MODEST GROWTH; FOCUS ON INFORMALITY 41 RUSSIA ECONOMIC REPORT JUNE 2019 This report is produced twice a year by World Bank economists in the Macroeconomics, Trade and Investment (MTI) Global Practice. The team that prepared this edition was led by Apurva Sanghi (Lead Economist for the Russian Federation, asanghi@worldbank.org) and consisted of Olga Emelyanova (Economist, GMTE2), Mikhail Matytsin (Research Analyst, GPV03), Irina Rostovtseva (Research Analyst, GMTE2), Katerina Levitanskaya (Senior Financial Sector Specialist, GFCE1), Eva Gutierrez (Lead Financial Sector Specialist, GFCEE), Yoki Okawa (Economist, MTI), Peter Stephen Oliver Nagle (Economist, MTI) and Collette Mari Wheeler (Economist, MTI). The focus note was produced by Apurva Sanghi based on a report “Stemming Russia’s Informality: Unearthing Causes and Developing Solutions by Apurva Sanghi, Samuel Freije-Rodriquez, and Aleksandra Posarac (all World Bank). Peer reviewers included Yaroslav Lissovolik (Chief Managing Director, Head of Analytical Department of Global Markets, Sberbank) and Bakyt Dubashov (Senior Economist, MTI). The report was edited by Christopher Pala (Consultant), and the graphic designer was Robert Waiharo (Consultant). The team would like to thank Andras Horvai (Country Director for Russia) and Sandeep Mahajan (Practice Manager, MTI Global Practice) for their advice and support. The team also would like to express their gratitude to the Department for Research and Forecasting of the Central Bank, Department for Macroeconomic Forecasting of the Ministry of Economic Development, Department for the budget policy and strategic planning of the Ministry of Finance, Gabriel Di Bella (Resident Representative, IMF) and Sergei Ulatov (Director for coordination, Eurasian Development Bank) for the collaboration. This report went to press on June 10, 2019. TABLE OF CONTENTS ACRONYMS AND ABBREVIATIONS . ............................................................................................................................. i EXECUTIVE SUMMARY................................................................................................................................................... iii I. RECENT ECONOMIC DEVELOPMENTS ................................................................................................................... 1 1.1 Global growth: As growth stabilizes, oil prices recover...................................................................................... 2 1.2 Russia: growth slows down in the first quarter of 2019..................................................................................... 4 1.3 Balance of payments: a flexible exchange rate regime and the continued accumulation of buffers help Russia weather external shocks..................................................................................................................................... 6 1.4 Labor Market and Poverty Trends: unemployment declines, wages increase, but disposable incomes are not growing............................................................................................................................................................... 7 1.5 Monetary Policy: the CBR keeps it relatively tight, but some relaxation is expected in the second or third quarter of 2019................................................................................................................................................... 9 1.6 The Banking Sector: relatively stable but weak, with uneven growth across different segments...................... 11 1.7 Fiscal policy: After the fiscal stance improved in 2018, the focus turned to national projects. .......................... 13 II. RUSSIAN ECONOMIC GROWTH IS EXPECTED TO SLOW DOWN AFTER TEMPORARY ACCELERATION IN 2018 19 III. CURBING RUSSIA’S INFORMAL SECTOR: UNEARTHING CAUSES AND DEVELOPING SOLUTIONS .................. 25 LIST OF FIGURES Figure 1: Global industrial production growth and manufacturing PMI has picked up ................................................. 2 Figure 2: Volume Growth in the goods trade continues to soften................................................................................. 2 Figure 3: Commodity market developments: ................................................................................................................ 4 Figure 4: Growth momentum picked up in the first quarter of 2018............................................................................. 5 Figure 5: Net exports became main growth driver in the second half of 2018.............................................................. 5 Figure 6: Economic growth weakened in the first quarter of 2019................................................................................ 5 Figure 7: Higher commodity prices widened the current account surplus in 2018. ....................................................... 6 Figure 8: Imports by value decreased in the second half of 2018 (y/y)......................................................................... 6 Figure 9: Labor force and employment started to decline ............................................................................................ 8 Figure 10: Unemployment rate remains low ................................................................................................................... 8 Figure 11: Real wages by sector decelerated in all sectors . ............................................................................................ 8 Figure 12: Real incomes dynamics remains slow ............................................................................................................ 8 Figure 13: The CBR keeps its key policy rate unchanged in the first five months of 2019 . ............................................. 9 Figure 14: In 2019, inflation rose above the CBR’s target................................................................................................. 10 Figure 15: Inflation expectations are elevated ................................................................................................................ 10 Figure 16: Credit growth continued in both the retail and corporate segments ............................................................. 11 Figure 17: Overall financial sector indicators remained stable . ...................................................................................... 11 Figure 18: The government pursues a policy of fiscal consolidation................................................................................ 15 Figure 19: Federal Budget (FB) non-oil and gas revenues grew....................................................................................... 17 Figure 20: FB expenditures dropped ............................................................................................................................... 17 Figure 21: FB non-oil/gas primary deficit improved......................................................................................................... 17 Figure 22: FB spending as a share of GDP decreased for national economy, public management, national security, social policy....................................................................................................................................... 17 Figure 23: National projects and financing....................................................................................................................... 17 Figure 24: National projects and financing....................................................................................................................... 18 Figure 25: The growth forecast for Russia suggests modest growth ............................................................................... 21 Figure 26: Russia’s informal employment is on the rise, ranging between 15.1 and 21.2 percent................................. 26 Figure 27: Russia’s share of informal employment is not that high when compared to other middle-income countries (2012- 2017).................................................................................................................................... 26 Figure 28: Net formal job creation in Russia’s medium and large enterprises has been close to zero............................ 28 Figure 29: Russia’s minimum to average wage ratio is among the lowest ...................................................................... 30 Figure 30: Russia’s effective tax rate on entering employment is comparatively low...................................................... 32 Figure 31: Russia’s marginal effective tax rate on increasing working hours is comparatively low.................................. 33 Figure 32: The rate of informal employment varies between 3.6% in Moscow to 64% in the Chechen Republic........... 35 LIST OF TABLES Table 1: Poverty ........................................................................................................................................................... 9 Table 2: Government fiscal stance strengthened in 2018............................................................................................. 14 Table 3: Global growth is expected to hover around 2.8 percent ................................................................................ 21 Table 4: Projected growth rates are modest ............................................................................................................... 21 Table 5: The moderate poverty rate is expected to continue to decline in 2018 and through 2021............................ 22 Table 6: Russia’s Employment Protection Legislation is strict by OECD standards. ....................................................... 31 LIST OF BOXES Box 1: In Russia, the shares of the education and health sectors in GDP are small compared to in advanced economies....................................................................................................................................................... 15 Box 2: Labor market regulations in Russia are broad and mandatory. ....................................................................... 28 Box 3: By OECD standards, regulations on redundancy dismissal in Russia are overly rigid and discourage formal employment......................................................................................................................................... 32 Box 4: Russia’s benefit schemes do not confer commensurate gains compared to those of other countries........... 34 Box 5: Reducing the cost of formality for employers only has a small impact on informality. ................................... 36 Box 6: Certain labor market regulations can be eased to incentivize formal employment........................................ 38 Box 7: The role of well-functioning labor inspection systems goes beyond mere enforcement................................ 39 Box 8: Russia’s Federal Tax Service has made admirable progress in implementing a risk-prioritization approach.. 40 ACRONYMS AND ABBREVIATIONS APB Asian-Pacific Bank Bbl Oil Barrel BSCF Banking Sector Consolidation Fund CBR Central Bank of the Russian Federation CPI Consumer Price Index EEG Economic Expert Group EM Emerging Markets EMDEs Emerging Markets and Developing Economies EPL Employment Protection Legislation ETRL Effective Tax on Labor EU European Union FB Federal Budget FDI Foreign Direct Investment FIFA Fédération Internationale de Football Association FLI Federal Labor Inspectorate FTS Federal Tax Service of Russia FX Foreign Exchange GDP Gross Domestic Product GNFS General Number Field Sieve GRP Gross Regional Product ICT Information and Communications Technology ILO International Labor Organization ILOSTAT International Labour Office (ILO) database on Labour Statistics Mb/d Millions of Barrels per Day METR Marginal Effective Tax Rate NGO Non-Governmental Organization NIFI National Research Institute of the Ministry of Finance of the Russian Federation NRR Net Replacement Rate NWF National Welfare Fund OECD Organization for Economic Co-operation and Development OFZ Federal Loan Bonds OIS Overnight index swaps OPEC Organization of the Petroleum Exporting Countries OS&H Occupational Safety and Health PIT Personal Income Tax PMI Purchasing Managers’ Index PP Percentage Point PTI Payment-to-Income PTR Participation Tax Rate Q Quarter R&D Research and Development REER Real Effective Exchange Rate Russia Economic Report | Edition No. 41 i RLMS Russia Longitudinal Monitoring Survey Rosstat Russian Federal State Statistics Service RUB Russian Ruble SIB Systemically Important Banks SIC Social Insurance Contribution Rate SMEs Small and Medium-Sized Enterprises TAXBEN IFS (Institute for Fiscal Studies)’s Tax and Benefit Microsimulation Model TJTC Targeted Jobs Tax Credit USD United States Dollar VAT Value-Added Tax WB The World Bank WIEGO Women in Informal Employment: Globalizing and Organizing WTI West Texas Intermediate y-o-y; y/y Year-on-year EXECUTIVE SUMMARY Real GDP growth in Russia surpassed expectations in 2018, reaching 2.3 percent, mostly due to one- off effects of energy construction. Forecasted growth of 1.2 percent in 2019 and 1.8 percent in 2020 and 2021 reflects a more modest outlook. Russia’s macro-fiscal buffers remain strong, with fiscal surpluses across all tiers of government and low public-debt levels. When compared to advanced economies, Russia spends less on health and education. Rebalancing in favor of these categories could improve the overall efficiency of public spending. Short-term inflationary risks have abated, with the Bank of Russia signaling a return to a neutral policy rate. Lending activity is recovering, but the banking sector remains afflicted with high concentration and state dominance. Having eased slightly, the poverty rate remains in double digits with many households close to the poverty line and lacking formal employment. Informal employment is rising in the face of close-to-zero net job creation by medium-sized and large formal enterprises. Key risks to medium-term growth include the expansion of economic sanctions, renewed financial turmoil in EMDEs, a dramatic drop in oil prices, and souring of the global trade environment. The recent double-digit expansion in household credit may also pose a risk to financial stability in the case of a deterioration in the macroeconomic environment. Recent developments current account surplus strengthened to 6.9 percent S upported by favorable global growth, higher of GDP in 2018. Difficult external financial conditions oil prices, one-off construction projects, and for emerging markets and elevated geopolitical Russia’s hosting of the FIFA World Cup, GDP tensions boosted net capital outflows to USD 67.8 growth accelerated to 2.3 percent in 2018 from 1.6 billion (about 4.1 percent of GDP) in 2018 and led percent in 2017. It was the highest reading since to a depreciation of the real effective exchange rate 2013. From the supply side, the growth acceleration of 7.7 percent. At USD 487.9 billion (or 15.9 months largely happened on the back of the completion of of import cover), international reserves stand at a one-off energy construction projects in the Tyumen comfortable level. In the first quarter of 2019, the region. From the demand side, both domestic current account surplus strengthened compared demand and net exports were important sources of to the same period last year on the back of lower growth. However, a VAT rate increase, a relatively import values and lower debt payments, reaching tight monetary policy, a higher base of 2018 and USD 32.8 billion (8.7 percent of GDP) compared a dip in oil production in the first quarter of 2019 to USD 30 billion (7.6 percent of GDP) in the same slowed the GDP growth rate to 0.5 percent, y/y. period last year. Relatively high levels of international reserves, Consumer price inflation, at 5.1 percent in a relatively low external debt and a flexible May, exceeded the CBR’s target of 4 percent exchange rate regime helped Russia limit exposure in annual terms since the beginning of 2019, to external volatility and absorb external shocks. when it experienced the most intense VAT pass- A new fiscal rule, which ushered in a stronger non- through effect. A relatively tight monetary policy, oil/gas current account, also strengthened Russia’s together with a softening of financial conditions external position. Supported by higher commodity for emerging markets, helped curb inflationary prices and a robust export volume growth, the pressures; inflation appears to have peaked in Russia Economic Report | Edition No. 41 iii Executive Summary March. However, household inflation expectations Despite recent bailouts, Russia's banking sector and corporate price expectations remain elevated. remains relatively weak, with a lower capital Higher oil prices, combined with a weaker ruble, adequacy ratio (12.2% as of April 2019) and a better tax administration, and a conservative fiscal higher ratio of non-performing loans (10.4%) than policy further improved fiscal balances at all levels in other emerging markets. The recent double-digit of the budget system in 2018. The general, federal, expansion in household credit may pose a risk to and regional governments registered surpluses financial stability in case of a deterioration in the of 2.9, 2.6, and 0.5 percent of GDP, respectively. macroeconomic environment, although consumer Overall public debt, at 14.3 percent of GDP, remains lending risks appear to be contained owing to low. The non-oil/gas general government primary tightening prudential regulations aimed at slowing deficit fell to 5 percent of GDP from 7 percent in unsecured consumer lending. The state continues 2017. The fiscal surplus is expected to roll over to to dominate the banking sector. As of April 1, 2019, 2019-2021. the top five banks generated 57 % of all banking sector profits, and state-owned banks accounted for New development goals announced by the 62% of all banking assets. These figures are skewed President in May 2018 have led to the shaping of upwards by the positive results of Sberbank, which 13 national projects, which total 25.7 trillion rubles accounts for about 30% of