100091 The World Bank in the Russian Federation 34 | September 2015 Balancing Economic Adjustment and Transformation Russia Economic Report Balancing Economic Adjustment and Transformation I. Recent Economic Developments II. Economic Outlook III. In Focus: Russia’s Dual Transformation This report is produced twice a year by World Bank economists in the Macroeconomics and Fiscal Management Global Practice. The team that prepared this edition was led by Birgit Hansl (Lead Economist and Program Leader in Russia, bhansl@worldbank.org) and consisted of Sergei Ulatov (Senior Economist), Olga Emelyanova (Research Analyst), Mikhail Matytsin (Consultant), John Pollner (Lead Financial Officer), Ekaterine Vashkamadze (Senior Economist), John Baffes (Senior Economist), Juan Chavez (Consultant), and Irina Rostovtseva (Team Assistant). Birgit Hansl authored the focus note on the fiscal implications of an aging population and a shrinking resource sector based on a World Bank paper by Harun Onder (Senior Economist) and Fernando Hernandez (Lead Economist) titled Fiscal Implications of Aging and Natural Resource Dynamics. Peer reviewers included Catriona Purfield (Lead Economist), Christos Kostopoulos (Lead Economist), and Praveen Kumar (Lead Economist). The report was edited by Sean Lothrop (Сonsultant), and the graphic designer was Robert Waiharo (Сonsultant). The team would like to thank Cyril Muller (Vice President of the Europe and Central Asia Region), Hans Timmer (Chief Economist of the Europe and Central Asia Region), Andras Horvai (Country Director for Russia), Miria Pigato (Practice Manager, Macroeconomics and Fiscal Management Global Practice), the Russia team at the European Bank for Development and Reconstruction, and the IMF Russia team for their advice and support. TABLE OF CONTENT Abbreviations and Acronyms ........................................................................................................................... i Executive Summary ............................................................................................................................................... ii I. Recent Economic Developments – Weathering the Storm .................................................................. 1 1.1 Growth ............................................................................................................................................................... 2 1.2 Balance of Payments .......................................................................................................................................... 9 1.3 Monetary Policy and the Financial Sector .......................................................................................................... 13 1.4 The Government Budget .................................................................................................................................... 16 1.5 Income and Poverty Trends ................................................................................................................................ 21 II. Outlook – High Uncertainty Prevails ........................................................................................................ 27 2.1 Growth and Poverty Dynamics ........................................................................................................................... 28 2.2 Risks and Policy Challenges ................................................................................................................................ 36 III. Russia’s Dual Transformation - The Fiscal Implications of an Aging Population and the Diminishing Economic Role of the Natural Resource Sector ................................................. 41 3.1 The Demographic Challenge ..................................................................................... .......................................... 42 3.2 The Growth Implications of Demographic Trends .............................................................................................. 43 3.3 The Fiscal Implications of Russia’s Aging Population ................................................................................ .......... 46 3.4 Can Russia’s Natural Resource Sector Mitigate the Fiscal Implications of an Aging Population? ....................... 50 References ................................................................................................................................................................. 52 Annex I: Russia’s Fiscal Rule and Savings from Natural Resource Revenues ............................................................... 53 Annex II: Main Macroeconomic Indicators ................................................................................................................. 54 List of figures Figure 1: GDP growth, y-o-y, percent ............................................................................................................... ............ 2 Figure 2: Demand composition of GDP growth ............................................................................................ ............... 2 Figure 3: Global industrial production and trade growth ................................................................................ ............ 3 Figure 4: Gross capital flows to developing ....................................................................................................... .......... 3 Figure 5: Global energy prices ..................................................................................................................................... 4 Figure 6: Growth in crude oil supply ............................................................................................................................ 4 Figure 7: Gross domestic income growth, y-o-y, percent ................................................................... ......................... 