytics and World Bank staff estimates. Russia Economic Report | № 37. May 2017 xi xii Russia Economic Report | № 37. May 2017 PART I RECENT ECONOMIC DEVELOPMENTS Russia Economic Report | № 37. May 2017 1 Part 1. Recent Economic Developments 1.1 Growth: a er almost two years of recession, Russia entered a path to recovery Global growth and trade started to strengthen at the end of 2016. Russia’s economy showed signs of overcoming the recession caused by the shocks of low oil prices and economic sanctions. Tradable sectors benefitted from the relative price adjustment and stabilizing commodity prices in the second half of 2016 and became the main drivers of economic growth, partly through increased exports. There was positive momentum in non-tradable sectors as well, which slowed the pace of contraction compared to 2015. The incipient positive momentum appears to have spilled into early 2017. Global economic trends owned companies’ infrastructure spending slowed the rebalancing trend from investment to consumption, Global growth started to strengthen at the end of although the structural shifts from manufacturing 2016. After a slowdown to 2.3 percent in 2016 driven to services and from external demand to domestic by weak investment and trade, global growth started demand continued. China’s economy expanded by to improve at the end of 2016 (Figure 1). Investment 6.7 percent, in line with its government’s plans and and exports gained momentum, although private expectations (Figure 2). consumption remained feeble. An upturn in the US and steady growth in the Euro Area and Japan supported Global trade bottomed out and external financing the upward trend. In China, strong public and state- conditions for the emerging economies remained benign. From its low point in 2013, trade growth Figure 1: Global growth is strengthening recovered in the second half of 2016, supported by improved industrial activity (Figure 3). Global financial Percent. Percent, yoyyoy Global Global AE AE EMDE EMDE conditions remained positive in early 2017. While the 8 U.S. long-term yield increased by 50 basis points and 7 currencies in many emerging markets depreciated after 6 the U.S. elections of November 2016, this increase was 5 not accompanied by a sustained re-pricing of risk and 4 of emerging-market assets. As a result, capital inflows 3 to emerging and developing economies were robust in 2 the first half of 2017. 1 0 Russia: recent economic developments 2011 2012 2013 2014 2015 2016 In 2016, the Russian economy showed encouraging Source: World Bank. AE stands for advanced economies. Series are seasonally signs of overcoming the recession it entered in the adjusted. second half of 2014. In 2016, Russia’s GDP contracted Figure 2: China: actual and targeted growth in line Figure 3: Global industrial production supported recovery in trade growth В % к предыдущему кварталу, урс с учетом сезонных колебаний Industrial production Промышленное производство %, год к году %, 3m-on-3m, saar 2003-08 average 2003-08 среднее 6 16 Ожидаемый рост ВВП 2011-16 2011-16 average среднее 5 14 Фактический рост ВВП 4 12 3 10 2 1 8 0 6 -1 Jan-2012 Apr-2012 Oct-2012 Jan-2013 Apr-2013 Oct-2013 Jan-2014 Apr-2014 Oct-2014 Jan-2015 Apr-2015 Oct-2015 Jan-2016 Apr-2016 Oct-2016 Jan-2017 Jul-2012 Jul-2013 Jul-2014 Jul-2015 Jul-2016 4 Source: Global Monthly, World Bank. Source: Global Monthly, World Bank. 2 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Box 1: Varying implica ons of an oil price shock: Russia had adapted well compared to other oil exporters Oil prices plunged by 77% from June 2014 to January 2016, severely undermining the activities of energy exporters. However, the macroeconomic implications of the shock varied across countries. This box reports the divergences among oil exporters to provide a cross-country perspective on the situation in Russia. Exchange-rate flexibility plays a key role in cushioning an export-price shock (IMF 2016). Figure B1-1 shows the impact of the oil price shock on growth, measured by the change in growth forecasts before the oil price shock and after the oil price shock for countries with and without flexible exchange rates, and for Russia. Figures B1-2 and B1-3 shows the impact on inflation and the current account. While the 2014-15 period marked most of the decline in oil prices, countries with an inflexible exchange-rate regime experienced modest decline in growth, due in part to supportive fiscal measures and an absence of high inflation. However, current accounts in inflexible exchange-rate regimes worsened significantly during the same period. Furthermore, by 2017, growth declined sharply in these economies. Five years after the oil shock, growth is expected to continue to drag. In contrast, countries with flexible exchange-rate regimes experienced both an earlier and smaller decline in growth, with growth expected to broadly recover in the five years following the shock. The implications for the current account were minimal. For Russia, growth adjustment happened earlier than for many oil exporters, reflecting the early impact of economic sanctions and the high inflation associated with the introduction of a floating exchange-rate regime. Exchange-rate pass- through is high when monetary policy credibility is not well established (Carriere-Swallow et al, 2016). Stabilizing exchange rates and inflation contributed to the V-shape recovery in 2016-17, reflecting increasing monetary credibility in Russia. Figure B1-1: Impact of Oil Price Shock Figure B1-2: Impact of Oil Price Shock Figure B1-3: Impact of Oil Price Shock on Growth on Inflation on the Current Account Percent Percent Russia Percent of GDP 0 12 Countries with Inflexible Exchange Rate 5 2014 2015 2016 2017 2018 2019 Countries with Flexible Exchange Rate 10 -1 0 8 2014 2015 2016 2017 2018 2019 -2 6 -5 -3 4 -4 -10 2 -5 0 Russia Russia -15 2014 2015 2016 2017 2018 2019 Countries with Inflexible Exchange Rate -6 Countries with Inflexible Exchange Rate -2 Countries with Flexible Exchange Rate Countries with Flexible Exchange Rate Source: IMF, World Bank. Notes: 1-3) Samples are energy-exporting emerging economies and frontier markets. Exchange-rate regime classification is as of 2014, and inflexible exchange rates include peg and no separate legal tender. Countries with flexible exchange rates include Colombia, Ghana, and Indonesia. Countries with inflexible exchange rates include Bahrein, Bolivia, Ecuador, Gabon, Kuwait, Oman, Qatar, Saudi Arabia, and Venezuela. Azerbaijan, Nigeria, Malaysia, and Kazakhstan are excluded from the sample because they are managed floats. Numbers are median of each country group. 2014-2015 data is the difference between the actual figures and forecasts. 2016-2019 data shows the difference in forecasts. The negative number indicates downward revision. 1) Change of GDP growth forecast by IMF from March 2014 to March 2017. 2) Change of inflation forecast by IMF from March 2014 to March 2017. 3) Change of current account forecast (percent of GDP) by IMF from March 2014 to March 2017. In the Europe and Central Asia region, in addition to Russia, Azerbaijan and Kazakhstan moved toward more exchange-rate flexibility (Figure B1-4,5,6). The Russian ruble started to depreciate in late 2014, which led to the acceleration of inflation and a growth slowdown in 2015. Conversely, depreciation of the Kazakh tenge and the Azerbaijani manat started in 2015, and inflation picked up in 2016. While the adjustments to the low oil prices are close to complete in 2017 for Russia, adjustments in Azerbaijan and Kazakhstan are expected to continue in 2017 and beyond. Currency depreciation and economic slowdown have aggravated the banking sector’s balance sheets in Azerbaijan and Kazakhstan, weighing on investment growth. Russia Economic Report | № 37. May 2017 3 Part 1. Recent Economic Developments Figure B1-4: Exchange Rate (LCU/USD) Figure B1-5: Impact of Oil Price Shock Figure B1-6: Impact of Oil Price Shock on Growth on Inflation index Russia Kazakhstan Percent Percent 0 12 250 Azerbaijan Russia Kazakhstan Azerbaijan 2014 2015 2016 2017 2018 2019 -1 10 200 -2 8 -3 6 150 -4 4 -5 2 100 -6 0 2014 2015 2016 2017 2018 2019 -7 -2 50 Russia Kazakhstan Azerbaijan -8 -4 2014 2014 2015 2015 2016 2016 2017 Source: IMF, World Bank. Notes: 4) Market exchange rate of local currency unit per US dollar. Normalized as January 2014 = 100. 5) Change of GDP growth forecast by IMF from March 2014 to March 2017. 2014-2015 data shows differences between the actual figures and forecasts. 2016- 2019 data is changes in forecasts. A negative number indicates a downward revision. 6) Change of inflation forecast by IMF from March 2014 to March 2017. 2014-2015 data is the difference between the actual figures and forecasts. 2016-2019 data shows changes in forecasts. A negative number indicates a downward revision. by 0.2 percent, y/y, compared to a 2.8 percent In 2016, private consumption contracted as inventory contraction in 2015. Meanwhile, according to the stock decreased, both on a smaller scale than in estimates of the Ministry of Economy1, the economy 2015. Net exports contributed positively. Fixed capital bottomed out in the first quarter of 2016 (Figure 4). investment remained subdued. A continued fall in The incipient positive momentum appears to have consumer demand on the back of a protracted fall in spilled into 2017. In the first quarter of 2017, GDP real incomes kept domestic demand depressed (-2.4 grew by 0.5 percent, y/y. In the first four months of percent y/y). However, the pace of contraction slowed 2017, industrial production expanded by 0.7 percent, down considerably, compared to 2015, as consumer y/y. Growth was registered in agriculture (0.7 percent, confidence improved. The inventory stock decreased y/y, in the first three months of 2017). PMI indexes for as well, but on a smaller scale than in in 2015. both manufacturing and services pointed to expansion Increasing exports (+3.1 percent y/y) and contracting (Figure 5). imports (-3.8 percent, y/y) became the main engines Figure 4: The economy bottomed out in the first for GDP growth (Figure 6). quarter of 2016 (GDP growth, percent, y/y and q/q, sa) Export-oriented production played an important role 2 in the expansion of tradable sectors. Taking advantage 1 of the relative price adjustment and stabilization 0 of commodity prices, tradables expanded by 1.2 -1 percent, y/y, after contracting by 1.9 percent in 2015. -2 Agriculture (which benefited from a good harvest) and manufacturing were the top contributors to growth -3 among tradable goods (Figure 7). -4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 Within manufacturing, growth was uneven. Food SA q/q y-o-y products, chemicals and oil products grew the most, in Source: Rosstat, Ministry of Economic Development. addition to textiles, clothing, and electric machinery. (Figures 9 and 10). However, a continued contraction in metallurgical industries, automobile production, 1   Seasonally adjusted numbers of quarterly growth, published office equipment and electronic goods still reflected by Rosstat previously, are not available yet, due to changes in the negative influence of depressed domestic demand methodology and thus quite short times series. 4 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Figure 5: Positive momentum appearsto have rolled over to Figure 6: Net exports contributed positively to GDP growth 2017 (IP, agriculture and cargo turnover growth, percent, y/y) in 2016 (Contribution to GDP growth by components, pp) 110 70 9 108 60 106 104 50 4 102 40 100 30 -1 98 20 96 94 10 -6 92 0 Apr-16 Apr-17 Feb-16 Sep-16 Feb-17 Jun-16 Jul-16 Mar-16 Mar-17 Dec-16 Aug-16 Oct-16 Jan-16 Nov-16 Jan-17 May-16 -11 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Industrial Production Cargo Consumption Gross Fixed Capital Formation Agriculture PMI services (RHS) Change in inventories Export Import Stat error PMI manufacturing (RHS) GDP growth Source: Rosstat. Source: Rosstat. Figure 7: Tradable sectors became main driver of economic Figure 8: Output growth was not followed with investment growth (Contribution of tradable sectors to GDP growth, pp) growth in many manufacturing sectors (percent, y/y) Transport and transportation equipment 0,8 Electro-technical and optical 0,6 Machines and equipment 0,4 Metallurgy and metal products 0,2 Other nonmetal products Rubber and plastic 0,0 Chemicals -0,2 Coke and oil products -0,4 Paper, pulp and polygraph -0,6 Wood processing Leather -0,8 Textile -1,0 Food products Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 -50 -30 -10 10 Agriculture and forestry Fishing Mineral extraction Manufacturing Investment growth in 2016, % Production growth in 2016, % Source: Rosstat. Source: Rosstat. on tradable sectors in 2016. Output growth was not public sector, was limited and turned slightly negative followed with fixed capital investment growth in many overall because of a fall in health and social services manufacturing sectors (Figure 8). provisions. A positive momentum in non-tradables mitigated Fixed capital investment remained subdued. Overall, the GDP contraction, compared to 2015. Incipient fixed capital investment decreased by 1.2 percent, growth in real wages somewhat supported demand compared to 2015. According to Rosstat’s data on for market services. In addition, reviving business medium and large enterprises, fixed capital investment activity in tradable sectors supported a recovery in was largely concentrated in mineral resource extraction associated non-tradable sectors (mainly transport and and services. Fewer manufacturing sectors (namely electricity production). Contractions in the retail and paper, pulp and publishing, chemicals and metals) wholesale trades slowed in annual terms, especially saw more investment growth in 2016 than in 2015. in the fourth quarter when a stronger ruble and Capacity utilization increased in some of these sectors, decelerating inflation improved consumer sentiment. but more investment, however, will be necessary to Thus, negative contributions of non-tradable sectors sustain growth. As in 2015, fixed capital investment to GDP growth decreased substantially compared to was mostly financed from enterprise profits, and the 2015, and even turned slightly positive in the fourth share of this financing increased in 2016. Due to a tight quarter of 2016 (Figure 11). Compared to 2015, the fiscal space, investment financed from the federal contribution of services, associated mainly with the budget decreased in 2016 compared to 2015. Russia Economic Report | № 37. May 2017 5 Part 1. Recent Economic Developments Growth in manufacturing sectors went hand in hand with growth in exports Figure 9: Growth in manufacturing industries (percent, y/y) Figure 10: Export growth rates (percent, y/y) Electronics Leather Other goods Vehicles Office equipment, computers Machinery, equipment and vehicles Chemicals (w/o gunpowder and explosives) Secondary raw materials processing Metals and metal products Machines and equipment processing (w/o… Textiles, textile products and footwear Metallurgy Rubber and plastic Wood, pulp and paper products Pharmacy Coke and oil products Leather raw materials, furs and its products Wood, pulp and paper products Wood processing Chemicals, rubber Textiles Tobacco processing Oil products Food processing (incl beverages) Extraction of crude oil and natural gas (incl. services) Minerals Extraction of stone and brown coal, peat Agriculture, hunting (incl. services) Food and agricultural raw materials (except for textiles) -10,0 -5,0 0,0 5,0 10,0 15,0 -15,0 -10,0 -5,0 0,0 5,0 10,0 15,0 20,0 Source: Rosstat. Source: Federal Customs Service of the RF. Figure 11: Negative contribution of non-tradable sectors to GDP growth decreased substantially, compared to 2015 (Contribution of non-tradable sectors to GDP growth, pp) 1,0 0,5 0,0 -0,5 -1,0 -1,5 -2,0 -2,5 -3,0 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Construction Retail and wholesale trade Hotels and restaraunts Transport and communication Finance Real estate State management, national security, social security Education Health Other communal and social services Housekeeping services Source: Rosstat. 