total system assets, (about USD 390 billion, or about 2.8 to 3.2 percent generating more than 37% of system-wide profits. of GDP annually) for 2019-2024. The 13 projects are divided into three specific areas: human capital (5.7 Unemployment declined further in the first quarter trillion rubles or 86.2 billion USD), quality of life (9.9 of 2019 to a current 4.8 percent. Real wage growth trillion rubles or USD 149.9 billion), and economic in 2018 was above the rate of inflation in both growth (10.1 trillion rubles or USD 152.8 billion). tradable and non-tradable sectors; it was highest in They are mostly financed from the federal budget. the public sector. However, real-income dynamics The liquid part of the National Welfare Fund could worsened toward the end of 2018 and beginning exceed 7 percent of GDP by the end of 2019, giving of 2019, suggesting a contraction in real terms of the government the ability to invest part of it in some unobserved components (informal earnings, domestic infrastructure projects. But while Russia’s for example). The poverty rate under the national infrastructure gaps are large, substantial investment definition (population share with incomes below in domestic infrastructure projects from the liquid 10,287 rubles/month in 2018) declined slightly to part of the fund could reverse the achievements of 12.9 percent in 2018, from 13.3 percent in 2017. the fiscal rule. This reduction was driven by growth in the main sources of income, wages and pensions. In January 2019, the government adopted measures to increase the efficiency of public Outlook, risks and challenges expenditures for the period of 2019-2024. Such measures include regularly reviewing public expenditures for their efficiency, managing tax R ussia’s overall growth prospects for 2019-21 remain modest at 1.2 to 1.8 percent in 2019- 2021, in line with its current potential growth expenditures, and improving public procurement trends. GDP growth in 2019 is projected to be procedures. These are important steps in the right 1.2 percent. Continued oil production cuts and direction. However, the shares of the education deterioration in the external environment (which and health sectors are small compared to advanced affects export growth) are factors weighing down on economies and rebalancing spending towards these GDP growth in the second quarter on top of subdued sectors could further improve overall effectiveness domestic demand. A less tight monetary stance and efficiency of public spending. and acceleration in the implementation of national iv Russia Economic Report | Edition No. 41 Executive Summary projects weigh in favor of growth acceleration in The share of informal employment, a pervasive the second half. Yet, weak growth dynamics in the phenomenon in Russia, is estimated to range first half are expected to affect the annual growth between 15.1 and 21.2 percent. The fiscal loss of number through the carry over effect. GDP growth underpayment by informal workers is estimated is expected to accelerate to 1.8 percent in 2020 and to between 1 to 2.3 percent of GDP. However, 2021. Household consumption growth is expected stemming Russia’s informal labor tide does not to rebound after its 2019 deceleration, and lend itself to an obvious single fix. For example, implementation of national projects is expected to policies that reduce payroll taxes to lower the support investment demand. cost of formal labor are not enough. Instead, the findings point to a three-pronged policy The outlook is subject to risks. Downside risks to mix that would lead to (i) more-flexible labor Russia’s growth outlook stem from the potential legislation in certain areas, backed by more- expansion of sanctions, deterioration of financial effective enforcement; (ii) a stronger safety net market sentiment, souring global trade environment with better unemployment benefits; and (iii) a and a dramatic drop in oil prices. The recent more -workforce. Specifically, Russia’s labor code expansion in household credit may pose a risk to and regulations could be adjusted in the areas of financial stability in the case of a deterioration in the labor contracts, minimum wages, and redundancy macroeconomic environment. Public investment dismissal. Labor inspection services are also an growth is subject to the successful and efficient important line of defense against informality, implementation of government infrastructure and a more client-focused and risk prioritization investment initiatives. On the upside, national approach, which the Federal Labor Inspectorate is projects, aimed at strengthening human capital moving towards, works better to decrease informal and increasing productivity, could positively affect employment. A well-designed unemployment Russia’s potential growth in the medium-term, insurance system and consolidating small and depending on how well they are implemented. fragmented benefits programs into larger income/ means-tested benefits could provide incentives Special topic: Informal employment in Russia to register as unemployed and to subsequently S table economic growth, wage growth in the private sector, and the indexation of pensions to inflation should support disposable incomes and seek formal work. However, informality can only be partially alleviated with specific fiscal or labor market measures. Systemic solutions to contribute to a gradual decline in the poverty rate reduce informality will require broader policies. in 2019-21. However, many Russians lack formal The antidote to reducing informality is the faster employment. This edition’s special topic (Part 3) creation of more formal-sector jobs: In both 2017 focuses on the spread of informal employment in and 2018, net job creation by medium and large Russia and possible measures to address it. enterprises was close to zero. Russia Economic Report | Edition No. 41 v PART I RECENT ECONOMIC DEVELOPMENTS I. Recent Economic and Policy Developments 1.1 Global growth: As growth stabilizes, oil prices recover Global growth remains subdued after losing momentum in late 2018 and early 2019. The slowdown in industrial activity has accompanied a deceleration in the growth of the global trade of goods, especially in exports of EMDEs. After recovering over the first quarter of 2019, crude oil prices sharply declined in late May and early June, with Brent falling to roughly USD 60/bbl. Oil production surged in the United States, while output in Saudi Arabia and Russia fluctuated on production agreements. G lobal growth remains subdued after losing considerable momentum in late 2018 and early 2019. Growth in industrial production and Global financing conditions continue to ease, with rising equity valuations and falling borrowing costs. Market expectations for central banks’ policy manufacturing under the Purchasing Managers’ rates have been pushed further into the future— Index (PMIs) continued to weaken in early 2019 the European Central Bank is not expected to (Figure 1). Major central banks continued supporting increase rates until 2021, while markets expect the activity with accommodative policy rates amid Federal Reserve to lower them as soon as late-2019 soft inflation. In Emerging Market and Developing (based on an OIS curve analysis on Bloomberg). Economies (EMDEs), however, inflation accelerated Most EMDEs continue to enjoy benign financing on the back of rising energy and food prices conditions, with rising equity prices and falling towards the beginning of the year. Global trade yield spreads. Following substantial outflows in the continued to soften, with new export orders falling second half of 2018, capital flows to EMDEs were throughout early 2019 (Figure 2). The slowdown in essentially flat for 2019Q1. Recently released data trade has been particularly acute in Asia, especially show that EMDE foreign exchange-denominated with respect to imports. The increase in tariffs by debt in several countries rose substantially in 2018. the United States and retaliatory actions by China in May have re-escalated trade tensions, with the Amid slowing exports, industrial activity in the potential costs cascading across value chains and Euro Area, Russia’s largest trading partner, remains amplifying policy uncertainty. notably weak, while the services sector is relatively Figure 1: Global industrial production growth and Figure 2: Volume Growth in the goods trade continues manufacturing PMI has picked up to soften (Percent, 3m-on-3m saar) (Percent, 3m-on-3m saar) Index, 50+=expansion 20 8 55 15 6 53 10 5 4 51 0 -5 2 49 -10 0 47 -15 Mar - 18 May -18 Sep -18 Nov -18 Jan -19 Mar - 17 May -17 Sep -17 Nov -17 Jan -18 Jul -18 Jan -16 Mar - 16 May -16 Jul -16 Sep -16 Nov -16 Jan -17 Jul -17 Mar -19 Apr -16 Apr -17 Apr -18 Apr -19 Oct -16 Oct -17 Oct -18 Jan -16 Jul-16 Jan -17 Jul-17 Jan -18 Jul-18 Jan -19 Industrial production growth Manufacturing PMI (RHS) World Advanced economies EMDEs Source: CPB Netherlands Bureau of Economic Analysis, Haver Analytics, World Bank. A. PMI stands for Purchasing Managers’ Index (PMI). Readings above 50 indicate expansion, readings below indicate contraction. The last observations were in February 2019 for industrial production and March 2019 for manufacturing PMI. B. EMDEs = emerging market and developing economies. Last observation was January 2019. 2 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments resilient. The external environment has become OPEC countries were slower to adhere to the more challenging as uncertainty regarding the reduction, with Russia projected to reach its initial United Kingdom’s exit from the European Union target in April. OPEC and its coalition partners continues, with the deadline extended to October are slated to meet in late June to decide whether 31, 2019 as the government and the opposition to extend the oil production cuts given recent negotiate a compromise deal. Activity indicators volatility in oil prices amid heightened uncertainty in Japan rebounded slightly at the end of the regarding global demand and a re-escalation of first quarter of 2019 but have not fully recovered trade tensions. Production has also fallen in Iran from significant weakness in previous months. and Venezuela, which are exempt from the OPEC Meanwhile, growth in China, Russia’s second- agreement. Crude oil production fell by a third largest trading partner, stabilized at 6.4 percent in Venezuela since September to 0.9 mb/d in (y/y) in 2019Q1, on the back of monetary and March 2019. In Iran, the impact of U.S. sanctions fiscal stimuli. Despite signs of improving activity, on production has been substantial, despite the China’s policy uncertainty index remains near an waivers. Output has fallen 1.1 mb/d relative to its all-time high. peak in the second quarter of 2018, comparable to the impact of previous sanctions in 2014. The Crude oil prices fell sharply, by 15 percent, in the announcement by the U.S. that it would not renew second half of the second quarter after rising waivers to the sanctions on Iran when they expire nearly 40 percent in early 2019 (Figure 3A). In at the start of May boosted oil prices in late April. late April, Brent reached USD 75/bbl, and the West Texas Intermediate (WTI) rose to USD 66/ The prices of metals and some agricultural bbl, driven primarily by supply developments, with products also staged a partial recovery in the demand remaining robust. Since late April, prices first quarter of 2019, following drops in the have once again slid, by roughly 15 percent, on second half of 2018 (Figure 3C). The recovery the back of concerns over weaker global demand in metal prices reflected improving growth and a re-escalation of trade tensions between prospects for China – which accounts for half of major economies. The earlier sharp fall in prices global consumption – as well as a series of supply in the last quarter of 2018 was triggered by the bottlenecks and concerns, such as the Vale dam United States decision in November to grant accident in Brazil (iron ore, nickel) and heavy floods waivers to its sanctions against Iran to eight in Chile (copper). Similarly, supply factors helped countries. This coincided with a sharp increase boost some agricultural commodity prices. These in supply among OPEC countries, primarily Saudi included weather-related planting delays for U.S. Arabia (in anticipation of a shortfall arising from wheat and corn as well as lower expectations for the sanctions), as well as surging production in U.S. soybean plantings on concerns about trade the United States. It resulted in an increase of oil tensions. In contrast, natural-gas prices have fallen production (Figure 3B). sharply, with price differentials between the three main price benchmarks shrinking (Figure 3D). The In response, OPEC and its coalition partners, fall in prices was due to a combination of weak including Russia, agreed to implement production demand resulting from a warmer-than-expected cuts of 1.2 mb/d starting in 2019. Output among winter and the restarting of nuclear power plants these countries has fallen sharply, particularly in Japan, together with rising supply, particularly in Saudi Arabia, where production is down more from liquefied natural gas. than 1 mb/d relative to its November peak. Non- Russia Economic Report | Edition No. 41 3 I. Recent Economic and Policy Developments Figure 3: Commodity market developments: A. Crude oil prices recovered over the fi rst quarter of 2019 on surged in the United States, while output B. Oil producti in Saudi Arabia and Russia fl uctuated on producti on agreements (US$/bbl) (Mb/d, y/y) 90 2 80 1 70 60 0 50 40 -1 Jul -18 Apr -18 Apr -19 Jan -18 Oct -18 Jan -19 2015 2016 2017 2018 2019 Brent WTI United States Saudi Arabia Russia rst C. Agriculture and metal price indices recovered in the fi D. Natural gas prices have fallen in 2019 quarter of 2019 (US$/mmbtu) (US$/bbl) 12 130 10 120 8 110 6 100 4 2 90 0 80 Mar - 18 May - 18 Jul - 18 Sep - 18 Nov - 18 Jan - 19 Mar - 19 May - 19 Oct-17 Oct-18 Jan-17 Apr-17 Jan-18 Apr-18 Jan-19 Apr-19 Jul -17 Jul -18 U.S. Europe Japan Agriculture Metals Source: Bloomberg, International Energy Agency, World Bank. 1.2 Russia: growth slows down in the first quarter of 2019 Supported by favorable global growth, higher oil prices, one-off construction projects, and Russia’s hosting of the FIFA World Cup, GDP growth accelerated to 2.3 percent in 2018 (the highest reading since 2013) from 1.6 percent in 2017. Domestic demand continued to be an important growth driver. Meanwhile, deceleration of import growth made net exports emerge as another important growth driver. In the first quarter of 2019, however, GDP growth slowed down to 0.5 percent, y/y, from 2.7, y/y, in the fourth quarter of 2018 on the back of a VAT rate increase, relatively tight monetary policy, higher base of the last year and a slowdown in oil production. I n 2018, GDP growth totaled 2.3 percent, y/y, exceeding expectations and growth rates for the previous five years. Growth momentum picked up growth acceleration largely happened on the back of the completion of construction projects – a one- off effect of energy sector projects in the Tyumen in the first quarter of 2018 and stayed at about the region. Other sectors that contributed to GDP same level during the year, slightly accelerating in growth acceleration were finance (on the back of the fourth quarter (Figure 4). On the supply side, continued credit expansion), transport (benefiting 4 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments Figure 4: Growth momentum picked up in the first y/y, from 5.2 percent, y/y, in 2017. Favorable quarter of 2018 global growth and the World Cup supported the (Percent) acceleration of export growth in 2018. Moreover, 3 1.0 2.7 a weaker ruble and slowdown in consumption 2.5 2.3 0.5 growth led to destocking, which contributed to 2.2 2.2 2 1.9 0.0 deceleration of import growth, making net exports 1.5 an important growth driver. -0.5 1 -1.0 Economic growth weakened significantly in 0.5 -1.5 the first quarter of 2019 (Figure 6). Flash GDP 0.3 growth estimates suggests growth slowed down 0 -2.0 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018 Q4 2018 Q1 2019 to 0.5 percent, y/y, (-1.6 percent, q/q adjusted for GDP growth, percent, y/y GDP growth, percent, qoq, sa seasonality). While deceleration was expected on Source: Rosstat. the back of a rise in the VAT rate, a relativley tight monetary policy, high base of the last yeart, some from the FIFA World Cup hosted by Russia and skewness of public spending to the second half of higher growth in mineral resource extraction), the year, and the OPEC+ agreement, the slowdown hotels and restaurants (also helped by the cup). exceeded expectations: 0.8 percent growth by the Ministry of Economic Development, 1 to 1.5 Both domestic demand and net exports were percent growth from the Cental Bank. Details on important sources of growth in 2018. Even with the supply or demand side are not available yet. a decline in its contribution, domestic demand High-frequency statistics point to weaker growth remained an important driver of GDP growth. in industrial production in the first quarter of 2019 Weak growth in real disposable incomes and (with a pickup in April), on the back of OPEC+ REER depreciation led to a slowdown of household agreement and modest growth in manufacturing. consumption growth in 2018. Conservative fiscal The slowdown of retail trade and market services policy weighed on public consumption and investment indicate subdued consumer demand. Investment growth. Despite support from the completion of demand growth weakened as well: fixed capital one-off construction projects in 2018, fixed capital investment growth slowed down to 0.5 percent investment growth slowed down to 2.9 percent, of GDP, y/y, compared to 2.9 percent, y/y, in the Figure 5: Net exports became main growth driver in Figure 6: Economic growth weakened in the first the second half of 2018 quarter of 2019 (Percentage point) (Percent) 115 6 59 110 4 57 105 2 55 100 53 0 95 51 -2 90 49 -4 85 47 -6 80 45 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Oct-16 Oct-17 Oct-18 Apr-17 Apr-18 Apr-19 Apr-16 Jul -18 Jul -16 Jul -17 Jan-17 Jan-18 Jan-19 Jan-16 2017 2017 2017 2017 2018 2018 2018 2018 2019 Consumption Change in inventories Gross fixed capital formation Export PMI services (RHS) PMI manufacturing (RHS) Import (-) Stat error Industrial Production Cargo Agriculture Output in five basic sectors GDP growth Construction Source: Rosstat. Source: Rosstat, HSBC. Russia Economic Report | Edition No. 41 5 I. Recent Economic and Policy Developments fourth quarter of 2018. A slump in wholesale Russian customs reveals a drop in the exports of trade: -7.4 percent, y/y, could reflect inventory base metals, oil products and machines, suggesting destocking (Figure 8). Preliminary statistics from lower export growth. 