5 Figure 8: Quarterly GDP growth, y-o-y and q-o-q sa, percent ..................................................................................... 5 Figure 9: Business confidence surveys in manufacturing ......................................................................... ................... 6 Figure 10: Key constrains to manufacturing, Rosstat business survey, percent ............................................................ 6 Figure 11: Real Effective Exchange Rate and oil price (Brent), Q4 2007 = 100 .............................................................. 7 Figure 12: Fixed investment growth by sector, H1 2015, y-o-y, percent ....................................................................... 8 Figure 13: Employment growth by sector, H1 2015, y-o-y*, percent ............................................................... ............. 8 Figure 14: Growth in tradables, value-added, y-o-y, percent ........................................................................................ 8 Figure 15: Contribution to GDP growth ........................................................................................................... .............. 8 Figure 16: The current-account balance ........................................................................................................................ 9 Figure 17: The overall trade balance, the services trade balance, the investment income balance, and oil prices ...... 9 Figure 18: External debt stock, US$ billions ......................................................................................... ......................... 10 Figure 19: CDS spreads for 5-year bonds ................................................................................................. ...................... 10 Figure 20: Remittance outflows, Q1-2015 ..................................................................................................................... 11 Figure 21: Remittance inflows, Q1-2015 ............................................................................................... ........................ 11 Figure 22: Net capital flows in the banking sector, billion US$ ...................................................................... ............... 11 Figure 23: Net capital flows in the non-banking sector, billion US$ ............................................................................. 11 Figure 24: CPI inflation components, y-o-y, percent .................................................................................. ................... 13 Figure 25: Central Bank key policy rate ............................................................................................. ............................ 13 Figure 26: Oil prices and Ruble exchange rate .......................................................................................... .................... 14 Figure 27: Credit growth, y-o-y, percent ....................................................................................................................... 15 Figure 28: Profitability and credit risk, percent ........................................................................................... ................. 15 Figure 29: Federal budget revenue and budget balances, 2007-2015, percent of GDP ............................................... 16 Figure 30: Primary federal budget expenditures, 2014, percent of GDP ...................................................................... 16 Figure 31: The anti-crisis plan by expenditure category, billion rubles ......................................................................... 18 Figure 32: The anti-crisis plan by financing sources, billion rubles ............................................................... ................ 18 Figure 33: Contribution to real wage growth, y-o-y, percent ........................................................................................ 21 Figure 34: Real wage growth by sector, y-o-y, percent .................................................................................... ............. 21 Figure 35: Beveridge curve ........................................................................................................................................... 22 Figure 36: Employment and economic activity rates, percent ..................................................................... ................ 22 Figure 37: Foreign citizens residing in the Russian Federation as of August 2015 ........................................................ 22 Figure 38: Social expenditures, percent of GDP ................................................................................ ........................... 23 Figure 39: Contribution to overall real income growth, y-o-y, percent ........................................................................ 24 Figure 40: Credit growth to households and household savings rates ......................................................................... 24 Figure 41: Real income growth by income quartiles, y-o-y, percent ............................................................................. 24 Figure 42: Population shares by income level and the size of the middle class, percent ............................................. 24 Figure 43: Poverty rate by regions, 2014, percent ......................................................................................... ............... 25 Figure 44: Real GDP growth projection, y-o-y, percent ............................................................................ ..................... 28 Figure 45: Real GDP projection, percent, 2012=100 .................................................................................. ................... 28 Figure 46: Global oil spare capacity and inventories .................................................................................................... 