1.2 Balance of payments: stable despite substan al external vola lity Despite adverse terms-of-trade conditions in 2016 and continued restrictions on Russia’s access to international capital markets, the balance of payment remained stable, with the REER slightly depreciating. The current account surplus shrank as the trade surplus decreased on lower export receipts, especially in the first half of the year. An incipient import recovery was an additional negative factor for the trade balance in the second half of 2016. Meanwhile, net capital outflows decreased on the back of lower debt payments. Relatively tight monetary policy increased interest in ruble assets and limited net capital outflows. Improved terms-of-trade conditions helped the current account in the first quarter of 2017, which translated into larger net capital outflows. The current account, which remained in surplus, was bottomed out by mid-2016 (Figure 12). In the driven largely by the trade balance. first half of 2016, the terms of trade deteriorated, leading to a decline in export receipts of 30 percent. • In 2016, adverse terms of trade weakened the The REER depreciated by 8.5 percent in the same current account surplus. Negative trends for the period, causing imports to drop by 8.5 percent in prices of the major commodities exported by Russia value in the first half of 2016, y/y, but not enough 6 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Figure 12: Prices for the major commodities exported by Oil prices increased by about 60 percent y/y in the Russia rebounded in the beginning of 2016, (ln) first quarter of 2017. Imports (by value) grew by 25 percent, associated with a stronger ruble and the 5 10 possible restocking and purchasing of equipment for 4,5 9,5 investment, but import growth was weaker than the 4 36-percent increase in export receipts. Consequently, 9 3,5 the trade balance strengthened, leading the current 3 8,5 account to grow to US$22.8 billion. 2,5 8 2 The financial-account dynamics mirrored those in the 1,5 7,5 current account. The international reserves import cover stood at a healthy 18 months. 1 7 Jan-2014 Mar-2014 May-2014 July-2014 Sept-2014 Nov-2014 Jan-2015 Mar-2015 May-2015 July-2015 Sept-2015 Nov-2015 Jan-2016 Mar-2016 May-2016 July-2016 Sept-2016 Nov-2016 Jan-2017 Mar-2017 • In 2016, a weakening of the current account was Crude oil, Brent ($/bbl) Iron ore, cfr spot ($/dmtu) Natural gas, Europe ($/mmbtu) Aluminum ($/mt) (rhs) matched by a strengthening of the financial account. Copper ($/mt) (rhs) Nickel ($/mt) (rhs) In the banking sector, net capital outflows decreased Source: World Bank. Figure 13: In the second half of 2016, imports of goods Figure 14: Improvement in services and labor income picked up on stronger ruble and incipient economic recovery accounts deficits could not compensate for the worsening trade balance (percent of GDP) 60000 100 40000 80 20000 60 0 40 -20000 -40000 20 -60000 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Aug-2014 Oct-2014 Aug-2015 Oct-2015 Aug-2016 Oct-2016 Apr-2014 Apr-2015 Apr-2016 Feb-2014 Feb-2015 Feb-2016 Feb-2017 Jun-2014 Jun-2015 Jun-2016 1q 2q 3q 4q 1q 2q 3q 4q 1q 2q 3q 4q 1q 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 Oil price (Brent), Dec 13 = 100 Goods Services Import of goods, Dec 13 = 100, SA Compensation of employees Investment income REER, Dec 13 = 100 Transfers Current account balance Source: CBR, Haver. Source: CBR, Rosstat, Ministry of Finance. to compensate for the decline in export receipts. In by US$36.5 billion to US$8.4 billion2, mostly on the the second half of the year, imports of goods picked back of lower debt payments. In the non-banking up on a stronger ruble and an incipient economic sector, net capital outflows decreased by US$4.1 recovery (Figure 13). Overall in 2016, the trade billion to US$20.4 billion, partly due to increased FDI balance fell to US$90.0 billion from US$148.5 billion inflows from the Rosneft privatization. Meanwhile, in 2015. Improvements elsewhere (for example, in confidence in the ruble strengthened as oil prices services and labor income accounts deficits) could recovered and macro stabilization was achieved. A not compensate for the deterioration of the trade relatively tight monetary policy increased interest balance (Figure 14). Thus, the current account in ruble assets, which offered attractive returns, surplus fell from US$68.9 billion in 2015 to US$25 leading to an increase in portfolio investment billion in 2016. inflows in 2016. • In the first quarter of 2017, improved terms of 2   Adjusted for currency swaps and correspondent accounts of trade strengthened the current account surplus. resident banks in the central bank, and repayments of foreign- currency loans by large banks to the central bank. Russia Economic Report | № 37. May 2017 7 Part 1. Recent Economic Developments Figure 15: Russia’s external debt decreased, Figure 16: Russia’s 5-year CDS spread was lowered US$ billion, e-o-p substantially 250 600 500 200 400 150 300 100 200 50 100 0 0 1 2 3 4 5 6 7 8 9 0 1 2 1 2 3 4 5 6 7 8 9 0 1 2 1 2 3 4 Jan-2015 Feb-2015 Mar-2015 Apr-2015 May-2015 Jun-2015 July-2015 Aug-2015 Sept-2015 Oct-2015 Nov-2015 Dec-2015 Jan-2016 Feb-2016 Mar-2016 Apr-2016 May-2016 Jun-2016 July-2016 Aug-2016 Sept-2016 Oct-2016 Nov-2016 Dec-2016 Jan-2017 Feb-2017 Mar-2017 Apr-2017 State Banks Non-banking sector Russia Turkey Brazil Chile 2015 2016 Indonesia Kazakhstan Latvia Mexcio Source: CBR, Bloomberg and World Bank staff estimates. Source: Haver. • In the first quarter of 2017, the stronger current Lower borrowing costs (Figure 16) and better economic account translated into higher net capital outflows. prospects helped the non-banking sector increase roll- This reflected mainly the accumulation of foreign over debt ratio. In the first quarter of 2017, the trend assets by the banking sector. The non-banking sector toward deleveraging in the non-banking sector was increased its net foreign liabilities and registered a interrupted and companies slightly increased their net capital inflow. Net capital outflows rose from external debt. US$14.1 to US$22.3 billion. Adjusted for exchange-rate movements, the public • International reserves are currently at a healthy debt increased in 2016 by 14.4 percent compared 18 months of imports, compared to 16 months of to the previous year. The external debt stayed at a imports in 2015. International reserves increased comfortable level. Purchases of ruble government by US$9 billion in 2016, compared to 2015. This bonds by non-residents on the secondary market, increase largely reflected price changes and offering attractive returns, contributed to increase repayments of foreign-currency loans by large banks the external government debt. In addition, for the to the Bank of Russia3. In the first quarter of 2017, first time since 2013, the government issued US$1.75 the central bank’s reserves increased partly due to billion in 10-year Eurobonds with an effective rate of foreign currency purchases, which it conducted on 4.75 percent in May and US$1.25 billion in 10-year behalf of the Ministry of Finance since February. Eurobonds with an effective rate of 3.9 percent in September 2016. Russia’s 5-year CDS spreads, the The trend of corporate external debt deleveraging, highest among comparator countries, have lowered which started in the second half of 2014 with the substantially (Figure 16). Overall, by the end of 2016 introduction of sanctions that restricted Russia’s with the correction for exchange-rate movements, access to international financial markets, continued Russia’s external debt (public and private) shrank by in 2016, but on a smaller scale. The external debt of 4.7 percent compared to the end of 2015 and reached the banking and non-banking sectors, adjusted for US$513.5 billion. Russia’s external-debt sustainability exchange-rate movements, dropped by 11.7 percent indicators weakened marginally from 37.9 percent and 4.0 percent respectively in 2016 (Figure 15). For of GDP and 15.8 months of exports in 2015 to 40.6 the non-banking sector, the roll-over ratio increased percent of GDP and 18.7 months of exports in 2016, but from about 71 percent in 2015 to 81 percent in 2016. stayed at a moderate level. The government’s external debt increased from 2.2 percent of GDP in 2015 to 3.3 3   These loans were originated by the Central Bank in 2015 to percent of GDP in 2016, staying at a comfortable level. support large banks’ external debt payments under the sanctions regime. 8 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments 1.3 Labor Market and Poverty Trends: unemployment is stable and wages are recovering, but economy-wide unit labor costs are increasing faster than the OECD average and they vary across sectors Unemployment decreased slightly, inflation slowed and real-wage growth resumed. But poverty also increased, as the sharp decline in pension income more than offset the incipient recovery in real wages. However, the prevalence of extreme poverty remained marginal. The employment and labor force participation reflecting the weak situation in the real sector. The rates are still near maximum historical levels, while number of part-time employees is experiencing slow unemployment is close to minimum. The absolute growth and remains far below the levels of the 2009 numbers of economically active and employed people crisis period. The replacement ratio of the number of hardly changed in the first three months of 2017 hired and fired workers is stable. The average number compared to the same period of 2016. However, the of hours worked is declining slowly. The sectoral seasonally adjusted labor-force participation and composition of employment changed slightly: the employment rates grew to levels above 69 and 65 highest growth in employment, for the second half of percent respectively to compensate for the decline in 2016 relative to the second half of 2015, was registered the working-age population (Figure 17). As a result, in mining (5 percent) and education (3 percent) while unemployment decreased slightly. The unemployment employment mostly contracted in construction (5 rate went down to 5.5 percent in the first three percent) and the financial sector (4 percent). Figure 17: LFP and employment rates are near maximum, Figure 18: Unemployment rate is close to minimum, (percent) (percent) 71 70 8 69 68 7 67 66 6 65 64 5 63 62 4 2011 2012 2013 2014 2015 2016 2017 2011 2012 2013 2014 2015 2016 2017 LFP rate Employment rate Total SA LFP rate, MA Empl. rate, MA Source: Rosstat, Haver Analytics and World Bank staff estimates. Source: Rosstat, Haver Analytics and World Bank staff estimates. months of 2017, compared to 5.9 percent a year ago Real wages started to grow as inflation decelerated. (Figure 18). The structure of unemployment remains Their growth was positive since August 2016. In the the same, with the gaps between male/female and first three months of 2017, average growth was 1.9 rural/urban unemployment remaining stable and most percent compared to the same period of 2016. The unemployment still being long-term (30 percent of the fastest wage growth was in the tradable sectors (Figure unemployed had been looking for a job for at least 19), especially in agriculture (5.6 percent in the past six a year). Due to low labor mobility, unemployment months compared to the same period year ago) and by regions remained very unequal and followed the manufacturing (3.7 percent). The biggest contraction national trend. of wages was in real estate (6.5 percent) and utilities (3.4 percent). Other labor-market indicators have not been overly affected. The vacancy rate4 is decreasing slightly, However, disposable income continued to decline in real terms, driven by non-wage income components. 4   Ratio of vacancies to the total numbers of jobs. Russia Economic Report | № 37. May 2017 9 Part 1. Recent Economic Developments Figure 19: Real wage dynamics started to grow, Figure 20: Real incomes continue to decline, (percent year on year) (percent year on year) 25 15 20 15 10 10 5 5 0 0 -5 -5 -10 -15 -10 -20 -15 2011 2012 2013 2014 2015 2016 2017 2011 2012 2013 2014 2015 2016 2017 Tradables non-Tradables Public Wages Pensions Disp income Source: Rosstat and World Bank staff estimates. Source: Rosstat and World Bank staff estimates. Note: pension dynamics adjusted for January 2017’s one-time payment. The 8-percent growth in disposable income in January subsistence minimum level were increased at a lower 2017 was explained by a one-time payment to rate. Still, in 2017, the pensions were indexed to end- pensioners of 5,000 rubles. In all other months at the year inflation, which is likely to have positive effect in end of 2016 and in early 2017, the real-income dynamics statistics during the year. were negative (Figure 20). This is also explained by self-employment income and small-business activity Driven by the continued contraction of disposable that is not directly captured by income statistics and incomes, the poverty rate increased slightly in thus is less reliable. These sources of income are 2016. In 2016, 19.8 million people or 13.5 percent of particularly important for the people in the bottom population had incomes below the subsistence level. of the distribution. Even after adjustment for the one- This was 0.2 percentage points higher than a year time 5,000-ruble payment, the pension dynamics were ago (Table 1). However, the poverty line decreased in still negative in real terms. In 2016, pensions were absolute terms in third and fourth quarters of 2017, so indexed at 4 percent – below that year’s inflation rate. the growth was still positive compared to the previous Moreover, the effects of indexation were even smaller year. because some supplements that bring pensions to the Table 1: Poverty rates increased slightly in 2016 2010 2011 2012 2013 2014 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2015 2015 2015 2015 2016 2016 2016 2016 Poverty rate, percent 12,5 12,7 10,7 10,8 11,2 15,9 15,1 14,1 13,4 16,0 14,6 13,9 13,5 Number of poor, 17,7 17,9 15,4 15,5 16,1 22,9 21,7 20,3 19,2 23,4 21,4 20,3 19,8 million people Источник: Росстат. Box 2: Unit labor costs (ULC) are increasing significantly in Russia and affec ng compe veness, despite the ruble deprecia on As Figure B2-1 shows, over the past nine years, ULC* in Russia grew by about 2.5 times, compared to 2007 (2007 levels are set to 100). As the same figure shows, the growth of ULC across sectors in Russia was not uniform, with the fastest growth in mining, and the slowest in the financial sector. Growth in agriculture and manufacturing was lower than average for the economy in the period 2007-2016. The sharp ruble depreciation in response to the terms of trade shock of 2014 resulted in substantial improvement in Russia’s competitiveness with respect to the OECD countries. Bilateral Real Exchange Rates (RERs), calculated with a change in ULC in the manufacturing sector as a measure of inflation, depreciated substantially in 2014. Nevertheless, even accounting for this depreciation, as Figure B2-2 shows, Russia’s competitiveness with respect to many comparators remains relatively low (recent RERs exceed the 2007 levels set to 100 for France, Spain, Czech Republic, for example). This suggests that growing ULCs are pulling down competitiveness, despite the benefits of the ruble depreciation. 