1.3 Balance of payments: a flexible exchange rate regime and the continued accumulation of buffers help Russia weather external shocks Relatively high levels of international reserves, a relatively low external debt and a flexible exchange rate regime helped Russia limit exposure to external volatility and absorb external shocks. The new fiscal rule, which ushered in a stronger non-oil/gas current account, also strengthened Russia’s external position. H igher energy prices for major commodities exported by Russia as well as robust export volume growth widened the current account this. Increased geopolitical tensions and uncertainty cut FDI inflows to Russia from 1.8 percent of GDP in 2017 to 0.5 percent of GDP in 2018. Net capital surplus to about 6.9 percent of GDP (USD 113.8 outflow in the private sector grew from 2.0 percent billion) in 2018 from 2.1 percent of GDP (USD 33.2 of GDP in 2017 to 4.1 percent of GDP in 2018 as billion) in 2017 (Figure 7 and Figure 8); net capital a result of an increase in the acquisition of foreign outflows increased substantially in 2018 compared assets amidst increased uncertainty and difficult to 2017. A stronger trade balance (11.7 percent of external conditions for emerging markets. Net GDP in 2018 vs 7.3 percent of GDP in 2017) was extrenal liabilities decreased while banks continued the main factor behind a growing current account debt payments. Pressure on the financial account surplus. Net capital outflows increased substantially resulted in a REER depreciation by 7.7 percent in in 2018 compared to 2017: net capital inflows turned 2018, y/y. The non-oil/gas current account deficit into net capital outflows in the government sector improved to 8.9 percent of GDP in 2018 from 10.2 from the second quarter of 2018, mainly through percent of GDP in 2017, largely reflecting gains in the sell-off of OFZ bonds. Increased geopolitical the non-oil/gas fiscal balance on the back of the tension and a tightening of monetary policy in the new fiscal rule. advanced economies were the main reasons for Figure 7: Higher commodity prices widened the Figure 8: Imports by value decreased in the second current account surplus in 2018 half of 2018 (y/y) (Percentage point) (Percent) 12 -4.0 110 100 8 90 4 80 -8.0 70 0 60 -4 50 40 -8 -12.0 30 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 20 2017 2017 2017 2017 2018 2018 2018 2018 2019 Apr -14 Apr -15 Apr -16 Apr -17 Apr -18 Apr -19 Aug -14 Aug -15 Aug -16 Aug -17 Aug -18 Dec -13 Dec -14 Dec -15 Dec -16 Dec -17 Dec -18 Transfers Investment income Compensation of employees Services Goods CA Oil price (Brent), Dec 13 = 100 Import of goods, Dec 13 = 100, SA Non - oil/gas CA (rha) REER, Dec 13 = 100 Source: CBR. Source: CBR. 6 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments In the first quarter of 2019, the current account period last year, driven mainly by the acquisition of strengthened compared to the same period last foreign assets by the banking sector. year on the back of lower import values and lower debt payments. According to preliminary data, in International reserves gained USD 18.1 billion in January-March 2019, the current account surplus the first quarter of 2019 and stand at a comfortable reached USD 32.8 billion (8.7 percent of GDP) USD 487.8 billion. This gain was largely because compared to USD 30 billion (7.6 percent of GDP) of the resumed foreign currency purchases under in the same period last year. The value of exported the fiscal rule framework. Growth in international goods dropped to USD 101.2 billion from USD reserves had stalled in September 2018, when the 101.7 billion in the same period last year, reflecting Central Bank suspended FX interventions in the somewhat lower oil prices compared to the same fiscal rule framework to stabilize financial markets. period last year, a reduced grain harvest in 2018, Reserves amounted to USD 468.5 billion in the and lower exports of machines, equipment and end of 2018 and increased to USD 487.8 billion in transport vehicles. REER depreciation (-5 percent, the first quarter of 2019, compared to USD 432.7 y/y) weighed down on import values, somewhat in the end of 2017. The import cover stayed at a strengthening the trade balance. Lower debt levels comfortable level, slightly higher than at the end combined with a weaker ruble supported the 2017 (17.1 months of goods and services in the investment-income balance. As global financial end of March 2019, compared to 15.9 months at conditions eased somewhat in the beginning of the end of 2017). The Central Bank refrained from 2019, the government sector registered a net inflow intervening on its own, in line with its flexible of portfolio investment (mainly in OFZ bonds). FDI exchange-rate regime. Relatively high levels of inflow increased to 3 percent of GDP from 1.6 international reserves, a relatively low external percent of GDP in the first quarter of 2018. Yet, debt (27.3 percent of GDP at the end of 2018), and overall net capital outflows from the private sector the recently established macroeconomic framework grew to USD 25.6 billion (6.8 percent of GDP) from helped Russia to limit exposure to external volatility USD 20.6 billion (5.2 percent of GDP) in the same and absorb external shocks. 1.4 Labor Market and Poverty Trends: unemployment declines, wages increase, but disposable incomes are not growing Unemployment declined further in the first quarter of 2019 to a current 4.8 percent while real wages increased. In 2018, real wage growth was positive in both tradable and non-tradable sectors and was highest in the public sector. However, real income dynamics worsened toward the end of 2018. The poverty rate under the national definition decreased in 2018, driven by a rebound in household incomes. T he employment and labor-force participation rates declined slightly while unemployment was close to a minimum. The absolute number These rates were at 59 and 62 percent. The decline in economic activity was partly driven by the aging of the population and the increased shares of older of employed people decreased by 700,000 to 71.4 cohorts, which on average have lower participation million in the first quarter of 2019, compared to the rates. The effect of the increased retirement age has levels of a year earlier (Figure 9). The labor force not translated to the labor force participation rates decreased during the same period even more, by yet. Lower labor supply also that led to decrease 900,000 people, to 75.0 million. Employment and of unemployment rates by another 0.3 percentage labor force participation rates declined in the first points in the first quarter of 2019 (to 4.8 percent) quarter of 2019 compared to the same period a year (Figure 10). ago by 0.4 and 0.6 percentage points respectively. Russia Economic Report | Edition No. 41 7 I. Recent Economic and Policy Developments Figure 9: Labor force and employment started to Figure 10: Unemployment rate remains low decline (Million people) (Percent) 78 6.5 76 6.0 74 5.5 72 5.0 70 4.5 68 2015 2016 2017 2018 2019 4.0 Labor force Employment 2015 2016 2017 2018 2019 Labor force, SA Employment, SA Total SA Source: Rosstat and Haver Analytics. Source: Rosstat and Haver Analytics. Real wage growth decelerated in all sectors. Real non-tradables, the highest real wage growth wage growth in the last quarter of 2018 and in the rates were in the wholesale and retail trade (4.5 first quarter of 2019 was much slower than in the percent), while wages in construction increased beginning of 2018. This can partly be explained by only by 2.1 percent. the effect of a high base a year ago (Figure 11). The fastest real wage growth was in the public sector: Real disposable income dynamics remains health (10.6 percent in the September 2018 - volatile. In the last quarter of 2018, real disposable February 2019 period compared to the same period income growth was minus 1.4 percent (Figure 12). a year ago) and R&D (7.1 percent). Real wages grew The decline is partly explained by increases in robustly in agriculture (6.3 percent). Real wage the effective tax burden and obligatory payments growth in other tradable sectors was much lower: including loan services and repayments. Rosstat 1.4 percent on average (3.7 percent in mining, and took the decision of not reporting this indicator a decline of 0.4 percent in manufacturing). Among monthly anymore. It will be reported only quarterly Figure 11: Real wages by sector decelerated in all Figure 12: Real incomes dynamics remains slow sectors (Percent, year on year) (Percent, year on year) 20 20 15 15 10 10 5 5 0 0 -5 -5 -10 -10 -15 -15 -20 -20 2015 2016 2017 2018 2019 2015 2016 2017 2018 2019 Wages Pensions Tradables Non-tradables Public Disp income Disp inc., 12-months MA Source: Rosstat and World Bank staff estimates. Note: Pension and disposable income dynamics adjusted for January 2017’s one-time payment Source: Rosstat and World Bank staff estimates. 8 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments starting from 2019, with a slightly different The official poverty rate declined slightly in 2018. methodology.1 The dynamics in the first quarter of Driven by growth in the main sources of income, 2019 was negative (contraction of 2.3 percent to wages and pensions, the poverty rates in Russia the same period of last year) according to the new decreased in 2018 compared to 2017. The poverty methodology. Labor pensions were indexed at 7.05 rate dropped from 13.2 percent in 2017 to 12.9 percent in January 2019 – above the current rate of percent in 2018 (Table 1). inflation – and social pensions were indexed by 2 percent in April 2019. This should support the level of pensions and keep it growing in real terms. Table 1: Poverty (Cumulative) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2010 2011 2012 2013 2014 2015 2016 2017 2017 2017 2017 2018 2018 2018 2018 Poverty rate, 12.5 12.7 10.7 10.8 11.2 13.3 13.3 15.0 14.4 13.8 13.2 14.2 13.6 13.3 12.9 percent Source: Rosstat. 1.5 Monetary Policy: the CBR keeps it relatively tight, but some relaxation is expected in the second or third quarter of 2019 In the beginning of 2019, the CBR’s monetary policy remained consistent with the inflation-targeting regime. A relatively tight monetary policy, together with a softening of financial conditions for emerging markets, helped curb inflationary pressures. Inflation appears to have peaked in March and reached 5.1 percent in May. However, household inflation expectations and corporate price expectations remained elevated. T he Central Bank of Russia kept the policy rate unchanged at 7.75 percent as inflationary risks decreased. In January-May 2019, the CBR kept Figure 13: The CBR keeps its key policy rate unchanged in the first five months of 2019 (Key policy rate, percent) 12 the key policy rate unchanged since its increase by a cumulative 50 basis points in the second half 11 of 2018, thus bringing it up to 7.75 percent in 10 annual terms, which is above the neutral rate2 of 6 to 7 percent (Figure 13). The 2018 increase was 9 sufficient to curb the effects of one-off inflationary 8 factors, such as the ruble depreciation, turbulence 7 in emerging markets and the value added tax (VAT) rate increase in January 2019. 6 Dec-15 Dec-16 Dec-17 Dec -18 Oct-16 Oct-17 Oct-18 Jun-16 Jun-17 Apr-16 Apr-18 May-17 Feb-17 Feb-18 Sep-15 Sep-16 Sep-17 Sep-18 Jul-16 Mar-16 Mar-17 Mar-18 Jan-15 In the first quarter of 2019, the annual consumer Source: CBR. price inflation significantly increased, exceeding the target of 4 percent, while still remaining below and commodity markets stabilized and the VAT the CBR’s expectations (Figure 14). The short-term pass-through to prices was quite moderate. Thus, inflationary risks softened: the foreign financial after its peak in March, when the annual consumer 1 Among the most important differences are the decreased share of unobserved incomes (from 26 to 11 percent) and changes in the accounting for foreign currency operations. 2 A neutral key rate would not either decelerate or accelerate inflation, relative to the target level of 4 percent. Russia Economic Report | Edition No. 41 9 I. Recent Economic and Policy Developments inflation edged up to 5.3 percent, y/y, from 4.3 substantially. Among the key factors that contributed percent in December 2018 and marked the highest to this decline were a stabilization of gasoline prices, reading since December 2016, it started to ease in a stronger ruble exchange rate and an adaptation to April, reaching 5.1 percent in May, y/y. The inflation the VAT rate increase. The most significant decline is expected to return to the 4 percent target in in corporate price expectations was registered in the first half of 2020. The CBR also signaled that if trade. This may indicate that companies viewed the situation developed in line with their baseline the process of the VAT hike’s pass-through to prices forecast, it may renew its movement to a 6-to-7- as mostly complete. However, in April - May 2019, percent neutral rate in Q2-Q3 of 2019, but needs to the dynamics of inflation expectations of economic proceed at a slower pace, given continuing upside agents was mixed. Corporate price expectations risks to the inflation outlook. One is that despite the continued to decline to the level of 9.5 percent, reduction in short-term risks, the overall balance while household inflation expectations slightly of medium-term risks remains tilted towards increased to 9.3 percent. pro-inflationary ones. Among the key risks are geopolitical factors, renewal of volatility in financial Elevated geopolitical tensions and difficult markets, acceleration of household credit growth, external financial conditions for emerging which puts upward pressure on prices, and a rise in markets resulted in the ruble’s depreciation inflation expectations. in 2018. However, in the beginning of 2019, the ruble exchange rate strengthened. For the period Household inflation expectations and corporate of January-May 2019, the currency appreciated price expectations remained elevated. Household about 4 percent against US dollar, supported by inflation expectations for twelve months ahead an easing of global financing conditions, higher oil rose starting May 2018 after an increase in gasoline prices and lower risk perceptions. The situation in prices. They continued their upward trend till the the foreign exchange (FX) market stabilized after beginning of 2019, influenced by the weakening a period of volatility in the second half of 2018.3 of the ruble, an increase in the prices of selected Starting January 2019, the CBR resumed its forex consumer goods and a VAT hike (Figure 15). interventions in the fiscal rule framework. In the Corporate-sector inflation expectations also rose first four months of 2019, the CBR’s FX purchases for three months ahead. In February-March 2019, amounted of about USD 17.4 million, compared to both household and corporate expectations fell USD 16.2 million in the same period of 2018. Figure 14: In 2019, inflation rose above the CBR’s Figure 15: Inflation expectations are elevated target (CPI index and its components, percent, y-o-y) (Percent) 12 20 18 10 16 8 14 6 12 10 4 8 2 6 0 4 2 -2 Dec-17 Dec-18 Dec-16 Nov-16 Oct-17 Nov-17 Oct-18 Nov-18 Oct-16 Jun-16 Jun-17 Jun-18 Aug-17 Aug-18 Aug-16 Apr-18 Apr-19 Apr-16 Apr-17 May-19 May-17 May-18 May-16 Feb-17 Feb-18 Feb-19 Feb-16 Sep-18 Sep-16 Sep-17 Jul-18 Jul-16 Jul-17 Mar-18 Mar-19 Mar-16 Mar-17 Jan-19 Jan-17 Jan-18 Jan-16 0 Jan -16 Feb -16 Mar -16 Apr -16 May- 16 Jun - 16 Jul -16 Aug -16 Sep -16 Oct - 16 Nov - 16 Dec -16 Jan -17 Feb -17 Mar -17 Apr -17 May- 17 Jun - 17 Jul -17 Aug -17 Sep -17 Oct - 17 Nov - 17 Dec -17 Jan -18 Feb -18 Mar -18 Apr -18 May- 18 Jun - 18 Jul -18 Aug -18 Sep -18 Oct - 18 Nov - 18 Dec -18 Jan -19 Feb -19 Mar -19 Apr -19 May- 19 Core in ation CPI in ation Food in ation Non-food in ation Services in ation CPI in ation Household in ation expectations Corporate in ation expectations, sa Source: CBR and Haver Analytics. Source: CBR. 10 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments 1.6 The Banking Sector: relatively stable but weak, with uneven growth across different segments The Russian banking sector has been relatively stable, supported by modest economic growth and the proactive position of the regulator. The CBR has been taking timely steps to address the risks of the accelerated consumer-lending growth, and it continued its sector clean-up by revoking the licenses of some smaller banks and focusing on the financial rehabilitation of large financial institutions. However, the continuing fast-paced expansion in household credit may pose a risk to financial stability in the case of a deterioration in the macroeconomic environment. T he Russian banking sector is stabilizing as the modest economic growth supports lending growth, though dynamics vary from segment to assets and return on equity have been growing steadily, reaching 1.8 percent and 15.9 percent respectively as of April 1, 2019 (Figure 17). These segment, and credit risk and sector performance figures are skewed upwards by the positive results indicators remain stable. Corporate demand for demonstrated by Sberbank, which accounts for new loans strengthened as credit to the corporate about 30 percent of total system assets, generating sector in Rubles grew by 11.4 percent, y/y, as of more than 37 percent of system-wide profits. As of May 1, 2019 (Figure 16). Lending to households in April 1, 2019, the top 5 banks generate 57 percent Rubles continues to grow in double digits – at 