31 Figure 47: The growth of global oil demand ................................................................................................................. 31 Figure 48: Poverty rate projections, percent ..................................................................................................... ........... 32 Figure 49: Population dynamics in the Russian Federation, 1970–2050 ...................................................................... 42 Figure 50: Baseline trajectories and projection boundaries ......................................................................................... 45 Figure 51: Baseline revenue trajectories and projection boundaries ........................................................................... 47 Figure 52: Baseline trajectories and projection boundaries: primary expenditure ...................................................... 48 Figure 53: Fiscal sustainability indicators ...................................................................................................................... 50 List of tables Table 1: Contribution to growth by demand components, percentage points ......................................................... 6 Table 2: Balance of payments, 2010-2015, billion US$ ..................................................................................... ........ 12 Table 3: Net capital flows, 2010 -2015, billion US$ ................................................................................................... 12 Table 4: Russia’s external debt stock, 2013-2015, billion US$ ................................................................................... 12 Table 5: Russia’s external debt service schedule, 2015-2017, billion US$ ................................................................ 12 Table 6: The federal budget of 2013-2015, percent of GDP ...................................................................... ................ 17 Table 7: The consolidated budget of 2012-2015, percent of GDP ............................................................................ 20 Table 8: Poverty trends, 2010-2015 ............................................................................................................ .............. 24 Table 9: Global GDP growth, percent ........................................................................................................................ 29 Table 10: Economic indicators, baseline scenario .......................................................................................... ............. 32 Table 11: Economic indicators, lower-bound scenario .......................................................................... ..................... 34 Table 12: Economic indicators, upper-bound oil scenario .......................................................................... ................ 36 Table 13: Marginal effects of labor productivity, oil prices, and labor policies on baseline GDP ................................ 45 Table 14: Marginal impacts of alternative scenarios on the baseline debt-to-GDP ratio, percentage point deviation 50 List of boxes Box 1: Global economic trends ..................................................................................................................... ............. 3 Box 2: Energy price trends ...................................................................................................................... ................... 4 Box 3: Trends in business and consumer confidence .................................................................................. ............... 6 Box 4: The effect of the REER adjustment on Russia’s tradable sector ...................................................................... 8 Box 5: Remittance trends ............................................................................................................................ ............... 11 Box 6: Oil prices and exchange-rate dynamics ................................................................................................ ........... 14 Box 7: Amendments to the 2015 Federal Budget ...................................................................................................... 17 Box 8: The Government anti-crisis plan and its implementation ............................................................................... 18 Box 9: Russia’s fiscal rule ........................................................................................................................ .................... 19 Box 10: Labor market trends ........................................................................................................................... ............ 22 Box 11: Channels of fiscal income support for lower-income households .................................................................. 23 Box 12: The global economic outlook .............................................................................................................. ............ 29 Box 13: Global oil-price forecasts ............................................................................................................. ................... 31 Box 14: Financial market restructuring options ............................................................................................. .............. 38 Box 15: The Chilean experience with fiscal rules and financing social security liabilities ............................................ 