10 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Figure B2-1: Unit Labor Costs (ULC) increased significantly Figure B2-2: Russia’s competitiveness improved in 2014 in Russia in recent years, 2007=100% but it remains low RER calculated with change in ULC with respect to selected OECD countries, 2007=100% 160 150 280 140 250 130 220 190 120 160 110 130 100 100 90 70 80 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Agriculture Mining Czech Republic Spain United States Manufacturing Transport&Communication United Kingdom France Norway Construction Finance Total Source: OECD, Rosstat, Haver Analytics and World Bank staff estimates. Source: Rosstat, Haver Analytics and World Bank staff estimates. * Unit labor costs is one indicator to track changes in competitiveness over time. ULCs are defined as the average cost of labor per unit of output produced. According to the OECD definition, ULC is ratio of “total labor compensation per hour worked” to “output per hour worked” (labor productivity). For the sectoral analysis in Russia analyses, we used a simplified approach due to lack of data of total labor compensation in Russian statistics. ULCs are calculated as average formal wages in sector multiplied by number of employed and divided by real gross values added in the sector. 1.4 Monetary Policy: gradual monetary easing amidst an uncertain and vola le external environment Monetary policy remains prudent and consistent with inflation targeting. A moderately tight monetary stance helped reduce the average inflation rate from 15.6 percent in 2015 to 7.1 percent in 2016. Headline inflation almost reached the end-year target of 4 percent as early as April 2017, falling to 4.1 percent, y/y. Recognizing that several one-off factors supported the reduction in headline inflation, the Bank of Russia pursued a cautious approach to monetary easing as inflation expectations, although following a downward trend, remained elevated. The Bank of Russia pursued a measured approach to at 9.25 percent following the most recent cut of 50 bps monetary easing in 2016 and in the first quarter of in April 2017, when CPI inflation fell to 4.1 percent y/y. 2017 (Figure 21). The regulator took a long pause after Uncertainty about the pace and parameters of the US a key rate cut in August 2015 as inflation expectations monetary-policy tightening, which would otherwise remained elevated. The central bank resumed increase the attractiveness of US assets and create monetary easing only in June 2016 (Figure 22). The pressure for capital outflows in all the EMDEs, also key factor that affected inflation expectations was the influenced the key policy rate decisions of the Bank of new round of ruble depreciation during September Russia as they strived to provide stable and predictable 2015-February 2016 on the back of subsiding oil prices. economic conditions. Some degree of uncertainty regarding fiscal policy also delayed monetary policy normalization. This Monetary easing, with federal budget deficit financing uncertainty was largely resolved in the fourth quarter provided by the Reserve Fund and the central bank of 2016 with the introduction of amendments to the to the Deposit Insurance Agency (DIA), resulted in budget law of 2016 and the adoption of the three- a gradual relaxation of the monetary stance. The year federal budget law for 2017-2019. The bank has monetization of the economy increased with the gradually lowered the key policy rate, which now stands M2to-GDP ratio rising from 38.6 percent at the end of Russia Economic Report | № 37. May 2017 11 Part 1. Recent Economic Developments Figure 21: The Central Bank cuts key policy rate gradually Figure 22: Inflation expectations follow the downward path, but stay elevated 19 80 18 75 17 16 70 15 65 14 13 60 12 55 11 10 50 Sept-2013 Mar-2013 Apr-2014 July-2014 Nov-2014 Dec-2014 Feb-2015 Mar-2015 May-2015 Jun-2015 Aug-2015 Sept-2015 Dec-2015 Jan-2015 Mar-2016 Apr-2016 Jun-2016 July-2016 Sept-2016 Oct-2016 Dec-2016 Feb-2017 Mar-2017 Apr-2017 Expected inflation, median Exchange rate, Rub/USD Source: CBR and World Bank staff calculations. Source: CBR and World Bank staff calculations. Figure 23: Monetization of the economy increases Figure 24: Structural liquidity deficit narrowed 25 42 41 8 000 000 20 40 6 000 000 39 15 38 4 000 000 10 37 2 000 000 36 5 35 0 34 -2 000 000 0 33 Nov-15 Nov-16 Jul-15 Oct-15 Jul-16 Oct-16 May-15 May-16 Jan-15 Jan-16 Jan-17 Mar-15 Apr-15 Mar-16 Apr-16 Mar-17 Apr-17 Aug-15 Aug-16 Feb-15 Feb-16 Feb-17 Sep-15 Sep-16 Jun-15 Jun-16 Dec-15 Dec-16 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Bank deposits with Bank of Russia Debt on overnight, lombard loans and loand secured by gold Debt on loans secured by non-marketable assets or guarantees FX swap debt Average Money Supply growth, y-o-y, sa, percent (LHS) REPO debt (auctions) REPO dept (fixed rate) Average Money Supply, percent of GDP (RHS) Structural liquidity deficit Source: CBR and World Bank staff calculations. Source: CBR, WB staff calculations. 2015 to 41.5 percent at the end of 2016 (Figure 23). the Reserve Fund for federal budget deficit financing The observed moderate relaxation in monetary stance and liquidity provision by the Bank of Russia to the resulted in a reduction in money-market rates from Deposit Insurance Agency increased liquidity in the 11.8 percent y/y at the end of 2015 to 9.9 percent banking sector and reduced the structural liquidity y/y in April 2017. Real interest rates5 decreased from deficit in 2016. Prior to 2016, the central bank had high levels at the beginning of 2015 (about 7 percent been operating in an environment of high structural y/y in February 2015), but stayed at the level above 5 liquidity deficits, using refinancing instruments to keep percent, keeping monetary conditions relatively tight. money-market rates close to the key policy rate level (Figure 24). However, in August 2016, as the structural The structural liquidity deficit in the banking system6 liquidity deficit narrowed and an increasing risk narrowed substantially in 2016, leading the central emerged of money-market rates dipping below the bank to introduce a new monetary policy instrument policy rate. So the Bank of Russia introduced one-week (one-week deposit auctions) to keep money market deposit auctions that became an important instrument rates close to the key rate. Substantial spending from of monetary policy, targeting excess liquidity in certain banks. The regulator has also gradually toughened 5 collateral requirements after a significant softening in  Real interest rate is calculated with expected inflation, calculated based on the center for development consensus forecast. 2014-2015. It sold government bonds from its portfolio 6  The structural liquidity deficit - stable demand from the credit and raised reserve requirements. Thus, overnight institutions for liquidity provision by the Central Bank. The level of money-market rates remained close and slightly above structural liquidity deficit equals a positive difference between the Central Bank’s claims to credit institutions on refinancing operations the key rate, translating the key policy rate dynamics to and liabilities to them on operations for absorbing excess liquidity. the market (Figure 25). 12 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Figure 25: Money market rates remained close and Figure 26: Inflation slowed down (CPI index and its slightly above the key rate components, percent, y-o-y) 25 12,5 12,0 20 11,5 15 11,0 10,5 10 10,0 5 9,5 9,0 0 Dec-14 Dec-15 Dec-16 Oct-14 Oct-15 Oct-16 Aug-14 Aug-15 Aug-16 Apr-14 Apr-15 Apr-16 Apr-17 Jan-14 Nov-14 Jan-15 Nov-15 Jan-16 Nov-16 Jan-17 Feb-14 Sep-14 Feb-15 Sep-15 Feb-16 Sep-16 Feb-17 May-14 May-15 May-16 Jun-14 Jul-14 Jun-15 Jun-16 Jul-15 Jul-16 Mar-14 Mar-15 Mar-16 Mar-17 REPO 1 day, fixed Mosprime, 1 day CBR policy rate Core inflation CPI inflation Food inflation Non-food inflation Services inflation Source: CBR. Source: CBR and Haver Analytics. A moderately tight monetary policy and an helped by the stronger ruble. In April 2017, headline accommodative fiscal policy, helped by temporary inflation reached 4.1 percent y/y, almost hitting the factors, eased inflation pressures in 2016. In 2016, end-year target of 4 percent. the average annual headline inflation decelerated to 7.1 percent from 15.6 percent in 2015 (Figure 26). The In 2016 and the first quarter of 2017, oil prices slowing of food inflation from 19.1 percent in 2015 to remained the key driver of the ruble exchange 6.0 percent in 2016 played a key role in the inflation rate. Another important factor behind the exchange slowdown. The high base in 2015 – largely attributed rate movement was the mild monetary stance in to restrictions on food imports and the pass-through developed countries, which supported capital inflows effect from the ruble depreciation – was the main to emerging markets (Figure 27). The sharp fall in oil reason behind the deceleration in food inflation. The prices from September 2015 to January 2016 led the latter was also supported by a bumper harvest in 2016. ruble exchange rate to depreciate to its record low of Lower inflationary pressures were translated into a 83.6 RUB/USD. However, the sustained recovery in lower core inflation, which fell from 13.7 percent in oil prices since March 2016, especially in the fourth December 2015 to 6.0 percent in December 2016, quarter of 2016, when OPEC and non-OPEC countries reached an agreement on cutting oil production, also Figure 27: Oil prices remained the important driver of the supported a rebound in the ruble. The relatively stable ruble exchange rate (changes in oil prices and the nominal oil prices in the second half of 2016 and the first quarter exchange rate, logarithmic scale) of 2017 hardened demand for ruble-denominated financial assets, which offered attractive returns in 5 3,5 4,8 3,6 view of soft monetary conditions in major developed 4,6 3,7 countries, notably the United States. This demand has 4,4 3,8 also been supported by lower CDS spreads, indicating 4,2 3,9 the diminished impacts of geopolitical factors on the 4 4 3,8 4,1 exchange rate. 3,6 4,2 3,4 4,3 3,2 4,4 3 4,5 Jan-2014 Apr-2014 July-2014 Oct-2014 Jan-20154 Apr-2015 July-2015 Oct-2015 Jan-2016 Apr-2016 July-2016 Oct-2016 Jan-2017 Apr-2017 Oil price (Brent), ln Rub/USD, ln (rhs, reverse order) Source: CBR and World Bank staff calculations. Russia Economic Report | № 37. May 2017 13 Part 1. Recent Economic Developments 1.5 The Financial Sector: the banking system has largely stabilized, but has not yet fully recovered and credit growth remains stalled As the Russian economy slowly recovers from a two- Figure 28: Key credit and performance risks remained year recession, the banking sector has been showing unchanged signs of increased stability. In 4Q16-1Q17, the key credit risk and performance indicators remained Capital adequacy ratio NPLs to total loans largely unchanged (Figure 28), signaling that the Loan loss provisions to total loans worsening trend may be over. Capital adequacy Return on assets 15 remained stable at around 13 percent, due to Return on equity profitable bank performance and weak loan growth. While nonperforming loans remain high by historical 10 levels at nearly 10 percent, there are no signs of further deterioration. The financial results of banks suggest 5 they have stabilized as the banking sector returned to profitability. In 2016, sector profits totaled RUB930 0 billion, comparable to pre-crisis levels. Dec-15 Dec-16 Oct-15 Oct-16 Aug-16 Apr-16 Apr-17 Jan-14 Jan-15 Jan-16 Nov-16 Jan-17 Feb-16 Sep-16 Feb-17 May-16 Jun-16 Jul-16 Mar-16 Mar-17 Despite the signs of growing stability in the banking sector, lending activity remained subdued, reflecting Source: CBR. a weak economic environment, a relatively tight monetary policy, a high level of debt burden and the ongoing adjustment to the terms-of-trade conducted by the Bank of Russia to reduce the level of shock (Figures 29 and 30). Adjusted for exchange- dollarization. Retail loans also grew by low single digits, rate movement, the stock of loans to the private mainly due to strong demand for mortgages supported sector shrank by 2.1 percent by the end of 2016. by the government’s interest-rate subsidies program While corporate loans in foreign currency decreased, (through 2016) and substantially lower mortgage rates. corporate loans in rubles grew by low single digits. Demand for both retail and corporate loans (including This is largely due to increased currency risks for from SMEs) remained constrained by a decline in real non-tradable sectors and macro prudential measures disposable income and weak economic growth. Stock of loans to the private sector shrank Figure 29: Corporate credit growth, (y-o-y, percent) Figure 30: Household credit growth, (y-o-y, percent) 18 120 15 50 16 100 40 14 80 10 30 12 20 60 10 5 10 40 0 8 20 -10 6 0 0 -20 4 -20 -30 2 -5 -40 0 -40 -50 -2 -60 -10 -60 Jan-15 Nov-15 Jan-16 Nov-16 Jan-17 Sep-15 Sep-16 May-15 May-16 Jul-15 Jul-16 Mar-15 Mar-16 Mar-17 Jan-15 Nov-15 Jan-16 Nov-16 Jan-17 Sep-15 Sep-16 May-15 May-16 Jul-15 Jul-16 Mar-15 Mar-16 Mar-17 In Rub In foreign currency (RHS) In Rub In foreign currency (RHS) Source: CBR, WB staff calculations. 