24.0 of all banking sector profits, and the state-owned percent, y/y, at the same time. Lending to SMEs banks account for 62 percent of all sector assets. has been stagnating despite various government support measures. While earlier recapitalization System-wide capital adequacy ratio remained of some large banks negatively affected banking- largely unchanged for the past six months at 12.2 sector profitability, the latter continued to improve, percent as of April 1, 2019. The continuing fast- supported by lending growth and stable NPLs. As paced expansion in household credit may pose a of May 2019, banking-sector profits totaled RUB risk to financial stability in case of deterioration in 750 billion (USD 11.4 billion), compared to RUB the macroeconomic environment, but consumer 537 billion in the same period of 2018. Return on lending risks appear to be contained by tightening Figure 16: Credit growth continued in both the retail Figure 17: Overall financial sector indicators remained and corporate segments stable (y-o-y, percent) (Key credit and performance indicators, percent) 27 18 24 21 15 18 15 12 12 9 9 6 3 6 0 -3 3 -6 -9 0 Jan -16 Jan -17 Jan -18 Mar-19 Jan-16 Apr -16 Jul-16 Oct-16 Jan-17 Apr -17 Jul-17 Oct-17 Jan-18 Apr -18 Jul-18 Oct-18 Jan-19 Apr -19 Capital adequacy ratio NPLs to total loans Loan loss provisions to total loans Return on assets Companies Household Return on equity Source: CBR, World Bank staff calculations. Source: CBR. 3 In order to reduce the volatility in the FX market, the CBR suspended FX interventions from August to December 2018. Russia Economic Report | Edition No. 41 11 I. Recent Economic and Policy Developments regulations. The CBR has taken timely steps Credit to SMEs had declined during the 2015-2016 to address the risks linked to the accelerated recession. This trend was reversed only recently, but consumer lending growth by adjusting risk weights SME lending volumes are still below the pre-crisis on unsecured retail loans three times in 2018 (the level (RUB 6.8 trillion in 2018), and the outstanding latest increase became effective on April 1, 2019). SME loan portfolio remained flat in 2017-2018 at Additionally, the CBR is considering implementing RUB 4.2 billion (13 percent of total outstanding payment-to-income (PTI) limits, with the first step business loans and 4.1 percent of GDP). The National being obligatory reporting of the ratio to the CBR Project on SME and Individual Entrepreneurship by banks and microfinance organizations starting Support (National SME Project) envisions provision October 1, 2019. The Parliament is drafting a law to of RUB 261.8 billion (USD 4 billion) public funds for prohibit lending to borrowers whose monthly loan improving SME access to finance, with a significant instalments exceed 50% of their family income. portion going to subsidized bank lending. It is planned that the volume of subsidies under the Despite rapid growth in Russian retail loans, the new program administered by the Ministry of current situation is different from the one that Economic Development and SME Corporation led to the 2014 retail-loan crisis. Current retail- since 2019 (“Program 8.5”) will increase lending loan growth in Russia is slower than in 2012-13, manifold. Under this program, the participating and there are no signs of nonperforming loans banks (currently 70 banks) are compensated for picking up. The system-wide retail nonperforming the difference between the interest rate at which loan ratio has held largely steady since the they lend to SMEs (capped at 8.5 percent) and the beginning of the year, with some signs of decline market rate, with compensation limited to no more – notably a drop of 5.1 percent as of April 1, 2019. than 1.5-2.75 percent differential. For this purpose, Interest rates are also lower than in the past, the federal budget in 2019 allocated RUB 9.2 billion which means households’ debt-servicing capacity (USD 142 million), which is expected to generate has improved even as their debt burdens have RUB 1 trillion (USD 15.4 billion) in subsidized SME increased. In addition, bank retail loan portfolios loan issuance in 2019 (or 15 percent of the 2018 are now almost entirely denominated in the local SME loan issuance volume). Overall, it is planned currency (only 0.7 percent of retail loans are forex- that the banks will issue RUB 10 trillion in subsidized denominated), shielding them from currency risks. SME loans in 2019-2024, with the federal budget However, extended loan durations may indicate subsidies for this purpose reaching RUB 56 billion that the banks have extended repayment periods (USD 862 million) in 2019-2021. to make loans affordable, without considering the underlying purpose of the loan, which may be The CBR’s license-revocation activities have short-term by its nature. Extended loan repayments slowed as the regulator has focused on the enable borrowers to “borrow long-term and spend financial rehabilitation of several large financial short-term.” The core risk is that the borrower institutions, including SIBs. As of May 1, 2019, will need to renew such expenditures (domestic there were 469 banks in Russia, compared to 499 consumption, health, education) whilst existing six months earlier. Following a series of bailouts loan repayments continue – and will, therefore, of large and Systemically Important Banks (SIBs) need to seek additional loans, resulting in additional in 2017-2018, in January 2019, the CBR bailed financial pressure. out the Moscow Industrial Bank (33rd by assets) via its Banking Sector Consolidation Fund (BSCF) In 2019, the government put in place a massive, and provided liquidity support in the amount of subsidized program to increase lending to SMEs. RUB 40 billion (USD 615 million). Capital shortfall 12 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments is estimated at RUB 60-100 billion (USD 0.9-1.5 approximately 75 percent of the banking-system billion). Since the BSCF was established by the CBR assets), which are subject to stricter prudential in 2017, ten banks were bailed out under its new requirements. Banks with a total capital exceeding resolution mechanism, with RUB 2,3 trillion spent RUB 3 billion (USD 46 million) receive a “universal” on bank recapitalization and provision of liquidity. license, which allows them to run a full scope of In March 2019, the regulator tested its first attempt banking operations but forces them to comply with to privatize a bank that had been recapitalized by a wide range of regulatory requirements. Banks BSCF by putting up for sale the Asian-Pacific Bank with total capital of less than RUB 1 billion receive (APB) for RUB 9.86 billion (USD 152 million) in an a “basic” license and are subject to a simplified open auction. But ultimately, the CBR had to cancel regulatory regime, but their operations are also the auction given the lack of investor interest due limited in terms of the types, currencies and to the complexity of the procedure. The central counterparts. Banks with a total capital of more bank will postpone APB’s privatization until the than RUB1 billion, but less than RUB3 billion, may next year, in the meantime considering changing its opt for either a basic or a universal license. As of auction format to allow for a broader set of options April 2019, there were 144 banks with basic licenses for privatizing resolved banks. in Russia, accounting for less than 0.5 percent of total banking system assets. Amendments to Russian banking laws introduced proportionate regulation starting from January Customer deposits remain the primary funding 1st, 2019. In line with the new regulatory regime, source for Russian banks. The sector’s reliance on there are now three types of banks in Russia: wholesale market funding is low, with customer SIBs, a category in effect since 2015), banks with deposits (almost equally split between corporate a universal license and banks with a basic license. and retail) comprising 80 percent of liabilities. The CBR publicly designates 11 SIBs (accounting for 1.7 Fiscal policy: After the fiscal stance improved in 2018, the focus turned to national projects In 2018, the general government fiscal balance improved on the back of higher oil prices and the government’s commitment to the new fiscal rule5. The general government registered surplus of 2.9 percent of GDP, the federal, 2.6 percent and the regional, 0.5 percent. The debt burden continued to decrease, both at the federal and the regional level. The government has put significant effort into shaping national projects, which total 25.7 trillion rubles (about USD 390 billion or between 2.8 to 3.2 percent of GDP annually) for 2019-2024. These projects are aimed at reaching goals set in the President’s May Decree. The liquid part of the National Welfare Fund (NWF), currently at about 3.6 percent of GDP, could exceed 7 percent of GDP by the end of 2019, giving the government the ability to invest part of it in domestic infrastructure projects. But while Russia’s infrastructure gaps are large, substantial investment in domestic infrastructure projects from the fund could reverse the achievements of the fiscal rule, which reduced the economy’s dependence on energy prices. In 2018, the general government fiscal balance improved on the back of higher oil prices and the government’s commitment to the new fiscal rule. GDP6 turned into a surplus of 2.9 percent of GDP in 2019 as general government revenues increased by 2.2 percent of GDP to 35.9 percent of GDP The general government deficit of 1.5 percent of (Table 2) and general government expenditures 5 The fiscal rule limits federal budget expenditures targeting federal budget primary deficit of 0.5 percent of GPD at the benchmark oil price of USD 40 per barrel in 2017 prices. 6 Cash basis, preliminary information. Russia Economic Report | Edition No. 41 13 I. Recent Economic and Policy Developments dropped by 2.2 percent of GDP to 33.0 percent of to the path of fiscal adjustment for the new fiscal GDP. Higher oil prices, combined with a weaker rule. The decrease in spending occurred mostly at ruble, resulted in higher oil/gas revenues (+2.2 the federal level: federal government spending on percent of GDP, compared to 2017). Certain non- defense and national economy fell by 0.4 percent of oil/gas tax revenues grew as a share of GDP GDP and social expenditures dropped by 1 percent (corporate income tax, VAT), reflecting the weaker of GDP. Social expenditures indexed mostly by the ruble, higher prices for exported commodities and CPI shrank as a share of GDP as the GDP deflator improved tax administration. Still, overall non-oil/ was higher than the CPI. Another reason was a gas revenues remained flat, largely because of high-base effect for 2017, when the government shrinking revenues from social taxes (-0.2 percent conducted a one-time payment to pensioners. The of GDP), the base for which shrank as a share of non-oil/gas general government primary deficit GDP. General government primary expenditures improved to 4.9 percent of GDP in 2018 from 7.1 decreased as a share of GDP by 2.2 percent of percent of GDP in 2017. GDP, as the federal government stayed committed Table 2: Government fiscal stance strengthened in 2018 General government (% of GDP)7 2017 2018 Revenues 33.7 35.9 Expenditures 35.2 33.0 Interest payments 0.9 0.9 Primary expenditures 34.3 32.1 Balance -1.5 2.9 Primary balance -0.6 3.8 Federal government* (% of GDP) 2017 2018 Revenues 16.4 18.7 Oil and gas revenues 6.5 8.7 Non-oil/gas revenues 9.9 10.0 Expenditures 17.8 16.1 Primary expenditures 17.1 15.3 Interest payments 0.8 0.8 Primary balance -0.7 3.4 Non-oil/gas primary balance -7.1 -5.3 Balance -1.4 2.6 Consolidated regional government (% of GDP) 2017 2018 Revenues 11.7 11.9 Expenditures 11.7 11.4 Primary expenditures 11.6 11.3 Interest payments 0.15 0.1 Balance 0.0 0.5 Primary balance 0.1 0.6 Extrabudgetary funds (% of GDP) 2017 2018 Revenues 11.6 10.5 Expenditures 11.6 10.7 Balance 0.0 -0.2 Source: EEG. 7 Due to consolidation, the sum of revenues (expenditures) at different levels does not equal revenues (expenditures) of the general government. 14 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments Higher energy prices and the federal government’s compared to 2013. Government spending on health commitment to the new fiscal rule turned the and education decreased more than average as the federal budget deficit of 1.4 percent of GDP in 2017 share of expenditures for health and education into a federal government surplus of 2.6 percent of decreased in 2017 compared to 2013 (Box 1). GDP in 2018. Thus, government national projects, increasing expenditures for education by about 0.1 percent of The consolidated regional budget primary surplus, GDP per year and for health by 0.2-0.3 percent of 0.1 percent of GDP in 2017, widened to 0.6 of GDP GDP per year, are steps in the right direction. in 2018 as tax revenues increased and expenditures Figure 18: The government pursues a policy of fiscal dropped as a share of GDP (national economy, consolidation social policy, -0.1 percent of GDP each). (Percent) 30 25,000 25 24,800 Overall, the general government primary non- 20 24,600 oil/gas fiscal deficit improved from 9.5 percent 15 24,400 of GDP in 2013 to 7 percent of GDP in 2017 10 24,200 5 24,000 and 5 percent of GDP in 20188 (Figure 18). This 0 23,800 was largely supported by a new macroeconomic -5 2013 2014 2015 2016 2017 2018 23,600 framework established by the government and -10 23,400 -15 23,200 its commitment to fiscal consolidation. The government used revenue from improved tax GG non- oil/gas primary deficit, percent of GDP Non- oil/gas revenes, pecent of GDP administration and expenditure cuts. General Primary expenditures, bln rubles, 2013 prices government expenditures decreased in real terms Source: Ministry of Finance of the RF. Box 1 In Russia, the shares of the education and health sectors in GDP are small compared to in advanced economies The shares of the education and health sectors in GDP Figure B1: State management sector is large while are small compared to advanced economies, while the educational and health sectors are small share of the public sector exceeds that of advanced (Percent) economies. Shares of spending on national economy Share of Value Added (which includes state support to various sectors of the economy, including roads construction and Public maintenance) in total public spending exceeds that of the advanced economies (Figures B1 and B3). Education Certain health and education sectors outcomes also lag Health those in advanced economics. While Russia’s education system shows good performance in Harmonized Learning 3 4 5 6 7 8 Percent Outcomes, there are areas where more government 25/75 percentile of sample Russia focus is needed, for example, in socio-emotional skills Russia data is from 2018. Other countries are latest values, usually 2015. Samples include 23 EU countries and US, Japan, Canada and China. (Figure B2). Expected increased investment in health and education from the national projects, if spent Source: World Bank. effectively and efficiently, can help improve productivity. 8 Preliminary information. Russia Economic Report | Edition No. 41 15 I. Recent Economic and Policy Developments Figure B2: Outcomes in socio-emotional skills can be Figure B3: The share of expenditures for health and improved education in Russia is lower than in OECD countries (Percent) (Percent) Relative performance in collaborative problem solving based on performance in PISA science, reading and mathematics Social protection Chinese Taipei Education Singapore Recreation, culture and religion Russia -22 Macao (China) Health OECD average United States 22 Housing and community amenities United Kingdom Environmental protection Turkey New Zealand Economic affairs Korea Japan 23 Defense and public order Germany France State management Australia 23 0.0 10.0 20.0 30.0 40.0 50.0 -30 -20 -10 0 10 20 30 OECD, 2016 Russia 2017 Russia 2013 Source: World Bank, World Economic Forum. Source: Federal Treasury of the RF, OECD. Collaborative problem solving is part of the PISA 2015 test which shows the ability of 15 years old students to collaborate in solving learning the problems, lead the team, and agree on solutions (the task example is available by this link - http:// www.oecd.org/pisa/test/other-languages/xandarurlreplace- menttest.htm). The debt burden continued to decrease both and export services development. at the federal and the regional levels in 2018. On the back of stronger non-oil revenues, the That year, external debt payments and capital federal budget surplus improved to 2.1 percent outflow from emerging markets resulted in a of GDP in the first four months of 2019, up from lower federal government external debt. Total 0.9 percent of GDP in the same period last year. In federal government debt reached 12.2 percent January - April 2019, non-oil and gas revenues grew, of GDP compared to 12.6 percent of GDP in 2017. compared to the same period last year (Figure 19). Regional debt decreased to 2.1 percent of GDP This was largely the result of a VAT rate increase9 from 2.5 percent of GDP in 2017, with a stronger and a weaker ruble in the four months of 2019, fiscal position. The number of regions with debt compared to the same period in 2018. Weaker volumes exceeding revenues fell from seven in ruble and higher energy goods production and 2017 to two in 2018 (Republic of Mordovia and export compensated for lower prices, keeping Kostromskaya oblast). oil and gas revenues at the same level (as a share of GDP) as in January – April 2018. Primary The National Welfare Fund (NWF) reached USD expenditures edged down by 0.1 pp. Spending on 58.1 billion (3.8 percent of GDP) by the end national economy dropped by 0.2 percent of GDP of 2018. In line with the fiscal rule, about USD and shrank in nominal terms (Figure 20 and 22). 65 billion of foreign currency purchased by the Lower primary expenditures and higher non-oil/ Ministry Finance in 2018 will be channeled to the gas revenue led to an improvement of the non- NWF in 2019. The liquid part of NWF could exceed oil/gas federal budget primary deficit (Figure 21). 