51 ABBREVIATIONS AND ACRONYMS CA Current Account CBR Central Bank of Russia CDS Credit Default Swap CIS Commonwealth of Independent States CPI Consumer Price Index ECA Europe and Central Asia EU European Union FDI Foreign Direct Investment GDP Gross Domestic Product LFP Labor-Force Participation NPL Nonperforming Loan NWF National Welfare Fund OECD Organization for Economic Cooperation and Development OPEC Organization of the Petroleum Exporting Countries PMI Purchasing Managers Index REER Real Effective Exchange Rate i Russia Economic Report | Edition No. 34 EXECUTIVE SUMMARY R ussia’s recession deepened in the first half of 2015 with a severe impact on households. The economy continues to adjust to the 2014 terms- contained systemic risks, and there are early signs of stabilization. Nevertheless, the pass-through effect of the December 2014 depreciation of-trade shock amid a tense geopolitical context boosted inflation to levels not seen since 2002. marked by ongoing international sanctions. Even as the recession deepened in the first half Oil and gas prices remained low through the of 2015 controlling inflation became the central first half of 2015, further underscoring Russia’s bank’s main policy challenge. Low oil prices vulnerability to volatile global commodity continue to put downward pressure on federal markets. The weakening of the ruble created a revenue, ushering in a period of difficult fiscal price advantage for some industries, boosting consolidation. Real public spending is expected a narrow range of exports and encouraging to fall by 5 percent in 2015, notwithstanding a investment in a certain sectors, but this was temporary increase in the first half of the year not sufficient to generate an overall increase caused by frontloaded expenditures as part in non-energy exports. Investment demand of the government’s anti-crisis plan to cushion continued to contract for a third consecutive some of the fiscal consolidation impact. Falling year. Economic policy uncertainty arising from oil revenues constrained the government’s an unpredictable geopolitical situation and the ability to counter the decline in real income, continuation of the sanctions regime caused and nominal increases in pensions and social private investment to decline rapidly ascapital benefits were below the headline inflation rate. costs rose and consumer demand evaporated. This accelerated an already troubling rise in the The record drop in consumer demand was driven poverty rate, which climbed from 13.1 percent by a sharp contraction in real wages, which fell by in the first half of 2014 to 15.1 percent in the an average of 8.5 percent in the first six months first half of 2015. of 2015, illustrating the severity of the recession. However, the deterioration of real wages was Adverse external conditions pose a serious also the primary mechanism through which the challenge to short-term growth prospects. Yet, labor market adjusted to lower demand, and high policy uncertainty prevails and the country’s unemployment increased only slightly from 5.3 outlook hinges not only on the evolution of percent in 2014 to 5.6 percent in the first half external factors but also on its internal capacity of 2015. The erosion of real income significantly to adapt to an increasingly difficult macro-fiscal increased the poverty rate and exacerbated context. The World Bank’s baseline scenario the vulnerability of households in the lower 40 anticipates contractions of 3.8 percent in 2015 percent of the income distribution. and 0.6 percent in 2016 before the economy recovers to a modest growth rate of 1.5 percent The policy response by the authorities in 2017. Given serious concerns regarding oil- successfully stabilized the economy. The price volatility, compounded by major downside transition to a free-floating exchange rate risks to the global economic outlook, this report allowed imports to adjust to a 17 percent presents upper-bound and lower-bound oil depreciation in the real effective exchange rate price scenarios along with the baseline. In the during the first half of 2015, strengthening the lower-bound scenario, in which oil prices fall current-account balance. Meanwhile, measures well below the baseline projection, real GDP to support the financial sector appear to have could contract by as much as 4.3 percent in 2015 Russia Economic Report | Edition No. 34 ii Executive Summary and by another 2.8 percent in 2016, followed by sector, which will continue to drive the profound zero growth in 2017. Even in the upper-bound structural transformation of the Russian scenario, in which oil prices recover, real GDP economy. would still contract by 3.1 percent in 2015 before growing by 1.3 percent in 2016 and 1.7 percent in Economic policy should support the economic 2017. For projection purposes all three scenarios transformation that began in 2014. Russian assume that sanctions will remain in force. Due policymakers are confronted with complex to the severity of the projected contraction and challenges posed by the short-term economic the vulnerability of lower-income households to adjustment to external changes coupled with economic shocks, poverty rates are projected to major internal long-term shifts in its society and increase sharply in all three scenarios. economy. In the short-to-medium term, Russia’s changing external environment will continue The macro-fiscal adjustment heightens risks to alter the internal structure of its economy. to financial stability and fiscal sustainability. While adapting to relative price changes and the Measures to support financial sector stability reallocation of productive factors to new sectors is will need to be managed carefully and with a difficult process, policies that facilitate Russia’s continuous monitoring, as declining asset values economic transformation could have lasting in Russia’s overcrowded financial sector may positive effects. Facilitating structural change will continue to expose weaknesses in bank balance be especially critical as Russia strives to cope in sheets. The emergency measures implemented the long-term with a simultaneous demographic by the government and the central bank provide and economic transformation driven by a rapidly short-term relief, yet these measures are also aging and shrinking population and by the keeping systemic risks elevated, and additional diminishing relative