14 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Figure 31: SME loans experiencing the sharpest decline As the economy recovers, lending is expected to pick up moderately in the next 6-12 months. In 9 000 40% the retail segment, growth is likely to be driven by 8 000 29% 30% mortgage lending due to declining interest rates – 7 000 15% 16% 20% which are almost at their lowest historical levels – and 6 000 5 000 10% substantial unmet demand for housing, supported 4 000 -6% -3% 0% by a stabilizing households’ income. In the corporate 3 000 -10% segment, SME lending is expected to see a moderate 2 000 -20% recovery supported by the general economic recovery -28% 1 000 -30% and by government support measures that were put 0 -40% in place in 2016 and will continue in the short to Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 medium term. In a longer term, both SME loans and SME Loan Issuance (RUB bln) Growth rate (%) mortgage loans have a high growth potential as their Source: CBR, WB staff calculations. penetration (measured as percentage of GDP) is still low by international standards, at around 12% and 5% The SME segment was hit the hardest by the recession, respectively (Figures 32 and 33). with SME loans experiencing the sharpest decline compared to other market segments (Figure 31). A The Bank of Russia has maintained its focus on modest recovery in this segment can be expected to cleaning up the banking system. The number of banks continue in 2017, supported by the general economic in Russia has fallen from 733 at the beginning of January recovery and by government measures that were put in 2016 to 616 as of March 1, 2017, as the regulator place in 2016 and will continue in the short to medium continued to withdraw licenses from problematic term. The development of the SME sector is a priority banks, including some among the top 100 by assets. for the Russian government, which adopted an SME In parallel, the central bank announced initiatives Development Strategy through 2030 and launched aimed at tightening banking-sector supervision, a three-year priority project to support individual reducing fraud and strengthening its bank-resolution entrepreneurs and small-businesses. To revive lending framework. These include closer supervision of bank to SMEs, several measures were put in place in 2016- auditors, increasing the accountability of banks’ senior 2017, including lowering capital charges on SME loans management for inaccurate reporting, having a central (the CBR lowered risk-weighting requirements on bank representative in each of its supervised banks qualifying SME loans to 75% from 100%); enhancing and establishing a special bank recapitalization fund financial-support mechanisms offered via the SME to replace the current, less-efficient rehabilitation Corporation and the SME Bank, and supporting the mechanism via the Deposit Insurance Agency. development of the SME securitization (the inaugural SME securitization was issued in 2H2016 and supported The introduction of a new regulatory régime for by the SME Bank). banks will allow the Bank of Russia to free up some Both SME loans and mortgage loans have a high growth potential Figure 32: Outstanding SME loans (% of GDP, 2013) Figure 33: Outstanding mortgage loans (% of GDP, 2013) 80 20% 18% 70 16% 60 14% 50 12% 10% 40 8% 30 6% 20 4% 2% 10 0% 0 Turkey Italy France Russia United USA Mexico United USA France Italy Turkey Russia Mexico Kingdom Kingdom Source: World Bank, OECD. Source: World Bank, OECD. Russia Economic Report | № 37. May 2017 15 Part 1. Recent Economic Developments resources and focus on the supervision of the larger 1 billion) and banks with a basic license (capitalized at and more complex financial institutions. The central between RUB 300 million and RUB 3 billion). Banks bank will introduce a proportionate regulation of the with a universal license will be allowed to perform the banking sector starting in 2018 under a law passed on full scope of banking operations and must comply with May 2, 2017. The regulation establishes a three-tier the full range of regulatory requirements, whereas banking system in Russia: systemically important banks banks with a basic license will have a limited scope and (the 10 largest banks, already in effect); banks with a simplified regulations. universal license (minimum capital requirement of RUB 1.6 Government Budget: important ac ons have been taken in prepara on for a new fiscal rule In 2016, the federal and general government’s fiscal deficits grew on the back of lower oil prices. However, the authorities contained the fiscal deterioration by consolidating expenditures and mobilizing some revenues (including from the privatization of Rosneft). In preparation for the introduction of the fiscal rule, the government passed a three-year federal budget law for 2017-2019, which emphasized fiscal consolidation and introduced a system of currency interventions in the domestic market. Adoption of the fiscal rule is expected to smoothen the influence of external volatility on the budget and the real exchange rate. The federal budget’s primary deficit widened in 2016 Expenditure consolidation was an important plank but remained contained. The primary deficit grew for containing the deficit. Compared to 2015, the from 1.7 percent of GDP in 2015 to 2.7 percent of federal government’s primary spending decreased by GDP in 2016 on the back of lower oil and gas revenues 2.6 percent in real terms. Pensions were indexed below (Figure 34). The primary non-oil deficit improved from inflation, and civil servant salaries and the savings 8.8 percent of GDP in 2015 to 8.4 percent of GDP in pillar of the pension system were frozen. In real terms, 2016. Meanwhile, excluding the one-off privatization government spending decreased across all categories receipts of Rosneft, the primary non-oil federal deficit except for social security, environmental protection fell to 9.2 percent of GDP. and national defense, partly due to the redemption of the debt of military enterprises in the end of the year (Figure 35) Figure 34: Federal budget deficit widened but remained contained (% of GDP) 20 0 -2 15 -4 10 -6 5 -8 0 -10 2015 2016 2015 2016 Primary expenditures Revenues Primary balance Non-oil primary balance Source: Economic Expert Group, World Bank staff calculations. 16 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Figure 35: Federal budget primary expenditures decreased • Extra-budgetary funds registered a marginal deficit of in real terms in 2016, (percent, y/y) 0.2 percent of GDP while pension system imbalances 20 increased. Federal government transfers that 10 covered the Pension Fund deficit grew to 2.4 percent 0 -10 of GDP from 2.1 percent of GDP in 2015, reflecting a -20 substantial dependence of the Pension Fund on the -30 federal budget. The government undertook some -40 measures aimed at decreasing the gap between -50 -60 Pension Fund revenues and expenditures, such as an increase of the retirement age of state employees and a temporary freeze of pension indexation for working pensioners. However, given the aging of the population, these measures are unlikely to cover the gap and a more systemic reform in the pension Source: Federal Treasury of the RF. system is needed. The general government’s7 fiscal stance also worsened but has remained contained. In 2016, the In January-March 2017, the federal government general government primary deficit rose to 2.8 percent balance strengthened on the back of increasingly of GDP from 2.6 percent the previous year. robust oil and gas revenues; however, increased spending marginally widened the non-oil primary • The consolidated regional budget registered a balance. Compared to January-March 2016, oil primary surplus of 0.2 percent of GDP in 2016. revenues in the federal budget rose by 2.2 percent of However, as the Special Focus section discusses, GDP to 7.6 percent of GDP on the back of higher oil there are significant variations in the quality of the prices. Federal budget primary expenditures increased regional budgets and there are concerns related to the growing role of federal government loans. 7  The general government budget includes the federal budget, the subnational budgets and extra-budgetary funds, i.e. pension, mandatory medical insurance and social security funds. Box 3: How do Russia’s government expenditures compare to those of other countries? Compared to OECD countries, at about 35 percent of Figure B3-1: Russia’s expenditures as % of GDP are low GDP in 2015, Russia’s general government expenditures compared to other countries’ are well below the OECD average of 45 percent of GDP General Government spending as percentage of GDP and by and 48 percent of GDP for EU-28 (Figure B3-1). They only exceed general government expenditures in Ireland (29.4 function: Russia vs. EU-28 and OECD average percent of GDP) and Switzerland (33.9 percent of GDP). 2015 A breakdown of expenditures shows that other countries Social protection spend more in social sectors (on social protection, Education education and health) and less in defense and housing and Recreation, culture and religion community amenities. Health Housing and community amenities Environmental protection Economic affairs Public order and safety Defense General public services TOTAL 0 5 10 15 20 25 30 35 40 45 50 OECD average (27 countries) EU-28 Russia Source: OECD, Federal Treasury of the RF, Eurostat. Russia Economic Report | № 37. May 2017 17 Part 1. Recent Economic Developments Table 2: Federal budget deficit expected to decrease over time (percent of GDP) 2016 2017 2018 2019 Budget law * Expenditures 19.8 18.7 17.4 16.2 Revenues 16.3 15.5 15.2 15.0 Oil and gas revenues 5.8 5.8 5.5 5.4 Non-oil and gas revenues 10.4 9.7 9.7 9.6 Balance -3.6 -3.2 -2.2 -1.2 Non-oil balance -9.5 -9.0 -7.7 -6.6 Oil price (Urals) 41 40 40 40 Source: Federal Treasury, Ministry of Finance. * Since the adoption of the federal budget law on the federal budget for 2017-2019, Rosstat has revised upwards the nominal GDP for 2016. This section, as reported by the Ministry of Finance, shows budget items as percentage of old GDP (In 2016, nominal GDP totaled Rub 86.0 trillion compared to Rub 82.8 trillion projected in the budget law). by 0.2 percent of GDP to 18.6 percent of GDP8. The primary expenditures would decrease by about 7 federal government balance consequently registered percent in real terms (deflated by CPI) over three years a primary deficit of 0.5 percent of GDP in January- and by 3.6 percent of GDP, almost evenly distributed. March 2017 (compared to -2.4 percent of GDP deficit The biggest expenditure cuts would occur in national in the same period last year). However, on the back defense, the national economy and in housing and of higher expenditures, the federal non-oil primary communal services. In real terms, all federal budget deficit worsened to 8.0 percent of GDP in January- expenditure categories would decrease over three March 2017 (compared to 7.9 percent of GDP in the years, except for environmental protection. Social same period last year). policy expenditures would decrease by 2.5 percent in real terms in 2019 compared to 2016, which would With an eye to the proposed new fiscal rule, the require increased targeting of these expenditures9. The government passed a three-year federal budget fiscal consolidation will also be supported by revenue law and introduced currency interventions in the mobilization efforts: the government projects to raise domestic market. The three-year budget law covering 1.1 percent of GDP in 2017-2019 predominantly from 2017-2019 provides for substantial fiscal consolidation, the transfer of dividends of state-controlled companies mainly through expenditure cuts and with some and by increasing tax revenue from the energy sector revenue mobilization efforts (table 2). The budget law (Box 4). is based on an average oil price of US$ 40/bbl for the 2017-2019 period. It is aimed at gradual consolidation, Amendments are planned to be introduced to the with the budget deficit falling to 1.2 percent of GDP federal budget law for 2017 in line with the budget in 2019, thus making the budget system almost consolidation. On May 18th, the government approved consistent with the fiscal rule, based on the US$40 the draft amendments to the federal law on the federal cut-off prices, that is currently being considered by budget 2017. If the amendments are approved by the the government. Compared to 2016, federal budget State Duma, the budget will be based on slightly higher oil prices and a higher growth rate of the economy 8  The increase in expenditures formed as a combination of the than is stipulated in the current law. Budget revenues following expenditure changes: higher spending on social policy (+1.1 percent of GDP), on the back of the one-off payment to pensioners are projected to increase by 1.1 trillion rubles (1.2 in January, national economy (+0.2 percent of GDP), environmental percent of GDP) and expenditures would increase by protection (+ 0.1 percent of GDP), housing and communal services 315 billion rubles (0.3 percent of GDP). As a result, the (+0.1 percent of GDP) and lower spending on national defense (-1.0 percent of GDP), national security (-0.2 percent of GDP), health 9 (-0.2 percent of GDP), and state management (-0.1 percent of GDP).  According to the Ministry of Finance, the social expenditures of Deficit financing, mainly from the Reserve Fund and privatization the budget system would also decrease by 2 percent in real terms proceeds, relieved the pressure for substantial debt accumulation in 2019, compared to 2016. Human development expenditures of despite growing financing needs in 2016. The federal budget debt the budget system (health, education, social, culture) would stay flat decreased marginally from 13.2 percent of GDP in 2015 to 12.9 in real terms in 2019, compared to 2016, due to increase in health percent of GDP in 2016. expenditures. 18 Russia Economic Report | № 37. May 2017 Part 1. Recent Economic Developments Box 4: The government plans to introduce the new fiscal rule in 2020* . The draft version of the fiscal ruIe is linked to a base oil price of US$40/bbl in real terms. Federal budget expenditures would be capped by the sum of three components: (i) oil and gas revenues at base oil price and corresponding exchange rate; (ii) non-oil and gas revenues in accordance with the baseline scenario, and (iii) interest payments. Oil and gas revenues deriving from an above-the-baseline oil price would be saved in the Reserve Fund, with extra non-oil and gas revenues used to pay off debt (and vice versa). In addition, if the size of the Reserve Fund will not exceed 5 percent of GDP, spending from the Reserve Fund cannot go beyond 1 percent of GDP. This condition establishes an additional limit on expenditures when the oil price is below the base price. The fiscal rule aims to support fiscal sustainability and smooth the impact of oil price volatility on the real exchange rate, budget system, and domestic demand. * The proposed fiscal rule is planned to be included to the amendments to the Budget Code in 2017. federal budget deficit would narrow to 2.1 percent of of currency sales is limited by the sum of purchases GDP from 3.4 percent of GDP in 2016, and the non-oil accumulated earlier. The Bank of Russia operates as primary deficit would improve to 7.6 percent of GDP an agent for the Ministry of Finance, conducting daily from 8.4 percent of GDP in 2015. currency purchases and sales. Currency operations largely comply with the proposed new fiscal rule. For In line with this proposed fiscal rule, in February instance, when oil prices were above the baseline in 2017, the Ministry of Finance began conducting the beginning of May 2017, the Ministry of Finance foreign currency purchases and sales in the domestic purchased foreign currency for Rb 253.3 billion market. Foreign currency is purchased when the price (US$4.4 billion). The Reserve Fund had shrunk to 1.1 of oil exceeds US$40/bbl and is sold if the opposite percent of GDP at the end of 2016 and the budget happens. The amount of currency purchases is defined law stipulates its depletion in 2017. Foreign currency by additional oil and gas fiscal revenues received by the purchases would allow the transfer of additional oil federal budget compared to the baseline scenario, as and gas revenues to the Reserve Fund in 2018. stipulated in the federal budget for 2017. The amount Russia Economic Report | № 37. May 2017 19 20 Russia Economic Report | № 37. May 2017 PART II THE OUTLOOK FOR THREE YEARS: GROWTH PROSPECTS ARE MODEST Part 2. The outlook for three years: growth prospects are modest A moderate recovery of the global economy is expected for 2017, on the back of continued solid growth by commodity importers and a pickup in commodity exporters during the year. Russia is heading toward a moderate growth rate over the 2017-to-2019 period (between 1.3% and 1.4%), supported by rising oil prices and macroeconomic stability. Global growth is expected to recover, but with Crude oil prices remain projected to average $55/ downside risks. After the divergence of growth in bbl in 2017, an increase of 29 percent from last 2015-16 for commodity exporters and commodity year, and $60/bbl and $61.5/bbl in 2018 and 2019 importers, global growth is projected to pick up to respectively10. The oil price increase in 2017 reflects 2.7 percent in 2017 with broad-based support. In rising oil demand and falling stocks and assumes an advanced economies, emerging and developing extension of the OPEC/non-OPEC agreement. Prices are economies, commodity importers, and commodity projected to increase to $60/bbl in 2018 as the market exporters, growth is expected to accelerate. It will regains balance, with shale production limiting larger be driven by the bottoming out of investment, price gains. There are significant risks to the oil price strengthening demand from advanced