7 percent of GDP by the end of 2019, giving the In January-March 2019, the general government government the ability to invest part of the NWF balance improved to 5.4 percent of GDP from 3.2 in domestic infrastructure projects. Currently, the percent of GDP in the same period last year. This government is also considering other opportunities was largely the result of lower spending on social for the fund’s investment, notably export financing policy, national economy, interest payments. 9 Base VAT rate increased from 18 to 20 percent since January 1, 2019. 16 Russia Economic Report | Edition No. 41 I. Recent Economic and Policy Developments Figure 19: Federal Budget (FB) non-oil and gas Figure 20: FB expenditures dropped revenues grew (Percent) (Percent) 20 20 0.9 0.7 15 8.2 15 8.2 10 10 16.5 16.4 5 10 10.9 5 0 0 Jan - Apr 2018 Jan - Apr 2019 Jan - Apr 2018 Jan -Apr 2019 Non-oil revenues Oil revenues Primary expenditures Interest payments Source: EEG. Source: EEG. Figure 21: FB non-oil/gas primary deficit improved Figure 22: FB spending as a share of GDP decreased for national economy, public management, national security, social policy (Percent) (Percent) 4 Sport 2.7 Media 1.8 2.1 2 Culture 0.9 Environment 0 Housing services Health -2 Education -4 Public management National economy -6 -5.5 National security -6.5 National defense -8 Soc. policy Non-oil/gas Primary balance Balance primary balance 0 1 2 3 4 5 6 Jan - Apr 2018 Jan - Apr 2019 Jan-Apr 2019 Jan- Apr 2018 Source: EEG. Source: EEG. Figure 23: National projects and financing The government continues shaping the national (Billion rubles) projects aimed at reaching the goals stated in the Infrastructure to improve connectivity May Decree. In February 2019, the government Export and international cooperation Economic growth Productivity approved the main indicators to be reached by the Digital economy national projects. The 13 projects are divided into 3 SME Science specific areas: human capital (5.7 trillion rubles or Environment protection Comfortable USD 86.2 billion), quality of life (9.9 trillion rubles Dwellings environment Safe roads or USD 149.9 billion), and economic growth (10.1 Culture trillion rubles or USD 152.8 billion). They are mostly Demography Human capital financed from the federal budget (Figure 23 and Education Health Figure 24). The projects address Russia’s need for 0 1000 2000 3000 4000 5000 6000 7000 higher human-capital financing. About 25 percent of the funds would go to infrastructure aimed at Source: Ministry of Finance. Russia Economic Report | Edition No. 41 17 I. Recent Economic and Policy Developments increasing connectivity. Figure 24: National projects and financing In January 2019, the government adopted (billion rubles) measures to increase the efficiency of public 4500 expenditures in 2019-2024. Such measures 4000 3500 included regularly reviewing public expenditures 3000 for their efficiency, managing tax expenditures, 2500 and improving public procurement procedures. 2000 These are important steps in the right direction. 1500 The government intends to complete a full cycle of 1000 budget expenditures review every six years, and it 500 0 also plans on implementing its findings regarding 2019 2020 2021 2022 2023 2024 expenditure efficiency. The introduction of tax Federal budget Consolidated regional budgets EBF Non-budget sources expenditure management would provide for a complex assessment of the efficiency of the current Source: Ministry of Finance. system of tax expenditures, currently estimated at business environment. 3.3 percent of GDP. These initiatives could create additional fiscal space and positively affect the PART II RUSSIAN ECONOMIC GROWTH IS EXPECTED TO SLOW DOWN AFTER TEMPORARY ACCELERATION IN 2018 Russia Economic Report | Edition No. 41 19 II. Outlook and Risks Global growth is expected to slow down to 2.8 percent by 2021. Downside risks to the global projection remain elevated, with forecasts predicated on no further escalation in trade tensions, stable commodity prices and diminishing headwinds from earlier disruptive financial market developments. Crude oil prices (defined as an average of Brent, West Texas Intermediate, and Dubai) are expected to rise somewhat from their current levels and average USD 66/bbl in 2019 and USD 65/bbl in 2020-21. Russia’s growth is forecasted at 1.2-1.8 percent in 2019-2021. If ongoing national projects are implemented effectively and efficiently, they could contribute to an increase in the potential growth, but only after 2021. G lobal growth is expected to reach 2.8 percent by the 2021 horizon (Table 3). Tepid growth in major commodity exporters, 1.4 mb/d. However, other major oil-producing countries, such as Saudi Arabia and the United Arab Emirates, could increase production to as well as a modest recovery in economies compensate for any shortfall as OPEC currently previously affected by acute financial pressure, has around 3.5 mb/d of spare capacity. But it are expected to offset decelerating activity is unclear how rapidly these countries will be in major economies. Sustained weakness willing to respond to a reduction in Iranian in global investment is anticipated to weigh exports. OPEC is due to meet in June to discuss on growth amid elevated economic policy whether to extend production cuts, especially uncertainty. Downside risks to the global in light of recent oil price volatility, or to respond projection remain elevated, with forecasts predicated on no further escalation in trade to any shortfall in production. As such, prices tensions between the United States and could stabilize from recent lows before rising China (as well as other major partners), stable in the second half of 2019. Other risks include commodity prices and diminishing headwinds conflict-related disruptions in Libya and further from both policy uncertainty and disruptive deterioration in Venezuela. On the downside, financial market developments. A sharper-than- global demand could turn out to be weaker expected slowdown in major economies, such than expected, while U.S. shale production as the United States, China, and the Euro Area, could surprise on the upside again. could also dampen global prospects. Non-energy commodity prices are expected to Price forecasts and risks be broadly flat over the next two years. Metal The price of crude oil (an average of Brent, prices are expected to continue their partial WTI, and Dubai) is expected to rise somewhat recovery in 2019 but decline modestly overall, from current levels and reach USD 66/bbl before picking up in 2020. Supply concerns in 2019 and USD 65/bbl in 2020-21. This is a (especially in copper, iron ore and zinc), and downward revision from the previous forecast China’s fiscal stimulus are expected to provide and reflects weaker-than-expected global support. Risks are broadly balanced. Agricultural growth and a much larger increase in U.S. prices are expected to fall 2.6 percent in 2019, production than anticipated in 2018. Risks to on average, amid ample stocks. In 2020, prices the oil price outlook relate primarily to policy are expected to rise 1.7 percent on expected decisions by major oil-producing countries. cuts in U.S. crop plantings and higher costs of The United States decision on April 22 to energy and fertilizers. Risks to the agriculture terminate waivers to its sanctions on Iran could price outlook are to the upside. Higher-than- put upward pressure on oil prices by reducing expected energy costs could lift the prices of Iranian oil exports, which are currently around crops such as grains and oilseeds. 20 Russia Economic Report | Edition No. 41 II. Outlook and Risks Table 3: Global growth is expected to hover around 2.8 percent (GDP growth projections, percent) 2016 2017 2018 2019f 2020f 2021f World 2.4 3.1 3.0 2.9 2.8 2.8 Advanced economies 1.7 2.3 2.2 2.0 1.6 1.5 United States 1.6 2.2 2.9 2.5 1.7 1.6 Euro Area 1.9 2.4 1.9 1.6 1.5 1.3 Emerging and developing economies 3.7 4.3 4.2 4.2 4.5 4.6 China 6.7 6.9 6.5 6.2 6.2 6 Russia 0.3 1.6 2.3 1.2 1.8 1.8 Crude oil (Brent, WTI and Dubai average, USD/bbl) 42.8 52.8 68.3 66 65 65.5 Source: WDI, World Bank staff projections. Russia’s overall growth prospects for 2019-21 Figure 25: The growth forecast for Russia suggests modest growth remain modest at 1.2 to 1.8 percent in 2019- (Real GDP growth, percent) 2021, in line with its current potential growth 3 110 trends (Figure 25 and Table 4). GDP growth in 2.3 100 1.6 1.8 1.8 2019 is projected to be 1.2 percent. Continued 2 90 1.2 oil production cuts and deterioration in the 1 80 70 US$ per barrel external environment (which affects export 0.7 Percent 0.3 60 growth) are factors weighing down on GDP 0 50 growth in the second quarter on top of subdued -1 40 30 domestic demand. A less tight monetary 20 -2 stance and acceleration in the implementation -2.3 10 of national projects weigh in favor of growth -3 2014 2015 2016 2017 2018 2019 2020 2021 0 acceleration in the second half. Yet, weak Oil price, average, rhs Real GDP growth (percent) growth dynamics in the first half are expected Source: Rosstat, World Bank. to affect the annual growth number through Table 4: Projected growth rates are modest (Major macroeconomic Indicators) 2017 2018 2019 2020 2021 GDP growth, percent 1.6 2.3 1.2 1.8 1.8 Consumption growth, percent 3.1 1.8 0.9 1.3 1.4 Gross fixed capital formation growth, percent 5.2 2.9 1.6 3.3 3.7 General government balance, percent of GDP -1.5 2.9 1.7 1.6 1.5 Current account (US$ billions) 33.3 114.9 86.3 82.3 80.1 Current account, percent of GDP 2.1 6.9 5.1 4.7 4.4 Exports (GNFS), bln USD 411.3 508.7 493.5 504.5 521.0 Imports (GNFS), bln USD 326.9 344.5 354.9 369.4 386.0 Trade balance (GNFS), bln USD 84.3 164.2 138.6 135.1 135.0 Trade balance (GNFS), percent of GDP 5.3 11.7 8.2 7.7 7.4 Capital and financial account (US$ billions) -19.6 -65.6 -36.1 -30.5 -26.3 Capital and financial account, percent of GDP -1.2 -4 -2.1 -1.7 -1.4 CPI inflation (average) 3.7 2.9 5 4 4 Source: WB staff calculations. Russia Economic Report | Edition No. 41 21 II. Outlook and Risks the carry over effect. GDP growth is expected dramatic drop in oil prices. The recent expansion to accelerate to 1.8 percent in 2020 and 2021. in household credit may pose a risk to financial Household consumption growth is expected stability in the case of a deterioration in the to rebound after its 2019 deceleration, macroeconomic environment. Investment and implementation of national projects is growth is subject to the successful and efficient expected to support investment demand. implementation of government infrastructure investment initiatives. Supported by relatively high oil prices, the general government budget is expected to Low potential growth remains a challenge for remain in surplus in 2019-2021. CPI inflation Russia. Currently potential growth is estimated peaked in March 2019. It is expected to at about 1.5 percent of GDP. Accumulated decelerate for the rest of 2019, averaging 5.0 structural and institutional challenges (low percent, y/y. The CPI inflation is expected to productivity growth, weak institutional return to the central bank’s target of 4 percent quality, lack of competition) and demographic in 2020-21. The forecast of a narrower external pressures weigh on potential growth. The surplus reflects lower oil prices and a pick- national projects, which target such important up in import spending. Net capital outflow areas as human capital, public infrastructure, is expected to decrease gradually with lower and demography, could positively affect debt payments. Russia’s potential growth in the medium-term. The moderate poverty rate is expected to Improvements in public financial continue to decline in 2019 and through 2021, management, which provide for level playing although social vulnerability needs to be field, are crucial for efficient implementation monitored. Continued growth of the economy, of the national projects. While there wage growth in the private sector, and the were many advances in public financial management, more remains to be done to indexation of pensions to inflation will support disposable incomes and contribute to a gradual improve the public procurement framework10. decline in the poverty rate (Table 5). However,This includes efforts to make it more many individuals lack formal employment and transparent and efficient, and leveling the many households remain close to the poverty playing field to enable firms to better compete for government contracts. For instance, in the line, suggesting a level of social vulnerability that will continue to require close monitoring.road sector, significant efficiency gains from current spending patterns can be realized Risks and challenges by (1) reviewing the procurement methods Russia faces risks both external and domestic. for civil works; (2) introducing performance- Downside risks to Russia’s growth outlook stem based management contracts; (3) introducing from the potential expansion of sanctions, improved asset-management techniques and renewed financial turmoil in EMDEs, and a ensuring that the programming of road works Table 5: The moderate poverty rate is expected to continue to decline in 2018 and through 2021 2011 2012 2013 2014 2015 2016 2017 2018 2019 f 2020 f 2021 f Poverty rate, percent 12.7 10.7 10.8 11.2 13.3 13.3 13.2 12.9 12.6 12.1 11.5 Source: Rosstat, WB staff calculations. 10 Systematic Country Diagnostic for the Russian Federation: Pathways to Inclusive Growth, World Bank, 2016. 22 Russia Economic Report | Edition No. 41 II. Outlook and Risks incorporates economic principles; (4) creating are to improve efficiency, operations and a more commercially oriented national road maintenance, and to finance a technically and agency; and (5) improving strategic planning. economically sound expansion program to In the railway sector, the key challenges keep up with rising demand. Russia Economic Report | Edition No. 41 23 PART III CURBING RUSSIA’S INFORMAL SECTOR: UNEARTHING CAUSES AND DEVELOPING SOLUTIONS * * This section is based on a new report “Stemming Russia’s Informality: Unearthing Causes and Developing Solutions“ by Apurva Sanghi, Samuel Freije-Rodriquez, and Aleksandra Posarac (all World Bank). The interested reader is referred to this report for more in depth discussion and technical analysis, including a list of references. III. Potential growth: Outlook and options for Russia Growing informal employment in Russia raises concerns about fiscal sustainability, productivity, and social protection. This part of the Russia Economic Report summarizes the most recent analysis on the size of the informal sector by employment, its determinants, and emerging policy directions to stem Russia’s rising tide of informality. A. How do Russia’s informality trends compare 10.9 to 15 million people (with the share of over time and with other countries? self-employed estimated to be between 25 and H ow large is informal employment in 50 percent). Russia? It increased from 12.5 percent in 2001 to 21.2 percent in 2016. It is defined as How does informality in Russia compare to other countries? It is worth noting that the follows: workers are considered formal if they nature of informality in Russia is different than have a contract in their main job, regardless that in most other countries. This is because of of the duration of contract; otherwise they Russia’s high education level, the economy’s are considered informal. Using various data non-agrarian structure, and its reliance on sources, as shown in Figure 26, informal hired labor (versus self-employment). This employment is on the rise in Russia. There is is apparent in Figure 27, which shows high a long-term increase in informality from the informal employment rates in low-income early 2000s (and even before that, based on countries – upwards of 90 percent in African RLMS data) through to 2016 (with a short countries – versus Russia’s 22 percent. period of stagnation or even a decrease in the However, middle-income countries such as second half of the 2000s). Encouragingly, these Kazakhstan and Turkey, who have a similar trends and estimates are consistent across GDPs per capita as Russia, show similar if not different data sources, including the official higher informal employment rates – 30 and 33 measure of informal employment monitored percent, respectively. Thus, compared to this by Rosstat. Informality is estimated to range set of middle-income countries, Russia’s share between 15.1 and 21.2 percent, or between of informal employment is not high. Figure 26: Russia’s informal employment is on the rise, Figure 27: Russia’s share of informal employment is ranging between 15.1 and 21.2 percent not that high when compared to other middle-income (Percent) countries (2012- 2017) 25 100 Mozambique Mali Bangladesh Niger Senegal Cote d'Ivoire Share of informal employment Uganda 90 Tanzania Angola Ghana Myanmar Percentage of informal employment Zimbabwe Bolivia Indonesia Pakistan India 20 80 Honduras Yemen, Rep. Nicaragua Guatemala Gambia, The Vietnam Ecuador Timor-Leste Paraguay 70 El Salvador Peru Namibia Egypt, Arab Rep. 15 60 Albania Colombia Guyana Dominican Republic Swaziland Mauritius 50 Mongolia Maldives Armenia Argentina Brazil Chile 10 40 Costa Rica Moldova South Africa Turkey 30 Kazakhstan Ukraine Uruguay Serbia 5 20 Russian Federation 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 10 Rosstat official Labor Force Survey European Social Survey 0 800 1,600 3,200 6,400 12,800 25,600 RLMS (primary jobs only) Life in Transition Survey GDP per capita 2015, PPP (constant 2011 international $) Source: Rosstat, RLMS, Labor Force Survey, European Social Source: ILO-WIEGO informal employment database and Survey, Life in Transition Survey. ILOSTAT informal employment harmonized series, www.ilo. org/ilostat (accessed June 4, 2018); and World Development Indicators for GDP data. Note: Data corresponds to the most recent estimates of the in- formal employment rate within the period 2012-2017. 26 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia Is informality rising or falling in Russia? By high-incidence sectors typically thought of as global comparisons at least, Russia’s share of attracting informality such as construction or informal employment does not appear too agriculture. different. However, over time, the Russian economy has been characterized by a steady, Changes in demographic characteristics also long-term increase in informality from play a small role. One common trend across all the early 2000s through to 2016. Informal surveys is that the probability of being informal employment increased in the first half of the in Russia has increased among those with only 2000s, then briefly leveled off or even fell, but basic education. Interestingly, one of the few it continued to increase afterward. Specifically, demographic characteristics to have changed Rosstat estimates that the country’s informal rapidly over the period is the proportion of workers with tertiary education, and this employment increased from 12.5 percent in has partially compensated for the growing 2001 to 17.6 percent in 2005, with a slight dip probability of informal employment among to 16.4 percent in 2010 followed by a further those without this level of education. In other significant increase in 2016, when it reached words, had the share in tertiary education 21.2 percent. It is this continued increase over not increased, the rate of informality would the past two decades that warrants further have grown even more. In 2010 for instance, attention. It is worth noting that the fall in according to RLMS data, on average and after informal employment in the second half of controlling for other personal characteristics, the 2000s coincided with the global financial people with higher education were 15.7 crisis. One plausible reason for why informality percentage points less likely to be informal decreased during the crisis years is that labor than those with basic education. By 2016, demand for using informal workers shrank. those with some tertiary education were 24.2 percentage points less likely to be informal that B. What Lies Beneath Russia’s Rising Informality? those with basic education. De-industrialization, changing demographics, Although migrants tend to be more informal, and increased migration are often factors the overall impact of migration on informality associated with rising informality. De- is indeterminate. Based on RLMS data for industrialization, with its sectoral shift from 2016, the share of informal migrant workers manufacturing to services, could indeed be in Russia’s informal labor force is higher a factor, since services tend to attract more (26.2 percent versus 15.7 percent of Russian informal labor. Changes in the composition of workers). On average, migrants are not too demographics could also be associated with an different from Russian workers in terms of increase in informality. For example, if women their age and gender composition. However, are on average more likely to be employed they are significantly less schooled, less likely informally, a higher share of women among all to reside in urban areas, more likely to work employed would thus be associated with higher in market services and to work longer hours. informality. Finally, migrant workers are often Migrant workers also get paid less per hour and perceived to be more likely to be informal. have a higher likelihood of receiving part or all their wages unofficially (29 percent versus De-industrialization cannot explain recent 19 percent for Russian workers). However, an changes in Russia’s informal employment. important limitation is that traditional surveys The change in informality is driven by a higher do not capture illegal migrants. Thus, the share incidence of informal employment across all of migrants is likely to be underestimated sectors and not by shifts in employment towards in survey data. Another factor to consider is Russia Economic Report | Edition No. 41 27 III. Potential growth: Outlook and options for Russia causality: does informality pull more migrants correlation coefficient of 0.41. That is, poorer or do migrants cause informality? Even so, regions are associated with higher informality, though prima facie the share of informal reinforcing the need for robust, formal job migrant workers is relatively higher, the extent creation in such regions. to which migrants thus contribute to informality is difficult to ascertain. Figure 28: Net formal job creation in Russia’s medium and large enterprises has been close to zero Informality is driven by a lack of formal jobs. 5,000 500 In Russia, formal net job creation has been 4,500 woefully low. Rosstat reported that the number 4,000 0 Thousands of persons Thousands of persons 3,500 of jobs created and destroyed for medium and 3,000 -500 large enterprises in 2018 were 2.22 million 2,500 and 1.93 million, respectively. In 2017, these 2,000 -1,000 numbers were 2.18 million and 2.21 million, 1,500 respectively. In other words, net job creation 1,000 -1,500 500 in Russia, at least in recent years, was close to 0 -2,000 zero. Figure 28 shows formal net job creation 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 for medium and large enterprises in Russia. Job creation Job destruction Net job creation (RHS) Sub-nationally, the relationship between Source: Authors’ estimations based on Rosstat. informality and Gross Regional Product (GRP) Note: Data for 2017-2018 are not consistent with the previous years due to methodological changes. is also found to be negative, with a Pearson Box 2 Labor market regulations in Russia are broad and mandatory On December 21, 2001, the State Duma in Russia adopted the Labor Code, the main legislative framework for labor regulations. The Code entered into force on February 1, 2002 and has been amended numerous times. The following separate pieces of legislation supplement provisions of the Labor Code: - The Employment of Population Act, 1991; - The Collective Agreements and Accords Act, 1992; - The Settlement of Collective Labor Disputes Act, 1995; - The Trade Union Act, 1996; - The Russian Tripartite Commission for Regulation of the Socio-Labor Relations Act, 1999; - The Fundamentals of Health and Safety Act, 1999; - The Compulsory Social Insurance Against Occupational Accidents and Diseases Act, 1998; - The Fundamentals of Public Service Act, 1995; - The Minimum Wage Act, 2000. Other important sources of labor law in the Russian Federation are decrees and orders issued by the Government, notably normative documents issued by the Ministry of Labor and Social Protection with a view to implementing labor legislation. Several other federal executive bodies are also empowered to issue normative acts within the powers given to them by federal legislation, decrees, and orders of the President or Government of the Russian Federation. According to Article 11 of the Labor Code, its application and that of other labor laws and regulations is mandatory in the entire territory of the Russian Federation for all enterprises (legal and physical entities), irrespective of their legal status and form of ownership. The labor contract should be in writing. 28 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia C. Are Labor Market Rigidities Driving On the employment contract: There is Informality? some room for improvement in the type of A well-functioning labor market is desirable employment contracts: for many reasons. From an informality • Open-ended contracts are the prevailing perspective, labor market rigidities can form of employment contracts in Russia, increase informal employment as they prevent accounting for 91 percent of all contracts formal firms from being able to hire or retrench for hired employees. This is on the high workers according to their economic needs. side when compared to the average of 59 Three aspects of the Russian labor market percent in EU countries. Only 8 percent were analyzed: (i) Russia’s labor legislation, of all contracts are fixed-term (compared including how it compares to other countries; to 28 percent in Poland and 26 percent in Spain), where the end of the employment (ii) Russia’s tax-benefits system, and whether it contract or relationship is determined by a creates disincentives to seek formal work; and definite period, and less than 1 percent of (iii) Russia’s labor mobility, both intersectoral contracts are for the completion of a specific and inter-regional. task. Russia could therefore consider more flexible forms of labor contracts. (i) How stringent are Russia’s labor market Specifically, the country may consider regulations? expanding the list of circumstances under Overly stringent rules and regulations in the which fixed-term/temporary contracts are labor code, such as restrictions on employment allowed, including for permanent tasks, contracts, hiring and firing, and high minimum and extend their maximum duration. Most wages, may make labor markets less flexible. fixed-term contracts are held by those If so, employers could be pushed to rely who are young, formerly unemployed, on informal employment to bypass these informally employed, or those with lower restrictive regulations. Box 2 summarizes education levels, namely, those with the Russia’s labor market regulations. weakest bargaining power. For these workers, fixed-term work can provide a Labor legislation in Russia is found to be pathway into formal employment and an broadly in line with internationally accepted opportunity to gain experience and skills. labor standards and norms, in particular, • Despite the requirement to have a written with those of the ILO. Indeed, out of the contract, 4 percent of salaried workers 77 conventions and 2 protocols ratified by in Russia (about 2.7 million individuals) the Russian Federation, 56 are in force, 18 work based on an oral contract. Russia conventions and one protocol have been could thus formalize such practices and denounced, one instrument abrogated allow oral labor contracts in the case of and three have been ratified in the past 12 short-term/casual employment – i.e., for a months. However, labor market regulations duration of up to two months. in Russia retain certain aspects that could be • On many occasions, workers would like to improved upon, particularly in the areas of the work overtime in excess of a standard work employment contracts, minimum wages, and week or on days off and public holidays in employee dismissals. Small firms, in particular, order to earn extra income. However, due bear a heavy burden in these areas, thereby to high wage premiums (50 to 100 percent exacerbating informality. for overtime work and double the rate for Russia Economic Report | Edition No. 41 29 III. Potential growth: Outlook and options for Russia work on days off and public holidays), it is Figure 29: Russia’s minimum to average wage ratio is costly for employers, especially in small among the lowest (Real GDP growth, percent) establishments, to arrange for such work. Moreover, in Russia, working on off days France 0.49 Slovenia 0.48 and public holidays is prohibited (except Lithuania 0.43 for the few cases envisaged by the Labor Turkey 0.43 Code). Russia could therefore consider Poland 0.43 Germany 0.42 lowering statutory wage premiums, Belgium 0.42 allowing for amounts of compensation to Portugal 0.42 Romania 0.41 be determined by a collective agreement, UK 0.41 local normative act, or a labor contract. Latvia 0.41 Regulations related to working on off-days Korea 0.4 Ireland 0.39 and public holidays could also be revisited. Hungary 0.39 Slovakia 0.39 On minimum wages Netherlands 0.38 Japan 0.35 Minimum wages can exacerbate unemployment Estonia 0.35 and informality if the minimum wage is above Czech Rep. 0.34 the market-clearing level, thereby reducing Greece 0.33 Spain 0.31 formal labor demand. High minimum wages USA 0.25 are typically more damaging for small and Russia 0.2 medium-sized enterprises (SMEs) because 0.00 0.10 0.20 0.30 0.40 0.50 0.60 these enterprises tend to be more labor Source: OECD online. intensive and financially weaker. Note: Data for selected countries is from 2016; Data for Russia is from mid-2017 The minimum wage setting was decentralized and increase unemployment and informality. in Russia in September 2007, which gave Labor rules governing dismissals therefore regions the power to set their own regional need to strike a balance between flexibility minimum above the federal floor. Workers for businesses and job security for workers. employed by federal establishments and Compared to prime-age workers, older and enterprises are exempt from regional minimum younger workers are at greater risk of dismissal. wage legislation. In some regions, regional and Others at higher risk include workers in small municipal employees are also excluded from firms and those employed on fixed-term and regional regulation, and the regional wage temporary contracts whose contracts might floor applies only to private-sector workers. not be renewed. On average, the ratio of the minimum to average wage in Russia was 20 percent in 2017, Employment protection legislation in Russia relatively lower than the 35 to 60 percent in is quite strict by international standards. As developed countries (Figure 29). Whether the far as the protection of permanent workers minimum wage is a major impediment to job against individual and collective dismissals is creation, however, is unclear. The estimated concerned, comparing Russian legislation to correlation between minimum wage and that of 34 OECD countries reveals that only nine informal employment rate is minus 0.40: OECD countries had more rigid legislation than negative, but not strong. Russia: Belgium, the Czech Republic, France, Germany, Italy, Luxembourg, Mexico, Portugal, On redundancy dismissal and Sweden (Table 6). To address this, Russia’s Overly stringent dismissal procedures can legislation could be restricted to focus on core limit new job creation in the formal sector and enforceable labor standards with the 30 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia Table 6: Russia’s Employment Protection Legislation is strict by OECD standards Protection of Protection of Specific Regulation permanent permanent requirements on temporary workers against workers against for collective forms of Country Year individual (individual) dismissal employment and collective dismissal dismissals Austria 2013 2.44 2.12 3.25 2.17 Belgium 2013 2.99 2.14 5.13 2.42 Czech Republic 2013 2.66 2.87 2.13 2.13 Denmark 2013 2.32 2.10 2.88 1.79 Estonia 2013 2.07 1.74 2.88 3.04 Finland 2013 2.17 2.38 1.63 1.88 France 2013 2.82 2.60 3.38 3.75 Germany 2013 2.84 2.53 3.63 1.75 Greece 2013 2.41 2.07 3.25 2.92 Hungary 2013 2.07 1.45 3.63 2.00 Latvia 2013 2.91 2.57 3.75 1.79 Lithuania 2015 2.42 2.23 2.88 3.33 Netherlands 2013 2.94 2.84 3.19 1.17 New Zealand 2013 1.01 1.41 0.00 0.92 Norway 2013 2.31 2.23 2.50 3.42 Poland 2013 2.39 2.20 2.88 2.33 Portugal 2013 2.69 3.01 1.88 2.33 Slovak Republic 2013 2.26 1.81 3.38 2.42 Slovenia 2014 2.39 1.99 3.38 2.13 Spain 2013 2.36 1.95 3.38 3.17 Sweden 2013 2.52 2.52 2.50 1.17 United Kingdom 2014 1.59 1.18 2.63 0.54 Russia 2012 2.47 2.86 1.50 1.25 Kazakhstan 2015 2.29 3.20 0.00 … Serbia 2015 2.23 1.67 3.63 … Note: The OECD indicators of employment protection are synthetic indicators of the strictness of regulation on dismissals and the use of temporary contracts. Data range from 0 to 6, with higher scores representing stricter regulation. The OECD has an elaborated scoring methodology for assessing and ranking countries. Source: OECD: https://www.oecd.org/employment/emp/oecdindicatorsofemploymentprotection.htm aims of finding a balance between flexibility informing workers that they will be attested and and security and providing a greater role for establishing an attestation committee. Even trade unions and employers associations to if a worker is found to be unsuitable for a job determine employment relations through during attestation, the employer has to offer collective bargaining. In addition, introducing him another job. In Russia, another obstacle an adequate unemployment insurance system for employers to adjust their workforce is would contribute to finding a better balance the requirement to provide (re)training to between flexibility and security. redundant workers. Sometimes there is also a reassignment obligation before an employer The Russian Labor Code allows for a worker can lay off a worker. This obligation is more to be dismissed in the case of insufficient common in high and upper-middle income qualification, but this needs to be proven countries. These requirements serve as an by internal attestation. The latter requires a additional burden, especially to small firms, special internal regulation on the attestation, and could be reconsidered (Box 3). Russia Economic Report | Edition No. 41 31 III. Potential growth: Outlook and options for Russia Box 3 By OECD standards, regulations on redundancy dismissal in Russia are overly rigid and discourage formal employment Stringent regulations affect most small and medium firms, thus disincentivizing formal employment. Many OECD countries exempt small firms from some or all employment protection requirements. Most commonly, small firms are exempt from additional notification or procedural requirements when undertaking collective dismissals. In addition, several OECD countries reduce or remove severance payments, notice periods, or the risk of being accused of unfair dismissal for small firms. For example, in Austria, Belgium, Denmark, Hungary, Ireland, and Switzerland, firms with 20 employees or less are exempt from requirements for collective dismissals. In Germany, establishments employing 10 or fewer employees are exempt from regular employment protection legislation. In Italy, firms with less than 15 employees are not required to disburse back pay or reinstate workers who are found to be unfairly dismissed. In Slovenia, employers with 10 workers or less can, by collective agreement, conclude fixed-term contracts irrespective of substantive limitations applying to fixed-term contracts and with longer duration. When terminating contracts in Slovenia, small employers do not have to verify the possibility of redeployment or retraining. Shorter statutory notice periods are allowed for small employers by collective agreement. Replacing severance