economies, and forecast. On the upside, stronger demand and greater a modest upturn in commodity prices. Nevertheless, compliance by OPEC/non-OPEC producers could the expected recovery in commodity exporters will accelerate rebalancing, as could supply outages among be weaker than expected, reflecting longer-than- major exporters (e.g., Libya, Nigeria, and Venezuela). expected adjustments to low commodity prices in OPEC policy decisions to expand production cuts could some countries. China’s slowdown is expected to also support higher prices, as could rising production weigh down on commodity importers’ acceleration. costs. Downside price risks include weaker compliance In 2018-19, its growth is expected to strengthen to with the OPEC agreement. Rising output from Libya 2.9 percent. However, risks to the outlook are tilted and Nigeria could delay rebalancing, as could slower to downside. While the widespread adoption of demand growth. A faster-than-expected rise in U.S. trade protectionist measures remains a tail risk in the shale oil production — from further efficiency gains presence of a complex value chain integration, policy and increased profitability stemming from potentially uncertainty, including geopolitical risks, has been lower taxes — could also affect the supply balance. elevated since the start of 2017. Negative events can Box 5 discusses the expected evolution of the Russian weigh on confidence, investment and growth. They oil sector, which so far has taken external headwinds can lead to the repricing of risk, which could lead to the well. sudden tightening of financial conditions for emerging 10  The World Bank oil price is an average of three prices (Brent, WTI and developing economies. and Dubai oil prices). The equivalent Ural oil prices (produced by Russia) are $53.8/bbl in 2017, $58.7/bbl in 2018, and $60.2/bbl in 2019. Box 5: The Russian oil sector: Increasing produc on and exports despite headwinds Russia, the world’s third-largest oil producer after the United States and Saudi Arabia, accounts for over 12 percent of global oil supplies (Figure B5-1). It exports nearly 8 million barrels per day (mb/d), only marginally less than Saudi Arabia’s oil exports (by contrast, the United States imports around 12 mb/d). Russia accounts for a little over 3 percent of global consumption (Figure B5-2), and Russian oil consumption has been relatively stable during the past two decades at around 3 mb/d. Thus, all growth in production goes for exports. Oil and oil products accounted for about 40 percent of Russian merchandise exports in 2015. Oil is also the largest source of tax revenue to the Russian economy. Russian oil consumption, which had been relatively stable at 2.7 mb/d during 1996-2010, began increasing and reached 3.3 mb/d in 2014. However, the recession, along with economic sanctions, exerted downward pressure on domestic oil consumption in 2015.Russian oil production still increased during the past 2 years by 0.19 mb/d in 2015 and 0.25 mb/d in 2016 and reached a record 11.34 mb/d in 2016. 22 Russia Economic Report | № 37. May 2017 Part 2. The outlook for three years: growth prospects are modest Figure B5-1: Russia was the third largest oil Figure B5-2: Russia accounted for only 3 percent of producer in 2015 global oil consumption in 2015 United States United States Saudi Arabia China Russia India Canada Japan China Saudi Arabia Iraq Brazil Iran Russia UAE Korea Kuwait Germany Venezuela Canada Mexico Iran Brazil Mexico Nigeria Indonesia 0 2 4 6 8 10 12 14 0 2 4 6 8 10 12 14 16 18 20 Source: BP Statistical Review. Source: BP Statistical Review. A further, (though marginal) increase in Russian oil production is also expected in 2017, but the larger cuts in production will decelerate the production growth. According to the International Energy Agency (IEA), production growth reflected higher production by small- and medium-size producers (including Gazpromneft, Novatek, Tatneft, Russneft, and Bashneft) as well as deceleration in decline rates across mature fields. Such growth was a result of investment in upstream activity thanks to the ruble devaluation, lower tax rates, and lower input costs. Total oil production is expected to increase to 11.38 mb/d in 2017 and peak at 11.54 mb/d in 2018, as new projects (including Lukoil’s Filanovskoe, Gazpromneft/Russneft’s Messoyakha, Gazpromneft’s Novoport, and Russneft’s Suzunskoe) will more than offset brownfield declines. Production is projected to decline marginally thereafter (Figure B5-3). In late 2016, Russia, along with Azerbaijan, Kazakhstan, Mexico, and Oman, agreed to join OPEC on production cuts to ease a supply glut and eventually support prices. Russia agreed to a 0.3 mb/d cut, beginning in January 2017 (OPEC and non- OPEC producers agreed to cut 1.2 mb/d and 0.56 mb/d, respectively). Russia’s cuts, which were expected to be gradual, were calculated over October 2016 production levels of 11.6 mb/d. Russia’s compliance was at 40 percent in January and February, increasing to 58 percent in March (or 0.174 mb/d) and 78 percent in April (Figure B5-4). Whether the agreement will be extended to the second half of 2017 will be decided during the May 25 OPEC meeting. Russian officials have expressed public support for a likely extension. Figure B5-3: Russian oil production has been increasing to Figure B5-4: Russian compliance to agreed cuts is record levels increasing 12 60% Consumption Exports 10 8 50% 6 4 40% 2 - 30% 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 2018 2021 January February March April Source: BP Statistical Review. Source: BP Statistical Review. Consistent with our projections in the previous Russia 2017 has been revised from 1.5 percent to 1.3 percent Economic Report (November 2016), the Russian largely because of the higher base of effect11. Growth economy is expected to grow from 2017 onwards. rates for 2018 and 2019 are expected at 1.4 percent The positive terms-of-trade effect, coupled with more (Figure 36). stable macroeconomic conditions, are expected to 11  Rosstat revised SNA data for 2015 and 2016. As a result, GDP positively influence consumer and investor sentiment, contraction in 2015 was lower than it was recorded previously (-2.8 leading to a recovery of domestic demand and modest percent compared to -3.7 percent before). 2016 quarterly growth economic growth in 2017-19. The growth estimate for was reviewed upwards so that expected fall of GDP by 0.6 percent was changed to 0.2 percent. Russia Economic Report | № 37. May 2017 23 Part 2. The outlook for three years: growth prospects are modest Figure 36: The economy is expected to grow in 2017-2019 at renew their stocks in 2017, boosting import growth a modest rate (real GDP growth, percent) to 10 percent y/y and providing support to some manufacturing sectors. We expect a pick-up in fixed 4 120 capital investment growth in 2017 to 2.0 percent due 3 2 100 to macro stabilization, improved investors’ sentiment 1 80 and a stronger ruble; together, these factors could 0 60 help companies realize some deferred demand for -1 equipment. The 2018 soccer World Cup could further 40 -2 support public investment. Fixed capital investment -3 20 growth is expected to accelerate to 2.5 percent and 3.5 -4 0 percent in 2018 and 2019 respectively, as economic 2012 2013 2014 2015 2016 2017 2018 2019 policy uncertainty subsides and external demand GDP growth Oil price, average (US$ per barrel) further improves. The lower cost of credit will also support the growth of fixed capital investment in 2018 Source: Rosstat, World Bank. and 2019. As we expect restocking to happen mostly in 2017, the investment-demand contribution to growth Supported by growth in real wages in the private will contract in 2018 and 2019, compared to 2017. sector, consumption is expected to drive growth in 2017-2019. We expect headline inflation to continue The contribution of net exports to growth is expected moderating, falling slightly below 4 percent in the end to be negative in 2017 and slightly positive in 2018- of 2017 and stabilizing around 4 percent in 2018-2019. 2019. With marginally slowing growth in the Euro Lower inflation will support real wages that will be the Area and Japan, a modest pick-up in growth in the US main source of real income growth, as pensions will and a gradual slow-down China, we expect exports be indexed with the inflation rate. As the economy to grow by 2 percent in 2017. The export growth recovers, improving consumer sentiment, growing rate will slightly increase in 2018 and 2019 on the real wages, and improved credit conditions are all back of higher global growth. From a low base in expected to lead to a growth in private consumption 2016, and supported by an improvement in domestic of 1.8 percent in 2017, and 2.5 percent in 2018 and demand (inventory restocking and deferred demand 201912 (Table 3). for investment imports), imports are expected to Table 3: Projected GDP growth by component, percent, y/y and contribution to GDP growth, pp Growth, y/y, percent Contribution to growth, pp 2017 2018 2019 2017 2018 2019 GDP 1.3 1.4 1.4 1.3 1.4 1.4 Consumption 1.1 1.6 1.6 0.7 1.0 1.1 Gross capital formation 8.0 1.5 1.1 1.5 0.3 0.2 Gross fixed capital formation 2.0 2.5 3.5 0.4 0.5 0.7 Export 2.0 2.3 2.5 0.6 0.7 0.8 Import 10.0 4.0 4.0 -1.5 -0.6 -0.7 Source: World Bank staff calculations. Investment demand is expected to pick up in 2017- continue recovering in 2017 and beyond. In 2017, we 2019. Given a massive inventory destocking in 2015 expect import growth to outstrip growth in exports, and a recovering economy, we expect businesses to thus leading to an overall negative contribution of net 12 exports. In 2018-2019, the net exports contribution to  Growth in consumption is tempered because of the planned fiscal consolidation which will limit government capacity to support GDP growth is expected to be slightly positive. consumption through real increases in public sector wages. 24 Russia Economic Report | № 37. May 2017 Part 2. The outlook for three years: growth prospects are modest Table 4: Major macroeconomic indicators 2016 2017 2018 2019 Oil price (US$ per barrel, WB average) 43.3 55 60 61.5 World economy growth, percent 2.3 2.7 2.9 2.9 GDP growth, percent -0.2 1.3 1.4 1.4 Consumption growth, percent -3.5 1.1 1.6 1.6 Gross capital formation growth, percent 1.5 8.0 1.5 1.1 General government balance, percent of GDP -3.5 -1.8 -0.5 0.3 Current account (US$ billions) 25.0 45.7 46.0 45.9 Current account, percent of GDP 1.9 2.9 2.7 2.6 Capital and financial account (US$ billions) -15.7 -31.7 -23.3 -21.3 Capital and financial account, percent of GDP -1.2 -2.0 -1.4 -1.2 CPI inflation (average) 7.1 4.1 4.0 4.0 Source: World Bank staff calculations. Higher oil prices will support the current account, Figure 37: Growth projections remain sensitive to oil prices which is expected to increase to 2.9 percent of GDP (GDP growth, percent) in 2017 from 1.9 percent of GDP in 2016. A further gradual increase in imports, including services imports, 2 is expected to slightly weaken the current account in 1,5 2018 and 2019 (Table 4). 1 Growth projections remain sensitive to oil prices. A simulated decrease of 15 percent in oil prices reduces 0,5 growth to 1 percent in 2017 and 1.2 percent for 2018 0 and 2019. A simulated rise of 15 percent in oil prices 2016 2017 2018 2019 increases growth to 1.6 percent for 2017 and 1.8 -0,5 GDP growth (baseline) GDP growth low (-15%) GDP growth high (+15%) percent for 2018 and 2019 (Figure 37). Despite policy efforts to reduce sensitivity, oil price volatility would still affect consumer and producer sentiment. We Source: World Bank staff calculations. expect a slightly higher response of the economy on the upper oil price-variation due to improved investor sentiment. Figure 38: The poverty headcount is likely to decline in 2017 and further (in percent) 14 14 0,422 13,5 14 0,420 13 13 0,418 12,5 13 0,416 12 12 0,414 11,5 12 0,412 11 11 0,410 10,5 11 0,408 10 10 0,406 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Poverty rate, % Scenario 1 (baseline) Scenario 2 (lower-bound) Scenario 3 (upper-bound) Gini (rhs) Source: Rosstat, World Bank staff calculations. Russia Economic Report | № 37. May 2017 25 Part 2. The outlook for three years: growth prospects are modest The poverty rate is expected to decrease because of The projected improvement in private consumption is decelerated inflation and a recovery in household also expected to support economic activity in the non- incomes and consumption. In the baseline scenario, tradable and tradable parts of the economy (Table 5). the poverty headcount is projected to decline in 2017 to 13 percent from 13.5 percent in 2016, and to Table 5: Recovery is expected to be broad-based: projected growth by sector continue declining to 12.3 and 11.6 percent in 2018 and 2019 respectively (Figure 38). Household consumption 2016 2017 2018 2019 and incomes will also be supported by an increase Agriculture 3.6 1.2 1.7 1.7 in pensions that were indexed by end-year inflation and are likely to increase slightly in real terms during Industrial production 1 1.2 1.6 1.3 2017. Figure 38 also shows the sensitivity of poverty Services -0.9 1.3 1.3 1.4 projections to the minus/plus 15-percent change in oil Source: WB staff calculations. prices (scenarios 2 and 3) compared to the baseline. Agriculture, in particular, is expected to benefit. The prognosis After high growth in 2016 on the back of a good Overall, the short-term prognosis for the Russian crop, we expect growth to slow down in 2017-2019. economy is favorable, with projected growth rates Previous years’ investment in the dairy sector would between 1.3 to 1.4 percent in the forecasting period support this growth. While a detailed analysis of the of 2017-2019. Among other factors for this recovery, agricultural sector is beyond the scope of this report, maintaining macro stability is a central contributing Box 2 discusses issues germane to productivity in two one. Moreover, a return to the three-year federal agricultural sub-sectors: pork production and dairy budget law and introduction of the updated fiscal rule farming. is expected to further increase economic predictability. Produc vity in pork produc on and dairy arming: revenues, profitability and labor produc vity Box 6: increase, but opportuni es remain to improve land and capital produc vity. This box examines selected factors, namely the productivity and profitability of farms, to interpret drivers and bottlenecks for agriculture-sector performance in Russia. The Ruslana database was used to assess the performance of farms in two priority livestock sectors: pork production and dairy farming. These are priority sectors for agricultural development and have been the focus of much policy attention since the 2000s. The two samples paint a representative picture of the performance of small, medium and large agro-enterprises. Both sectors – pork production and dairy farming – have demonstrated significant growth since 2007. Revenue growth in real terms between 2007 and 2016 was more than 200 percent for dairy and more than 1,000 percent for the pork industry. The largest growth in revenues was reported by large agro-enterprises, with averages of 40 percent per annum in the dairy sector and 150-200 percent per annum in the pork sector. More than the capital-intensive dairy sector, three-digit growth rates in revenues are transforming the pork industry, which is now being dominated by medium-to-large enterprises. Profitability in the dairy and pork sectors has also been growing, although the pace of growth has been slowing down since 2007. The main drivers of profitability in both sectors are relatively high domestic prices for both pork and milk (Figures B6-1 and 2) and relatively low domestic prices for feed, which makes up to 60 percent of production costs. So far, Russian farming enterprises enjoy favorable domestic market conditions characterized by protection from import competition and higher prices. In addition to their favorable domestic market situation, pork and dairy farms have also demonstrated advances in productivity. A separate analysis of economy-wide labor productivity in the agro-food sector (partial TFP analysis) shows that labor productivity has been increasing in the past 10-12 years, though with a small growth rate of 1.5 percent per year on average. Productivity increases are fueled by major technological advances that the agro-food sector carried out in the last decade, notably imports of new technologies and improved genetics, animal health conditions and management methods. However, at the farm-enterprise level, results for dairy vary depending on the farm size (Figure B6-3). Medium and large dairy farms reported average annual labor productivity growth of 3.3 to 3.6 times over the past 10 years, with large companies reporting labor productivity growth in the order of 10 times during this period. Small enterprises reported a productivity decline, and considering the sizeable contribution of small and medium enterprises in the dairy production, their results weighed on overall sector productivity. 