pay with unemployment benefits in small firms may also contribute to flexible work arrangements, especially in cash-strapped small firms. (ii) Does Russia’s tax-benefits system A. The Participation Tax Rate (PTR), which discourage formal work? measures the extent to which taxes and Benefits and taxes affect the take-home benefits reduce the financial gain from incomes of workers, thereby influencing their moving into work, is lower in Russia incentive to participate in the labor market. than in any comparator country. This is Overly generous benefits and excessively high consistent across most family composition taxes could reduce incentives of individuals to cases (single member family; single with participate in the labor force. However, overly children; one-earner couple, one-earner low benefits can also discourage participation couple with children; two-earner couple; in the labor force by reducing incentives for and two-earner couple with children). people to register as being unemployed, and Figure 30 illustrates the PTR results for a subsequently to seek formal work, for example. single person without children; compared This section assesses how Russia’s tax-benefit to the OECD average of almost 50 percent, system compares with EU/OECD countries. Russia’s is less than 25 percent. Specifically, using the OECD tax-benefits model, the analysis estimates various metrics of tax- B. Russia’s Marginal Effective Tax Rate (METR), benefits schemes in Russia. which measures the extent to which taxes Figure 30: Russia’s effective tax rate on entering employment is comparatively low (Percent) 80 70 Participation Tax Rate 60 50 40 30 20 10 0 Source: OECD TAXBEN model for the Russian Federation. Note: Fraction of additional gross earnings lost to either taxes or lower benefits when a jobless person takes up employment (for a single person without children, at 100% of average wage) 32 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia and benefits reduce the financial gain of 13 percent for 60 months of unemployment increasing work effort, is also comparatively – among the lowest among the countries in low. Figure 31 presents METR results for a the above table. Box 4 discusses the reasons single person without children for Russia behind the low NRR in Russia. and EU/OECD countries. Compared to other countries, Russia’s rate is the lowest, which D. The Effective Tax on Labor (ETRL), which suggests that high marginal tax rates should measures net taxes as a percentage of not discourage increasing work, at least the total labor cost for the employer, is compared to other countries. also lower in Russia than in many other comparator countries. Irrespective of the C. The Net Replacement Rate (NRR), which family composition, the ETRL for Russia measures the fraction of net income in hovers at about one third of the total work that is maintained when unemployed, labor cost for the employer. In the case is lower in Russia than in any comparator of the single member family (around 33 country, irrespective of the duration of percent), it ranks 9th from the bottom and is unemployment. This suggests that in Russia, significantly lower than the OECD average high incomes, when employed, are not a of around 40 percent. factor that discourage re-entry into the work force, at least compared to other countries. The above findings show that relative to other OECD/EU countries, Russian tax and benefits For example, in Russia, the estimated NRR in policies should not create major disincentives 2018 for a single person previously earning to seek employment or work more formal the average wage was around 25 percent hours. Indeed, in some cases, net benefits in for the first 12 months of unemployment Russia may be too low, thereby discouraging compared to the OECD average of 41 percent. participation in the labor force by reducing For those unemployed over the long-term (over incentives to register as unemployed, and 12 months), the NRR drops to an even lower subsequently to seek formal work. Figure 31: Russia’s marginal effective tax rate on increasing working hours is comparatively low (Percent) 70 Marginal Effective Tax Rate, % 60 50 40 30 20 10 0 Source: OECD TAXBEN model for the Russian Federation. Note: Fraction of additional gross earnings lost to either higher taxes or lower benefits when an employed person increases their working hours (for a single person without children, at 100% of average wage, moving from part-time to full-time). Russia Economic Report | Edition No. 41 33 III. Potential growth: Outlook and options for Russia Box 4 Russia’s benefit schemes do not confer commensurate gains compared to those of other countries Low NRRs in Russia are a result of the low benefits in the unemployment benefit system. At the maximum, the benefit replaces 14 percent of the average wage for 12 months. However, most of the unemployment benefit claimants received the minimum payment, which equals about 2.6 percent of the average wage in 2017. These rates have remained unchanged since 2009. This suggests that Russia may consider introducing a well-designed unemployment insurance system that would allow for more effective support to the unemployed. This could also provide incentives to register as unemployed, and to subsequently seek formal work. Housing and utility allowances, in addition to the unemployment benefit, are conferred to unemployed citizens under certain eligibility requirements that apply to other households as well. This allowance is an important component of the NRR. However, only 6 percent of all households in Russia receive a housing and utilities allowance, and as such it affects NRR (and METR) only in a limited number of cases. Child allowances are also extremely low in Russia, equivalent to a mere 2.5 percent of the minimum subsistence level. Consolidation of various small and fragmented child and family benefits into a larger income/means-tested family benefit would help (NIFI and Posarac, A., 2017). Maternity allowances for the first 18 months of a child’s life, together with sizable maternity capital benefits given to families at the birth of the second child, are social policy measures aimed primarily at demographic renewal of Russia; i.e., at incentivizing families to have more children. However, such assistance is “front-loaded” during the period from birth to 18 months. Stronger child protection requires a better policy, programming, and resource balance between the first 18 months and the rest of childhood. As such, it is difficult to consider unemployment benefits as having a negative influence on recipients’ decision to participate in the labor market. In fact, introducing a well-designed unemployment insurance system and consolidating small and fragmented benefits programs into larger, income/means-tested benefits could provide incentives to register as unemployed, and to subsequently seek formal work. (iii) How severe are sectoral and spatial D. Stemming Russia’s Informality Tide: No market labor rigidities in Russia? single fix, but multiple policy levers The analysis reveals that while intersectoral Policy levers for reducing informal mobility in Russia is comparable to most employment in Russia revolve around three advanced economies, inter-regional mobility, areas: direct intervention; removing labor- however, is low. For example, registered market rigidities; and enhancing skills training. internal migrants (both inter-regional and However, informality can only be partially intraregional) accounted for only 1.4 percent alleviated with specific fiscal or labor market of Russia’s population in 2002-2010, a rather measures. There are no quick fixes. Systemic small share. In contrast, their average share in solutions to reduce informality will require the U.S. was 13.7 percent of the population in broader polices. In particular, and although it 2000-2006, while in Canada and Japan it was may sound tautological, the best antidote to 14.6 and 4.6 percent, respectively. The fact high informal employment is the faster creation that the Russian population is not mobile in an of more formal jobs. A healthy economy is inter-regional manner is not surprising, given characterized by the entry of young companies Russia’s sheer size. The main implication for that boost its productivity. Dynamic firms, informality is that low inter-regional mobility whether new or established, are the source of translates into high inter-regional differences formal jobs when conditions are favorable. in informality (Figure 32). 34 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia Figure 32: The rate of informal employment varies between 3.6% in Moscow to 64% in the Chechen Republic (Percent) 70 60 50 40 30 20 10 0 Mari El Rep. Permskiy Krai Komi Rep. Mordoviya Rep. Tatarstan Rep. Buryatia Rep. Bashkortostan Rep. Karelia Rep. Kabardino -Balkarskaya Rep. Altai Rep. Moscow oblast Udmurtskaya Rep. Kalmykiya Rep. Severnaya Ose tiya – Alaniya Rep. Altaiskiy Krai Jewish Aut. oblast Tyva Rep. Primorskiy Krai Khakasia Rep. Krasnoyarskiy Krai Irkutskaya oblast Nenetsky Aut. Okrug Dagestan Rep. Moscow City Tumenskaya oblast (w/o aut. reg.) Bryanskaya oblast Saint Petersburg Ingushe tiya Rep. KhMAO - Yugra Tomskaya oblast Karachaevo -Cherkesskaya Rep. Kirovskaya oblast Vladimirskaya oblast Kamchatskiy Krai Rep. of Sakha (Yakutia) Amurskaya oblast Chechenskaya Rep. Yamalo -Nenetsky Aut. Okrug Tulskaya oblast Murmanskaya oblast Samarskaya oblast Lipetskaya oblast Tverskaya oblast Omskaya oblast Krasnodarskiy Krai Rostovskaya oblast Ivanovskaya oblast Yaroslavskaya oblast Kurskaya oblast Kostromskaya oblast Kaluzhskaya oblast Kemerovskaya oblast Magadanskaya oblast Adygeya Rep. Khabarovskiy Krai Pskovskaya oblast Saratovskaya oblast Chuvashskaya Rep. Astrakhanskaya oblast Zabaikalskiy Krai Sakhalinskaya oblast Orlovskaya oblast Stavropolskiy Krai Penzenskaya oblast Kurganskaya oblast Ryazanskaya oblast Novosibirskaya oblast Voronezhskaya oblast Arkhangelskaya obl. (w/o NAO) Kaliningradskaya oblast Smolenskaya oblast Ulyanovskaya oblast Chelyabinskaya oblast Sverdlovskaya oblast Tambovskaya oblast Chukostskyi Aut. Okrug Belgorodskaya oblast Volgogradskaya oblast Vologodskaya oblast Orenburgskaya oblast Novgorodskaya oblast Leningradskaya oblast Nizhegorodskaya oblast Source: Authors’ estimates based on Rosstat, Labor Force Survey, 2017. A. Directly intervening to lower the cost the minimum wage. Establishments of formal labor: One policy proposal located within industrial zones were implemented with some success in other fully subsidized for their calculated countries has been to reduce the employers’ social security contributions and income Social Insurance Contribution rate (SIC). To taxes, whereas establishments outside make up for the loss in fiscal revenues from industrial zones received compensation reducing the SIC rate (although some of for only 80 percent of such amounts. it would be made from a higher tax base Findings suggest that these subsidy because of lower informality), taxes may programs led to significant net increases need to be increased elsewhere. Typically, in registered jobs in eligible provinces: countries have maintained budget between 5 and 13 percent for the first neutrality of such policies by increasing the program and between 11 and 15 percent Value Added Tax rate (VAT). In principle, for the second. such tax maneuvers ought to increase • In the United States, the Targeted Jobs Tax incentives for firms to hire formal labor Credit (TJTC) program – which offered in- by lowering its cost, as well as be budget- work benefits staggered over a few years neutral. Examples of such policies in other – was found to have a net employment countries are presented below: effect of 7.7 percent. • North Macedonia implemented across- • In Argentina, a random assignment the-board labor tax reforms around 2010 wage-subsidy scheme targeting workers that led to significant growth in formal in temporary employment subsidized 50 employment. Specifically, a 1 percent percent of the first 18 months of wages decrease in the tax wedge led to a 0.9 to 3.1 for workers employed in permanent, percent increase in the employment rate. regular jobs. Findings indicate that • Turkey, in the early 2000s, introduced the program aided low-wage workers legislation under which firms could in finding regular wage employment. obtain (i) a subsidy on the social security However, these effects were only contributions due at the minimum statistically significant among women contribution base, and (ii) an income and youth. tax subsidy for the amount due at Russia Economic Report | Edition No. 41 35 III. Potential growth: Outlook and options for Russia Such tax maneuvers have been under Why is it that similar tax maneuvers that have consideration in Russia, but for reasons been successful in other countries have not discussed in Box 5, they would have a limited yielded such results in Russia? There are at least impact on reducing informality in the Russian three possible reasons for the muted results in context. the case of Russia: Box 5 Reducing the cost of formality for employers only has a small impact on informality In 2017, Russia’s Ministry of Finance proposed a comprehensive reform of the tax system aimed at shifting the tax burden from labor to consumption taxes, referred to as the Tax Maneuver 22/22. The reform suggests reducing the employers’ SIC rate from 30 to 22 percent, while simultaneously increasing the VAT rate from 18 to 22 percent. To assess the impact of this tax maneuver on inducing formality and budget neutrality, we constructed a detailed microsimulation model and calibrated it to the Russia context based on RUSMOD. RUSMOD is the first full-scale model in Russia that simulates most of the existing monetary tax-transfer policies implemented at federal and regional levels for a nationally representative sample of the population. In addition, we made certain assumptions: (a) workers and their employers would enter as contributors to social security (“payroll taxes”) and workers would start paying personal income tax on their earnings; (b) consumers would bear the burden of the VAT increase; (c) the economic incidence of SIC and Personal Income Tax (PIT) would fall on employees rather than employers. That is, workers would have to accept a lower take-home pay and employers would not have to accept higher labor costs to pay for SIC. Consequently, the tax maneuver would involve higher take-home pay for workers, but also higher VAT expenses for consumers; (d) we relaxed our legalistic definition of informal employment used so far. In other words, our analysis of the tax maneuver explicitly accounts for workers who work for a firm and either have no contract (about 6.7 percent of the employed as of 2016) or have a contract but receive envelope wages (about 8 percent of the employed). The self-employed (about 10.3 percent of total employment) are not included in this exercise because they are subject to a different tax regime. Based on these assumptions and various simulations, the key findings that emerge are: a. Such a tax maneuver would be fiscally neutral only if at least 50 percent of informal workers, i.e., around 7.5 percent of total employment (about 5 million workers), formalize. This is a high and unlikely transition rate from informal to formal employment. The increase in VAT, on the other hand, would partly compensate gains in take- home pay, leading to a slight increase in real incomes at the bottom of the distribution (0.1 percent). Both poverty and inequality would remain stable. b. Moreover, a behavioral micro-simulation exercise renders that only 6 percent of the informals would formalize as a reaction to the tax maneuver (i.e., around 600,000 workers) and the tax maneuver would not be fiscally neutral, leading to an additional fiscal deficit of 0.7 percent of GDP. In this scenario, real incomes of the first decile would increase by 1 percent, and poverty would decline slightly. c. The results are robust even with differing assumptions. If employers bear the incidence of PIT and SIC, then reductions in these taxes would accrue to employers and not to workers. Consequently, the tax maneuver would lead to lower real incomes among workers (because of no increase in take-home pay but higher VAT payments in consumption). Our micro-simulations show a decline in real incomes among the bottom decile of the distribution and slight increase in poverty rates. This can be partially offset by job creation (which we do not model in our exercise) because in such cases, any reduction in total labor costs could increase demand for formal labor. Targeting labor tax reductions to the low-skilled sector (where employers have more bargaining power and tax incidence is more likely to fall upon the employer rather than the employee) could thus incentivize formality in this segment of the workforce. These results indicate that such a tax maneuver, i.e., the reduction in SIC rates and increase in the VAT rate, is unlikely to have a major impact on reducing informal employment or attaining fiscal neutrality. A larger SIC reduction could do better strictly in terms of reducing informal employment but would come with higher fiscal costs. 36 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia One, the above findings are only first-order pensions could mean that the returns to approximations of the full impact of such their formal contributions are discounted tax maneuvers. A more complete analysis of even further. wage and labor productivity changes after a tax maneuver is also needed to know if there The implication in the Russian context is that would be net wage gains to formalization (i.e., changes in payroll taxes and consumption not only due to changes in tax and transfers, rates will reduce informal employment little but also due to productivity gains). or not at all. In addition, there need to be concerted efforts to increase information Two, the analysis specifically includes only about the benefits of becoming formal, and as the impact of formalization upon current net discussed earlier, and to improve some of these wages, VAT, and some social security benefits. benefits, many of which are comparatively low. However, it can be argued that long-term Doing so would help workers better gauge the benefits — particularly in terms of pensions long-term impact of their contributions. and health insurance — should also play a role in the worker’s decision to formalize. But B. Removing labor market rigidities. This workers may suffer from myopia (for example, involves action on three fronts: (a) bringing being unable to gauge the long-term impact of certain aspects of labor market regulations not contributing to social security). in line with global best practice; (b) consolidating certain aspects of the tax- Three, and more rationally, workers may benefits system to provide more rational indulge in moral hazard (i.e., free-riding on incentives to participate in the labor other people’s contributions to enjoy some market; and (c) increasing inter-regional social security benefits without contributing mobility. themselves). This is because in the current environment, informal workers enjoy benefits • Bringing labor market regulations such as social pensions and medical treatment in line with global good practice: As with scant contributions. In principle, taking discussed earlier, Russia’s labor code away such benefits from informal workers could and related regulations are particularly increase the cost of being informal. However, biting on SMEs, which are a source of attempting to reduce such “free-riding” may informal employment. Policy actions are risk upsetting the already tenuous social summarized in Box 6. contract between the state and citizens and reducing society-wide benefits of widespread However, existing legislation is only one side coverage of pensions and medical treatment. of the coin; the other is how well laws and Another factor to consider is managing regulations are enforced. Indeed, in many unintended consequences. For example, the countries, even state-of-the-art labor codes and impact of reducing the SIC is likely to be felt on EPLs are often ineffective because of evasion, the contributory pillar of the pensions system weak enforcement, and failure to reach the in Russia, which could be adversely affected informal sector. Achieving greater labor market in favor of a move towards general budget flexibility through non-enforcement of laws is a financing of pensions (from the proceeds sub-optimal choice because it undermines the of the higher VAT rate, for example). This rule of law, exposes firms to costly uncertainty, may have the rational but adverse effect impedes decent formal employment growth, of discouraging workers to become formal and leaves workers without adequate since such a de-linking of contributions from protection. This is where labor inspection plays Russia Economic Report | Edition No. 41 37 III. Potential growth: Outlook and options for Russia Box 6 Certain labor market regulations can be eased to incentivize formal employment This box summarizes the recommendations on adjusting Russia’s labor code and its regulations on labor contracts, minimum wages, and redundancy dismissal. - More flexible forms of labor contracts could be considered. Specifically, Russia could consider expanding the list of circumstances under which fixed-term/temporary contracts are allowed, including for permanent tasks, and extend their maximum duration. Most fixed-term contracts are held by young people, those who were formerly unemployed, informally employed, or those with lower education levels, namely, those with the weakest bargaining power. For these workers, fixed-term work can provide a pathway into formal employment and an opportunity to gain experience and skills. - Oral labor contracts, especially in case of short-term/casual employment for a duration of up to two months could be allowed and formalized. - Lowering statutory wage premiums could be considered, allowing for amounts of compensation to be determined by a collective agreement, local normative act, or a labor contract. Regulations related to working on off-days and public holidays could be also revisited. - Even though the minimum wage may not be a major impediment to job creation, there is a negative correlation between minimum wage and informality in Russian regions. In any case, working out benchmarks other than the subsistence minimum could be considered. - Employment Protection Legislation (EPL) could be restricted to focus on core and enforceable labor standards, and with the aim to finding a balance between flexibility and security, provide a greater role for trade unions and employers’ associations to determine employment relations through collective bargaining. In addition, introducing an adequate unemployment insurance system would contribute to finding a better balance between flexibility and security. - Regulations on redundancy dismissal in Russia are overly rigid by OECD standards, discouraging formal employment, and could be reconsidered. For example, when terminating contracts, small employers may not need to verify the possibility of redeployment or retraining. Shorter statutory notice periods could be allowed for small employers by collective agreement. Replacing severance pay with unemployment benefits in small firms may also contribute to flexible work arrangements, especially in cash-strapped small firms. an important role in monitoring compliance The ILO considers that the number of labor with labor standards. Box 7 highlights the inspectors in relation to workers should characteristics of high-quality, well-functioning approach the following: for industrial market labor inspection services. economies, 1/10,000; for rapidly industrializing economies, 1/15,000; for transition In Russia, the Federal Labor Inspectorate (FLI) economies, 1/20,000; and for least-developed is a unified, centralized system composed of countries, 1/40,000. However, in Russia, the the federal executive governmental body ratio was 1/34,400 employed in 2016, closest charged with state supervision and control to the least-developed country benchmark.12 of observance of labor law and other legal Current capacity of the FLI allows, on average, regulatory acts containing labor law norms for the conduct of one inspection in 28 years, and its territorial bodies. In conjunction with while the ILO recommends at least one every the Prosecutor’s Office, the FLI has the right five years. to carry out investigations and make binding decisions, including reinstating an employee In Russia, the institutional capacity to enforce who was wrongfully dismissed and awarding laws, and the culture of law compliance the employee wages in arrears. Even more vary significantly across regions and sub- so, these authoritative branches can initiate populations. All this may result in actual proceedings against the employer and its enforcement being close to non-existent in administrators for violating labor legislation. some sectors of the economy, and close to 12 In 2016, there were 72.4 million employees in Russia while the total number of staff of the Federal Labor Inspectorate was 2,438, including the number of labor inspectors. For comparison, in Latvia, there were 8,300 workers per one inspector. 38 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia Box 7 The role of well-functioning labor inspection systems goes beyond mere enforcement The institution of labor inspection has a two-fold nature. On one hand, labor inspectors enforce legal provisions dealing with labor regulations, occupational health and safety, social services, migrant workers, vocational training, social security, and other matters. On the other hand, labor inspection provides information, advice and training. Specifically, labor inspection services cover a set of five operational functions: 1. Promotion: Raising awareness of standards and national regulations that give effect to them, as well as disseminating best national and international practices. 2. Advice and information: Putting their knowledge and expertise to use in helping resolve specific issues during on-site inspections or, in a more prevention-oriented manner, in their contacts with duty-holders and their organizations. 3. Education: Often exercised in training for employers and workers, labor court officials, other government agencies, and NGOs. 4. Monitoring: Observing, keeping track of, and reporting on compliance levels in enterprises, economic sectors, and the country as a whole. 5. Enforcement: Ensuring compliance with the law. Modern inspectorates aim for 60 percent proactive inspections and 40 percent reactive inspections (accidents, complaints) based on an application of risk prioritization towards highest-risk workplaces. Advice to and stimulation of employers to implement legal requirements is the modern approach to compliance. Labor inspectors are obliged to first and foremost advise employers and employees to fulfill their obligations while leaving the option of punishing grave and consistent violations open. International studies of best practices highlight many characteristics of high-quality, well-functioning labor inspection services. These include adequate resources (both staff and infrastructure); recruitment and training policies designed to attract and retain high quality inspectors; central administration to improve consistency and reduce duplication; preventive targeting of firms based on risk; integration of different types of inspections to reduce the inspection burden on business; and a focus on prevention and education as well as enforcement. In particular, good cooperation is required between the labor inspectorate and other agencies, social partners, institutions, and NGOs. Detection and enforcement measures applied in OECD countries include information exchanges (linking computer files) using unique social security numbers; cooperation between labor, social security, and tax inspectorates; administrative requirements for the immediate declaration of new hires; making contractors responsible for the tax compliance of their subcontractors; encouraging employer and trade union denunciation of unfair competition; enforcing employees’ rights, such as protection against unfair dismissal, even within undeclared relationships; and strict sanctions. Lack of public awareness on legal rights associated with employment has also impaired law enforcement in several countries. Workers should know their legal rights and how to get them enforced. The evidence suggests that public opinion is often ill-informed in Russia. Running campaigns to inform individuals of their legal labor-related rights is thus crucial. In high-performance labor inspection systems, social dialogue provides the foundation for effective labor inspection work. In the Netherlands, Germany, the Nordic countries, and the UK, the Labor Inspection consults social partner organizations at national and sector levels on where problems exist, and they agree upon targets, projects, campaigns, etc., on an annual or even quarterly basis. This consultation process creates transparency, higher levels of acceptance, and “ownership” of the compliance process among duty-holders. Further, labor inspectorates in many countries have an obligation to stimulate (Netherlands) or animate (France) cooperation and dialogue among parties in enterprises. Measures must be designed to develop such social dialogue on labor inspection and occupational safety and health (OS&H) at all suitable levels. Furthermore, improved law-enforcement and the application of sanctions can be achieved through (i) better cooperation between relevant authorities (inter alia tax offices, police, labor and social inspectorates); (ii) reinforcement of the number of labor inspectors, better working conditions, and performance-based remuneration systems; and (iii) investment in training to update knowledge and develop skills in relevant areas of expertise. Russia Economic Report | Edition No. 41 39 III. Potential growth: Outlook and options for Russia complete in others. For example, in 2016, not helpful to combat informal employment, only 0.9 percent of enterprises in Dagestan especially in environments with inadequate were found to be without violations, and in governance. Rather, a more client-focused Arkhangelsk oblast, this was only 3 percent. and risk-prioritization approach, which the FLI On the other end, no violations were observed is moving towards, and that supports firms during inspections in the Republic of Komi in to comply with regulations and only uses 82.5 percent of cases; in Krasnodar Krai, in 66.1penalties and sanctions as a last resort, works percent of cases; in Moscow in 62.7 percent better to decrease informal employment. of cases; in Primorsky Krai in 61.8 percent of The Baltic countries implemented successful cases and in Novgorod oblast in 60.7 percent of reforms along these lines in the 1990s. Box inspected enterprises. 8 summarizes Russia’s Federal Tax Service’s experience and progress in adopting a risk- Summary judiciary statistics basically tell prioritization approach. the same story, showing significant inter- • Consolidating certain aspects of the regional variation in enforcement of the labor tax-benefits system to provide more regulations. The Far Eastern Magadan region, rational incentives to participate in the with 200 legal cases per 1,000 employees labor market: The earlier discussion filed to courts, took the leading place. It was of Russia’s tax-benefits system points followed by a few other Northern and Far to several benchmarks that are below Eastern regions, ranging between 30 and 70 comparator countries. An assessment of legal cases. In contrast, in mostly urban and various taxes yields the conclusion that densely populated regions like Moscow, St. by global standards at least, Russia’s Petersburg and Nizhny Novgorod oblasts, effective taxes are low and should not of every 1,000 employees, only 1 to 4 were involved in legal conflicts with their former or provide disincentives to seek formal current employers in regional or local courts. work. Benefits such as unemployment compensation, housing and utility Labor inspection services are an important allowances, and child allowances are line of defense against informality. While a also low by global standards. Maternity detailed analysis of the labor inspectorate allowances, though generous, are front- and its effectiveness is beyond the scope loaded. As such, it is difficult to consider of this report, international evidence benefits to the unemployed as having a suggests that a law-and-order approach that negative influence on their decision to focuses only on penalties and sanctions is participate in the labor market. Box 8 Russia’s Federal Tax Service has made admirable progress in implementing a risk-prioritization approach On the issue of mainstreaming risk prioritization in their daily work, Russia’s Federal Tax Service (FTS) may offer useful lessons. The FTS has made admirable progress by adopting a self-assessment of risk approach. The numbers of field tax audits have steadily declined, and efficiency has improved. Russia’s FTS no longer uses the 100 percent audits principle and it applies a risk-based approach to tax audits. Tax audit planning is an open process based on selecting taxpayers for field audits with the use of 12 publicly available criteria. Self-assessment of risk based on financial and operational performance helps enable the taxpayer to assess tax risks in a timely fashion. This approach has helped reduce the administrative burden for businesses and improve FTS performance. The numbers of field tax audits have steadily declined, and efficiency has improved. On average, only two out of 1,000 taxpayers, or 0.2 percent, have undergone a tax audit in the first nine months of 2018 40 Russia Economic Report | Edition No. 41 III. Potential growth: Outlook and options for Russia The main policy lever that thus emerges to demographic factors per se, the one is on the benefit side of the equation: exception and consistent finding across Russia could consider introducing a all surveys and databases is that it has well-designed unemployment insurance increased among those with only basic system and consolidating small and education. By 2016, those with some fragmented benefits programs into larger tertiary education were 24.2 percentage means-tested benefits. This could provide points less likely to be informal that those incentives to register as unemployed and with basic education. Other surveys show to subsequently seek formal work. qualitatively similar results regarding • Increasing inter-regional mobility: As education. Having a post-secondary discussed earlier, while intersectoral education seems to have prevented mobility in Russia is not a major concern, workers from becoming informal. In inter-regional mobility emerges as a other words, had the share in tertiary key rigidity in the Russian labor market. education not increased, the rate of This has implications for the ease with informality in Russia would have grown which formal firms can hire or retrench even more. This suggests that a longer- workers. Inter-regional mobility could term objective to reduce informality be increased by putting in place could be to enhance skills training in connective infrastructure, making real areas connected to the modern economy. estate markets (homes and land) more And given the reported shortages of skilled liquid, and addressing social barriers to workers faced by Russian employers, internal migration, especially for youth improvements and adjustments to Russia’s and women. vocational education and training system could also be considered. Equipping the C. Enhancing skills training: Even though a key workforce with necessary skills is likely to finding of this report is that the growing yield economy-wide benefits that will go informality in Russia cannot be attributed beyond reducing informality. Russia Economic Report | Edition No. 41 41 Russia Economic Report #41, June 2019 © 2019 International Bank for Reconstruction and Development / The World Bank Some rights reserved 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is available under the Creative Commons Attribution 3.0 IGO license (CCBY 3.0 IGO) http://creativecommons.org license/by/3.0/igo