26 Russia Economic Report | № 37. May 2017 Part 2. The outlook for three years: growth prospects are modest The main drivers of profitability in both sectors are relatively high domestic prices for both pork and milk Figure B6-1: Pork Prices (in rubles) Figure B6-2: Milk Prices (in rubles) IFCN milk price indicator 180 National milk price 2 500 160 140 2 000 120 nat. C / 100 kg ECM 1 500 100 80 1 000 60 40 500 20 0 0 2011 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2012 2013 2014 2015 '99 '02 '05 '08 '11 '14 Slaughter price, RUB per kg CW Source: Ruslana database. Source: Ruslana database. While these are encouraging developments for the pork production and dairy sectors, compared to similar farms Figure B6-3: Pork Prices (in rubles) in Europe and North America, non-feed costs (overhead, 3500 depreciation, paid labor and others) – which are around Labor productivity, revenue tnd RUB per 3000 40-50 percent of total costs – are higher on Russian farms. 2500 Both land and capital productivity per unit of milk produced 2000 is low in Russia compared with European and North employee 1500 American comparator farms, suggesting opportunities 1000 2008-2010 for improvement of land management and capital 500 2011-2013 2014-2016 intensification. 0 Labor productivity is relatively low compared with international competitors but so are salaries – thus labor costs are presently not higher than in Western farms. However, with improvements in the overall economic Source: Ruslana database. development and increasing wage levels, the agriculture sector must improve labor productivity if it wants to remain competitive with other sectors. In this context, the lack of skilled labor is also a profound disadvantage that needs to be addressed. It is worth emphasizing, however, that though Russia growth. Box 7 discusses various methods and is expected to grow modestly in the short-term measures of TFP growth in Russia, all which yield the future, its longer-term growth prospects remained same conclusion: TFP growth in Russia is low and constrained by low Total Factor Productivity (TFP) declining. Box 7: Russia’s poten al GDP and TFP revisited: declining produc vity trends Total factor productivity (TFP) is a measure of efficiency that is notoriously difficult to calculate. Simply put, it is the portion of output that cannot be explained by the traditional inputs of capital, labor and land. Its level is the measurement of how efficiently the inputs are utilized, and it depends critically on the accuracy and availability of data and of the behavioral forms that translate inputs into outputs. Traditionally, TFP is estimated as the residual explanation of GDP growth after accounting for the contribution of the factors of production: capital, labor (both unskilled and skilled) and land. The relative shares with which these inputs contribute to Russia Economic Report | № 37. May 2017 27 Part 2. The outlook for three years: growth prospects are modest growth are determined by the wage bill, the cost of capital, the returns to education and land rents. Often, data on factor quantities and prices are unavailable and need to be estimated; as a result, the residual, or TFP, is subject to measurement error. For example, the factor shares are often estimated using volume data (the number of hours worked, the number of employees and the amount of capital stock). This also requires various assumptions regarding the functional form of the economy-wide production function. The production function that is most commonly used in this type of exercise is the Cobb- Douglas production function, which assumes that labor and capital are used in fixed proportion in the production of goods. This result can be tested by nesting the Cobb-Douglas function into a constant elasticity-of-substitution (CES) function. Depending on the estimated coefficients, the factors of production may be complements, in which case an increase of labor in production will also result in an increase in capital, while substitution effects imply that using more labor in production will result in a reduction of capital*. The residual measure that is often labelled as TFP is, then, a catchall for all efficiency, technological effects and even measurement errors. The economy of Russia has been hit by deep structural changes over the last couple of decades. The transition to a market- based economy and changes in population and in its natural-resource base imply large shifts in TFP. Russia produces significant amounts of oil and gas, which contributes substantially to its output. The production function must therefore be augmented for resources to avoid possible bias in measuring TFP. The share of resources in output is calculated by multiplying the rents of oil and gas with the production of oil and gas and expressing it as a share of GDP. Another source that contributes to TFP is structural changes in employment mobility and human capital. This exercise assumes that skilled workers (skills are determined by education) are more efficient. Furthermore, we think of labor productivity growth as the contribution of within sectoral contributions (such as an increase in research and development) and between sectoral contributions that account for shifts in employment shares between sectors. If the employment share has increased in a productive sector, then structural change has contributed to productivity growth. In Russia, the share of employment in industry has declined since 2000, while the share of service employment has increased. A second measure of TFP is constructed by controlling for the number of years of education and the labor share of each industry (see McMillan et al. [2014] and Burns (2016]). The number of years of education is obtained from the Barro and Lee (2013) data set. Controlling for structural change and skills nets out more effects from TFP and arguably allows us to get closer to an accurate interpretation of TFP. Three estimates of TFP are presented in this box: (i) The CES production function without oil that uses only capital and labor as inputs; (ii) the estimate derived from a Cobb-Douglas production function and netting out the contribution of labor share changes from growth (here referred to as structural change) and (iii) one estimated from a Cobb-Douglas production function, but that includes hydrocarbon resources and education. The three methodologies provide useful comparisons in understanding TFP where (i) is a reference point to compare TFP growth by netting out distinctly different aspects of growth using (ii) and (iii). To calculate potential GDP, we follow Burns (2016) by smoothing TFP with an HP-filter and assume that capital is fully utilized. Figure B7-1 decomposes potential GDP into its components using (iii). The transition away from a centrally planned economy to a market-based economy is captured by the change in capital’s contribution to potential GDP growth in the late 1990s. The role of TFP in potential GDP growth started moderating in the early 2000s, while the labor force and the resources started contributing more to growth towards the end of the sample. The contribution of TFP to potential GDP since the global financial crisis of 2008/09 has almost disappeared, highlighting the constraints placed on productivity from the adverse effects of the crisis. Figure B7-2 summarizes the different TFP outcomes from the three methodologies. The estimate of TFP using (i) above is labelled CES and strikingly shows how large TFP was in the late 90’s controlling only for labor and capital. The magnitudes of TFP are markedly different in the late 1990s, illustrating the effects of leaving out oil and education (iii) and structural change (ii). More importantly, ignoring the effects of resources and education would have implied that TFP growth was moderating sharply, whereas the other measures suggest a more gradual moderation in TFP growth. None of the approaches is necessarily superior to the other. Each methodology strips some component from TFP. For example, TFP adjusted for skills and resources is much lower in the initial periods compared to the other measures. More importantly, the decline in TFP is also less marked when adjusting for skills and resources. Adding the resources reduces capital’s share in measuring TFP and seems to be an important factor in explaining the initial differences. However, regardless of the method used, all have the following in common: TFP growth across all measures has been declining over time, underscoring the challenge of addressing declining productivity growth in Russia. * Rough estimates using a CES specification for Russia suggest that the production function is a Cobb-Douglas. 28 Russia Economic Report | № 37. May 2017 Part 2. The outlook for three years: growth prospects are modest Figure B7-1: Decomposing potential GDP growth Figure B7-2: TFP growth according to different measures 12% TFP 10% K 12 LFPR 8% EDUC CES OIL 10 Structural Change 6% LF Education and resources 4% Potential GDP 8 2% 6 0% -2% 4 -4% 2 -6% -8% 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 -2 Source: Authors’ own calculations using WDI, Rosstat and ILO. Source: Authors’ own calculations using WDI, Rosstat and ILO. With low TFP growth and a declining labor force, much faster than in any other OECD country, weakening potential output growth is modest at best (around the competitiveness of the Russian economy. 1 to 1.5 percent of GDP), thus limiting GDP recovery Addressing these deeper structural challenges will growth rates. And as discussed in earlier sections, over have the sought-after payoff of inclusive, sustainable the past nine years, unit labor costs in Russia have risen and fast-paced growth. Russia Economic Report | № 37. May 2017 29 I 30 Russia Economic Report | № 37. May 2017 I PART III RUSSIAN REGIONS AND THEIR RESPONSES DURING THE CRISIS YEARS Part 3. Russian regions and their responses during the crisis years This part analyzes subnational fiscal trends in Russia in the context of an overall slowing of economic growth and falling oil prices since 2014. It discusses how Russian regions fared during the crisis and examines their fiscal prospects, focusing particularly on whether their crisis measures – driven by spending cuts – are sustainable over the medium term. Russia has a complex structure of subnational comprising more than 500 cities and more than 1,800 government. At the top level, the country is divided raions; and there are more than 20,000 second-tier into over 80 federal subjects, termed oblasts and municipalities, comprising more than 1,600 townships federal cities. Territorial subdivisions also include krais and more than 18,000 rural communities14. (administrative territories), republics, autonomous okrugs (territorial divisions), and autonomous oblasts. Under the current legislation, all municipalities The administrative units are grouped into eight federal (including rural settlements with small populations) districts, each headed by a presidential plenipotentiary are required to establish local governments, employ appointed by, and representing, the President of municipal office staff, formulate and execute budgets, the Russian Federation. The envoy monitors the and conduct an independent debt policy. The law performance of the regions in each federal district. assigns a set of expenditure responsibilities to each Hereafter, all these top-level geographical units will be tier of municipal government (See Box 8). In practice, referred to as “regions”13. municipalities tend to be highly dependent on their respective regional governments. They have limited The territory of each regional government is in taxing powers and depend on transfers and shared turn divided into what might be termed “first-tier taxes from their respective regions; as detailed below, municipalities.” These consist of large cities (formerly the only major federally designated source of revenue known as cities of oblast subordination) and rural for municipal governments is a share of the personal raions (districts); the latter contain a variety of forms of income tax (PIT). As a result, the municipalities tend to small towns and village governments, which this report function as spending agents of their respective regions, will refer to collectively as second-tier municipalities. rather than as independent tiers of government. There are more than 2,000 first-tier municipalities 14 13   IMF Article IV Consultation, July 2010.  The federal cities are also divided into municipalities. Recent (2014) legislation permits other large cities to do the same. Box 8: Russian federalism in the interna onal context In aggregate terms, the degree of fiscal decentralization in Russia is similar to that of other large, middle-to-high-income federal countries. The first figure below shows the share of total general government expenditures that are accounted for by subnational governments in Canada, the U.S., Australia, Russia, Brazil, and Germany. As shown, Russia is not unusual. It is less decentralized by this measure than the U.S. or Canada but roughly on par with the other three comparators. Another way to measure decentralization is to look at the size of subnational government as a share of GDP. Again, Russian subnational governments are not as large as those in Canada, but they are roughly on par with those in the U.S., Germany, and Brazil. Interestingly, the split in Russia between spending at the regional level and at the local (municipal) level is also similar to that in the U.S., Brazil, and Germany. A third approach is to calculate the percentage of subnational revenues that are derived from own-source revenues. By this measure, Russia is again fairly typical of large federations. Regional governments in Russia derive 80 percent of their income from own-source revenues (including shared taxes, distributed on the basis of origin). This is similar to the proportions in Germany (84 %); Canada (81%); and Brazil and the US (both 77 %). (Note that these figures refer only to regional governments. Local/municipal governments in Russia and other federations derive a larger proportion of their revenues from transfers from their respective regional governments.) 32 Russia Economic Report | № 37. May 2017 Part 3. Russian regions and their responses during the crisis years The degree of fiscal decentralization in Russia is similar to that of other large, middle-to-high income federal countries Figure B8-1: Subnational spending, Figure B8-2: Subnational spending, (percent of general government) (percent of GDP) 80 70 30 60 25 50 20 40 15 30 10 20 10 5 0 0 Canada USA Australia Brazil Russia Germany Canada USA Brazil Germany Russia Australia Province Local Source: Federal Treasury of the RF, IMF, and US census of govt. Source: Federal Treasury of the RF, IMF, and US census of govts. Note: data is based on IMF Government Finance Statistics (except US, where it also incorporates data on local finance from the US Census of State and Local Governments). Expenditures by central and provincial government are net of transfer to subordinate levels of government. Provincial government are net of transfer to subordinate levels of government. Func ons As shown in Figure 3916, the social sectors — education, social protection and health — together The functions of each tier of subnational government account for just over half of total subnational are set out in federal legislation. Subnational functions expenditures. In 2016, education was the largest single are broad-ranging. They include the provision of social functional category (26 percent); followed by transport assistance, education (kindergarten and grades 1-11), (20 percent); social protection (17 percent); and health and the operation of health care facilities (although care (13 percent). Social protection expenditures general hospitals are largely funded by the regional include not only payments to impoverished households divisions of the national health insurance fund and but to most old-age pensions. are managed at the federal level). In the infrastructure sectors, their responsibilities include regional and 16  Figure 1 shows the consolidated expenditures of all three tiers of intra-city roads. Subnational governments are also subnational government, with transfers from oblasts to raions and from raions to second-tier municipalities netted out. responsible for the provision of public utilities (e.g., district heating and water supply) and public Figure 39: Social sectors together account for just over half of transportation. In total, subnational governments total subnational expenditures account for about one-third of total government expenditure15. 15  In calculating this percentage, the total is calculated as the sum of federal expenditures, regional and municipal expenditures, and expenditures of federal extra-budgetary funds (the pension fund, social security fund, and the medical insurance fund together with its regional divisions). Due to intergovernmental transfers between these entities, when estimating the shares of each entity, all intergovernmental fiscal transfers are netted out. Thus, for example, subnational spending on hospitals, financed through the national health insurance fund, are not included in ‘subnational expenditures’. Source: Federal Treasury of the RF. Russia Economic Report | № 37. May 2017 33 Part 3. Russian regions and their responses during the crisis years Financing Figure 40: Shared taxes are the largest source of subnational government revenue The general budgets of all three tiers of subnational government (regional, and first and second-tier municipal governments) are financed from a combination of shared taxes, exclusive local taxes, own non-tax revenues, and intergovernmental transfers. All taxes are administered by the federal tax service with revenues returned in whole or in part to the jurisdiction in which they were collected. Shared taxes are the largest source of subnational government revenue. Two of them — the personal income tax (PIT) and the corporate income tax (CIT) — accounted for over half (53 percent) of total subnational revenues in 2016 (Figure 40). Regional governments are allowed to adjust the rate of the CIT Source: Federal Treasury of the RF. within a range of 13.5 to 17 percent. They have no control over the rate of the PIT. although these are often out of date. Proceeds The share of exclusive local taxes in the composition are retained at the municipal level. Municipal of subnational revenues is 23 percent, of which 8 governments are permitted to set the rate of the percent is derived from various forms of property tax. tax, subject to federal ceilings. The maximum rate of By far, the largest form of property tax — accounting residential properties is extremely low: 0.1 percent. for 68 percent of the total in 2016 — is the corporate Federal law also permits a long list of exemptions and asset tax. This is imposed on movable and immovable rate reductions for certain classes of taxpayers (e.g., property owned by registered companies. Until pensioners and veterans) and types of property. As a recently, assessments were based on book values, result, the yield of the building tax is trivial — only 0.36 which were substantially below market values. With percent of total subnational revenues. the encouragement of the federal government, regions are now gradually introducing market values for Then there are the subnational shares of certain particular groups of taxpayers. The maximum rate on excise taxes on alcohol and gasoline. Taken together the corporate property tax is a substantial 2 percent. (with other excise taxes), they account for 7 percent of total subnational revenues. Subnational governments In addition to the tax on corporate assets, there are also generate income from a variety of other taxes. two other forms of property taxes. The first is on land. Together, these account for about 8 percent of their This tax is imposed on both urban and rural plots of revenues. The most important one (accounting for a land (except forests). Since 2014, land has been valued third of the total) is the transport tax. Regions are also based on its cadastral value. Proceeds are retained entitled to revenues from certain mineral resource at the municipal level, and municipal governments extraction taxes, namely the tax on the extraction (including the cities of Moscow, St. Petersburg, and of common minerals and the tax on “other minerals Sevastopol) are permitted to set the rate of the tax, excluding hydrocarbons.” These taxes are not major subject to a ceiling of 0.3 percent on agricultural revenue sources from an aggregate standpoint but are and residential property and 1.5 percent for land in important in certain regions such as Sakha-Yakutia, a other uses. The land tax accounts for 20 percent of diamond-producing region. property tax revenues, although only 2 percent of total subnational revenues. Non-tax funding is also significant. Non-tax, own- source revenues are non-trivial; they account for about The second is a tax on buildings. This is imposed 7 percent of total revenues. At the same time, transfers on residential and commercial property owned by from the federal government (i.e., money distributed individuals (as opposed to corporations). Since 2014, to regional governments on a basis other than origin) the tax has been assessed based on cadastral values, accounted for 16 percent of regional revenues in 2016. 34 Russia Economic Report | № 37. May 2017 Part 3. Russian regions and their responses during the crisis years Table 6: Per capita revenues of regions vary widely, thousand rubles per capita Rich naturalresource based regions 88 - Chukotka 555 90 – Yamalo-Nenets 255 Autonomous Okrug Autonomous Okrug 61 – Sakhalin oblast 457 38 – Kamchatka Krai 205 84 - Nenets Autonomous 426 Okrug Moscow, Saint Petersburg 73 – Moscow 137 St. Petersburg 86 All others 77 – Altai Republic 79 28 – Vladimir oblast 41 07 – Komi Republic 78 27 – Bryansk oblast 40 19 – Krasnoyarsk Krai 74 63 – Smolensk oblast 40 48 - Moscow oblast 73 52 – Omsk oblast 40 22 – Khabarovsk Krai 68 55 – Penza oblast 36 23 – Amur oblast 64 15 – Chuvash Republic 36 11 – Tatarstan Republic 63 10 – Republic of North 35 Ossetia-Alania 78 – Jewish Autonomous 61 33 – Ivanovo oblast 35 Oblast 34 – Irkutsk Oblast 53 60 – Saratov oblast 35 80 – Republic of 53 04 – Republic of 34 Khakassia Kabardino-Balkaria 14 – Republic of 53 21 – Stavropol Krai 33 Ingushetia 57 – Pskov Oblast 41 03 – Republic of Dagestan 30 Source: Federal Treasury of the RF. The Russian budget code distinguishes three types of cost of living, and population density). The total transfers: dotacii, subsidii, and subventsii. amount of the transfer is determined endogenously; i.e., the federal government is required to contribute • Transfers that are not earmarked for specific uses whatever sum is needed to achieve the equalization are referred to as dotacii. They account for 42 target. Roughly three-quarters of the regions receive percent of total federal transfers. The largest dotacii equalization grants17. In 2016, they accounted for — and the largest single transfer from the federal about 78 percent of total dotacii. government to the regional tier of government — is the equalization grant. This grant is designed to raise • Subsidii are federal matching grants. These support the per capita budget revenues of poorer regions a wide range of federal programs, some of which (those with per capita revenues below the national involve capital investments. average) up to a target percentage of the national average. In calculating the equalization target, the • The third major category of transfers, subventsii, 10 richest and 10 poorest regions are excluded. consists of compensation for functions that Adjustments are also made to reflect variations in the strength of tax bases among different regions, 17  Starting in 2016, the transfer allocation rules guarantee that as well as differences in factors that affect the costs regions whose revenues from the equalization transfer are at least 10 percent greater than their other revenues shall receive no less of providing services (for example, labor costs, the than 90% of the previous year’ amount. Russia Economic Report | № 37. May 2017 35 Part 3. Russian regions and their responses during the crisis years subnational governments perform on behalf of the percent respectively. Still, the aggregate subnational federal government. These include unemployment balance improved over this period, with the deficit subsidies, rent subsidies granted to certain categories declining from 0.6 percent of GDP in 2014 to zero of federal beneficiaries such as war veterans or percent of GDP in 2016. As a percentage of revenues, victims of radiation catastrophes, benefits paid the consolidated subnational deficit declined from 8 to blood donors, and the costs of running civil percent to only 0.1 percent. And as Box 9 illustrates, registration offices. the good aggregate fiscal performance of subnational governments is not affecting the federal government Regional variaƟons in per capita revenues much. This is because of the hard line taken by the federal government in drastically reducing transfers These aggregate figures for Russia conceal substantial to regions by as much as 22 percent in real terms variations across regions — both in terms of the between 2013 and 2016. levels of aggregate revenues (per capita) and their composition. The table below illustrates the Russia’s economic slowdown triggered a fiscal variations in per capita revenues among regions18 adjustment at the subnational level; as aggregate (Table 6). The figure for each region includes the own- subnational revenues declined significantly between source revenues of subordinate jurisdictions. Thus, it 2013-16 (9 percent in real terms), the adjustment represents the consolidated per capita revenues of occurred mostly on the expenditure side (figure 42). all subnational governments in that region, from the regional government itself to the smallest second-tier Figure 41: Trends in subnational deficits: subnational municipality. Revenues are expressed in thousands governments seem to be weathering the ongoing slowdown of rubles per capita and include both own-source in the economy fairly well revenues and transfers from the federal government. 0,6 In essence, the regions fall into three groups. The 0,4 first group consists of the eight (generally) sparsely 0,2 populated oil/gas/gold-producing regions located in GDP 0 the far North and East of the country, mostly in Siberia. ВВП % of -0,2 The second group consists of the cities of Moscow and Percent -0,4 St. Petersburg, which receive unusually high own- -0,6 source revenues, notably corporate and personal -0,8 income taxes. Neither derives significant revenue from -1 federal transfers. The third group consists of all the 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 other regions. Only about 10 percent is derived from equalization transfers19. As a result, variations among Source: Federal Treasury of the RF. individual jurisdictions largely reflect variations in their respective tax bases. Figure 42: Trends in subnational revenues: aggregate subnational revenues declined significantly between 2013-16 Fiscal Performance 4000 At an aggregate level, subnational governments CIT 3500 seem to be weathering the ongoing slowdown in the PIT Excises economy fairly well. As figure 41 shows, the aggregate 3000 Constant Rub billions of 2015 Property taxes subnational balance reached its nadir in 2013 (at 0.9 2500 Other taxes percent of GDP), just as the slowdown in the economy 2000 Non-tax revenues was beginning (Russia’s GDP was still growing in 1500 Unconditional grants 2013, albeit at an anemic 1.3 percent). In 2014, the 1000 Matching grants GDP growth rate shrank to 0.7 percent. In 2015 and Compensation grants 500 2016, the economy contracted by 2.8 percent and 0.2 Other transfers 0 Other revenues 2012 2013 2014 2015 2016 18  The table does not include all regions. 19  The remaining 15 percent is derived from subsidii, subventsii, and Source: Federal Treasury of the RF. other federal transfers. 36 Russia Economic Report | № 37. May 2017 Part 3. Russian regions and their responses during the crisis years Box 9: Subna onal fiscal performance is not affec ng the federal government much At present, the fiscal difficulties of subnational governments are not directly affecting the federal government budget. This is because the federal government is taking a hard line: between 2013 and 2016, transfers from the federal government fell 22 percent in real terms. The federal government does have some exposure to subnational loan defaults. As of end-2016, federal loans to subnational governments totaled Rb 1 trillion. Subnational governments also have a significant level of debt to commercial banks. But the level of debt in most jurisdictions (including the largest ones) appears to be manageable. On the surface, therefore, the outlook from the federal government’s perspective is fairly good: subnationals are responding to the declines in revenues by cutting expenditures, rather than by running up debt or demanding federal bailouts (at least not successfully). One should not be too sanguine, however. Subnational governments may be engaging in fiscal maneuvers that are not evident in the data: e.g., accumulating arrears and unfunded obligations. Moreover, it is not clear how long the federal government can continue relying on expenditure cuts at the subnational level before the social and political consequences become so great that it is forced to step in. As a group, subnational governments managed to cut fit their own budget constraints, and they may have expenditures by 16 percent in real terms between responded to the decline in their overall revenues 2013 and 2016 — 7 percentage points more than the by doing exactly that. In addition to the cuts in social cuts in revenues. The largest cuts, in absolute terms, spending, subnational governments also made were in education (figure 43). Total spending on this substantial reductions in infrastructure spending; in sector fell 18 percent in real terms between 2013 and particular, cuts in the transport sector accounted for 2016 (increasing only 9 percent in nominal terms). 14 percent (in real terms) between 2013 and 2016. Spending on health declined 23 percent over the Spending in the housing and communal services sector period, although this was partly offset by an expansion fell even further, by 22 percent. in the number of facilities covered by the HIF. There were even sharp cuts in spending on social protection, While the aggregate subnational deficit in 2016 was which fell 6 percent in real terms over the period. It close to zero (0.01 percent of GDP and 0.1 percent of should be noted that regional governments have consolidated revenues), there were still signs of fiscal considerable discretion in designing their own social- distress in some jurisdictions. Eight jurisdictions had assistance programs. As long as federal guidelines are deficits of over 10 percent, measured as a share of their respected, regional governments may cut benefits to own revenues. The Republic of Khakassia, the Yamalo- Figure 43: Trends in subnational expenditures: Figure 44: Short-term loans account for over the adjustment occurred mostly on the expenditure side one-third of the subnational debt 3 500 000 000 Transport 3 000 000 000 3 000 Housing, utilities Bonds 2 500 000 000 constant Rbs Bns of 2015 2 500 Bank loans Rbs Bns of 2015 2 000 000 000 Education 2 000 Federal loans 1 500 000 000 Health 1 500 1 000 000 000 1 000 Social protection 500 000 000 500 Other - - 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2012 2013 2014 2015 2016 Source: Federal Treasury of the RF. Source: Federal Treasury of the RF. Доклад об экономике России | № 35. Апрель 2016 г. 37 Part 3. Russian regions and their responses during the crisis years Box 10: Federal controls over subna onal deficits At present, subnational deficits are controlled by a tight system of regulations set out in the Budget Code. The code specifies three types of ceilings. The first refers explicitly to deficits. Budget deficits of regional governments may not exceed 15 percent of annual revenues. For municipalities, the ceiling is 10 percent. In both cases, the calculation of revenues excludes intergovernmental transfers. In the case of municipalities, it also excludes revenues from shared regional taxes. Even tighter limits are placed on regions that are highly dependent on transfers. For regional governments that derived more than 40 percent of revenues from transfers during two of the three previous years, the deficit may not exceed 10 percent of revenues, excluding intergovernmental transfers. For municipalities that derived more than 50 percent of revenues from transfers, deficits may not exceed 5 percent of revenues (again, excluding transfers and shared regional taxes). The second and third ceilings control borrowing — i.e., the source of financing for deficits. In particular, the second ceiling refers to debt stocks. The Budget Code stipulates that the outstanding debt of a region or municipality may not exceed 100 percent of its annual revenues, excluding intergovernmental transfers. For transfer-dependent regions and municipalities, the ceiling is 50 percent. The third ceiling refers to debt service. The Budget Code stipulates that the debt service of a region or municipality may not exceed 15 percent of expenditures of the relevant year. In theory, these restrictions should act as a brake on subnational deficits. With explicit ceilings on the size of deficits and limited access to debt, subnational governments should be compelled to finance their expenditures from recurrent revenues supplemented by the sale of assets. But there are loopholes in the regulations, which are being addressed. For example, until 2017, federal refinancing loans were exempted from the debt ceilings. However, subnational governments may also accumulate debt in ways that evade tighter regulations. These can take the form of arrears to their employees and suppliers, including public utilities. These arrears can be accumulated by subnational governments themselves or by enterprises they own. The scale of these liabilities cannot be determined, as such information is not collected and published on a regular basis by the federal government or by the regions. Nenets Autonomous Okrug, and the Kostromskaya banks22. Commercial banks are increasingly reluctant oblast topped the list, with deficits of 27 percent, 23 to roll over their existing loans to subnational percent, and 15 percent, respectively20. governments and charge high interest rates if they are willing to roll them over at all. In response, the federal Subnational deficits, particularly during the first government has stepped in. Federal loans now account economic crisis (2009) and the more recent nadir of for one-third of subnational debt. Box 10 describes 2013, have resulted in growing levels of subnational the tight system of federal controls over subnational debt. As shown in Figure 44, the level of subnational deficits. debt peaked (in constant terms) in 2014, but it has since stabilized. Subnational debt totaled Rb 2,353 billion Prognosis at the end of 2016. This was equal to 35 percent of subnational discretionary21 revenues and 2.7 percent While subnational governments have, so far, of GDP. While the aggregate level of subnational debt successfully adjusted to the recent economic (35 percent) is not large, relative to revenues, some downturn, it is not clear how sustainable this individual regional governments are highly indebted. adjustment will be — and what its implications Over half of them have debt-to-revenue ratios in are for the services that subnational governments excess of 50 percent. The carrying costs of this debt is provide. Persistent cuts in spending on education will generally low, but its short-term nature represents a make it difficult to attract and retain qualified teachers, significant rollover risk in some jurisdictions. eventually resulting in declining levels of student learning. Cuts in spending on social protection will A significant part of subnational debt (39 percent) result in increased levels of poverty, not only among takes the form of short-term loans from commercial the economically disadvantaged but also among most pensioners. Cuts in transport will lead to increasing 20  However, these regions do not violate the 15 percent deficit 22  These banks are not, strictly speaking, private. Commercial bank restrictions imposed by the Budget Code because these restrictions lending financing of subnational governments is dominated by two do not apply to deficits covered by federal loans. state-controlled banks: Sberbank and VTB. 21  Discretionary revenues are defined as total own-source revenues (including shared taxes) plus unconditional grants. 38 Russia Economic Report | № 37. May 2017 Part 3. Russian regions and their responses during the crisis years traffic congestion and wear and tear on vehicles. Cuts complete them. Overall, the fiscal impact of cutting in spending on utilities will result in more erratic levels capital spending is not likely to be large. This is because of service. capital spending represents only a small proportion of total subnational spending (in Russia, the proportion SHORT-TERM MEASURES in 2015 was about 10 percent). Revenues Cutting the wage bill is likely to have a much larger In theory, the federal government could provide effect, due to the large proportion of subnational support — for instance, by increasing transfers to spending that is (presumably) devoted to salaries. In subnational governments. However, with the federal principle, there are two immediate ways to cut wage government itself fiscally constrained, there is a need spending. The first is by freezing nominal wages. This to look for additional measures. can have a substantial and immediate impact. With the inflation target of 4 percent, which the central On the revenue side, regional governments could bank strives to reach by end 2017, a freeze on current raise the CIT rate to the maximum 17 percent and nominal wages would reduce the wage bill by a refrain from granting exemptions and tax reductions proportionate percentage per year in real terms. This to individual firms in the future. Given the importance could, of course, run afoul of the federal directive of the CIT, this could have a significant impact on requiring the salaries of certain professions, such as revenues, particularly in the more industrial and teachers and health workers, to equal the prevailing urbanized regions. The federal government, for its wage in each region. But if regional wages are also part, could also increase the personal income tax rate, falling, even this obstacle might not have much effect24. which as noted earlier, is shared with subnationals. The second technique is to reduce staffing numbers. Subnational governments could increase the yields of Efforts to do so on a large scale can be difficult. In other taxes. For example, regional governments could most European countries, confirmed civil service accelerate the shift from book value to market value as employees are typically protected from dismissal the basis for assessing the tax on corporate property. except for cause (public-sector unions also play a role They could also transition more quickly to market in restraining downsizing). A more palatable approach values as the basis for assessing the land tax and the is to freeze new hiring. This can take time to have an building tax. The first of these measures could have a impact, however, as net reductions in staff cuts do significant impact on regional revenues. For the latter not occur until existing staff retire. Another approach measures to have an impact, the federal government is voluntary separation — where employees leave in would have to raise the ceiling on the maximum rates return for a financial compensation. But this can be of the land and building taxes. expensive, and employees can also raise problems of adverse selection. Only staff with good prospects of Expenditures finding alternative employment may take advantage of such programs, and they tend to be the most skilled On the expenditure side, subnational governments and hard-working employees — the very ones that could continue to pursue what appears to be their subnational governments would like to keep. current strategy — cutting capital expenditures and restraining the wage bill23. This is a common These strategies are only sustainable in the short- adjustment strategy for both central and local term. Eventually, capital spending must be resumed to governments in much of the region. As a short-term permit the expansion or replacement of infrastructure. measure, it can work well. On the capital spending side, new starts on capital works can be readily 24 postponed. But suspending ongoing capital works is  In the health sector, the direct impact of reducing real salaries would be limited. Regional governments are directly responsible more problematic, as half-completed works can fall only for financing specialized hospitals. The HIF is responsible into ruin long before funding becomes available to for financing the operating costs of all other health care facilities. Cost reductions in those facilities would not directly reduce the 23  Direct evidence of reductions in the wage bill is not available premiums that regional governments are required to contribute to as subnational expenditures in labor-intensive sectors, such as the HIF, although the resulting savings could result in a reduction in education, are classified as ‘transfers to municipal institutions’. premiums over the long term. Russia Economic Report | № 37. May 2017 39 Part 3. Russian regions and their responses during the crisis years Wages have to be increased in order to attract and Specific efficiency reforms can be found in individual retain qualified staff, and recruitment must be resumed sectors. The education sector would appear to be a to fill key positions. likely candidate. Regional governments could reduce spending on social assistance, exercising the discretion LONG-TERM MEASURES granted to them by federal legislation. A logical strategy would be to improve targeting. Some social In the longer run, fiscal sustainability will require assistance benefits are not means-tested at all (e.g., more fundamental changes aimed at improving benefits to labor heroes). In other cases, targeting is public-sector efficiency. The experiences of other imprecise. The housing allowance, for example, fails to countries suggest several possible targets. At the most target the poorest of the poor. general level, regional governments could undertake functional reviews to identify activities that could be But in the long run, the federal government may dropped or privatized. Regional governments could have to consider a fundamental rebalancing of the also pursue reforms in specific functional areas; e.g., division of revenues and functional responsibilities capital investment selection, construction-contract between the federal government and the subnational administration, or procurement reform. governments. It could either shift more functional responsibilities to the federal level or increase the Regions could undertake more targeted methods to revenues of subnationals. In effect, this would involve restrain their wage bills. Department-level functional a choice among sectors: does the federal government reviews could help identify redundant positions that want to spend more on the functions that are financed could be eliminated. Regions might also undertake pay from the federal budget? Or on the functions that are and grading reforms. Such exercises would be aimed at financed through subnational budgets? If the federal adjusting the salaries of individual positions to reflect government wanted to see an increase in spending on labor market conditions. It is certainly conceivable that education, for example, it could pay teacher salaries regional governments are paying too much for some directly — or provide an earmarked transfer for positions while paying too little for others. Pay and this purpose. If the federal government decided to grading reforms would allow regional governments increase spending on subnational functions in general, to increase salaries in occupations that have been it could raise the volume of existing, non-earmarked difficult to fill while constraining (or even reducing) transfers or increase the percentage of shared taxes salaries in occupations where regional governments that are distributed to the subnational level. Without are now paying more than the labor market requires. such shifts, Russia could be facing a long-term decline in the quality of its human capital, social services and infrastructure. References IMF 2016 “2016 External Sector Report.” Washington, D.C. International Monetary Fund. World Bank 2017. “Global Economic Prospects: Weak Investment in Uncertain Times.” Washington, D.C. World Bank. Yan Carriere-Swallow, Bertrand Gruss, Nicolas E Magud and Fabian Valencia, 2016. “Monetary Policy Credibility and Exchange Rate Pass-Through» IMF Working Papers 16/240, Washington, D.C. International Monetary Fund. 40 Russia Economic Report | № 37. May 2017 Russia Economic Report | № 37. May 2017 41 42 Russia Economic Report | № 37. May 2017 The World Bank in Russia 36/1 Bolshaya Molchanovka st., 121069, Moscow, Russia +7 (495) 745-7000 moscow@worldbank.org www.worldbank.org/russia