importance of the natural financial-market restructuring is warranted. resource sector. Successfully addressing these Monetary policy successfully prevented challenges will require a combination of fiscal costly delays in relative price adjustments, discipline, regulatory restraint and institutional highlighting the importance of the central bank’s capacity building, while resisting pressure to commitment to inflation targeting in the context adopt policies that may temporarily mitigate the of a flexible exchange-rate regime. Maintaining disruptive effects of the adjustment process at fiscal sustainability will become an especially the expense of long-term growth. In the short- pressing challenge as low oil prices deplete fiscal term, strong signals indicating the government’s buffers, and this will necessitate difficult policy commitment to regulatory discipline and to choices during the revision of the 2016 budget policies that facilitate the macroeconomic proposal. Expenditure priorities will need to adjustment process would speed up the recovery be reassessed, and a renewed discussion of of private-sector confidence and promote prospective adjustments to the fiscal rule is investment despite tight financial conditions. anticipated. Longer-term fiscal sustainability Conversely, a failure to adopt sufficiently deep issues will arise from a combination of major and sustained structural reforms could leave the demographic changes and the diminishing country trapped in low-growth equilibrium. relative importance of the natural resource iii Russia Economic Report | Edition No. 34 PART I Recent Economic Developments: Weathering the Storm R ussia’s recession deepened in the first half of this year, as the ongoing contraction in domestic demand accelerated. The economy continues to ride the waves of the 2014 terms-of-trade shock and the implications of geopolitical tensions and continuing international sanctions. Oil and gas prices remained low through the first half of 2015, further underscoring Russia’s vulnerability to global commodity markets. However, imports adjusted to reflect the depreciation of the real effective exchange rate, as the Central Bank of Russia successfully transitioned to a free float, which eased pressure on Russia’s external balances. Meanwhile, measures to support the financial sector appear to have contained systemic risks, and there are early signs of stabilization. Nevertheless, the pass-through effect of the December 2014 depreciation boosted inflation to levels not seen since 2002. Despite the deepening recession, controlling inflation became the central bank’s main policy challenge in the first half of 2015 as double-digit inflation rates eroded real wages and incomes. Real wage and income trends illustrate the depth of the recession and its negative impact on household consumption, which has dropped at a record pace. The decline in real wages was also the primary mechanism through which the labor market adjusted to lower demand, and unemployment increased only slightly. The decline in real incomes increased poverty rates and exacerbated the vulnerability of households in the bottom 40 percent of the income distribution. Russia Economic Report | Edition No. 34 1 I. Recent Economic Developments 1.1 Growth Russia’s recession, which officially began in the fourth quarter of 2014, deepened significantly in the first half of this year. Consumer demand dropped at a record pace as double-digit inflation eroded real wages and incomes. Meanwhile, continued policy uncertainty, a weak domestic market, and high capital costs prompted a sharp contraction in investment. R ussia’s worsening recession has highlighted its dependence on oil and gas exports, widening the gap between Russia and other sharply. After a weak first quarter, oil prices rose marginally to an average of just over US$62 per barrel in May, yet this rebound appears to have emerging economies (Figure 1). In the first been temporary, as both supply and demand quarter of 2015 growth dropped from an factors continue to put downward pressure on anemic but positive 0.4 percent to negative 2.2 global oil prices (Box 2). percent, and in the second quarter the economy contracted at a rate of 4.6 percent. Countries Russia’s economy continues to struggle with with close trade or financial ties to Russia are the impact of the 2014 terms-of-trade shock, now experiencing adverse spillover effects. as well as ongoing geopolitical tensions and Russia continues to struggle even as the global international sanctions. Domestic demand economy slowly improves, spurred by gradually continues to contract, and consumption dropped rising growth rates in high-income countries precipitously in the first quarter of 2015. Given (Box 1). The continuing recovery in the US the sustained decline in real wages and household and slow but steady growth in the euro zone incomes, this trend likely continued through the boosted the global economy during the second second quarter (Figure 2). GDP growth trends quarter of 2015, though growth remained only tell part of the story of the severity of the highly uneven among emerging and developing terms-of-trade shocks on households’ incomes countries. Persistently low commodity prices and consumption. In fact, terms-of trade losses caused growth prospects for commodity are much more severe than GDP contractions exporters and commodity importers to diverge in an oil-exporting country such as Russia. For Figure 1: GDP growth, y-o-y, percent Figure 2: Demand composition of GDP growth 12 15 10 8 5 0 4 -5 0 -10 -15 -4 -20 -8 -25 Q2 2015* Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009 Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011 Q2 2011 Q3 2011 Q4 2011 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 -12 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Q1-14 Q1-15 Consumption Gross Fixed Capital Formation GDP growth OECD Oil-exporters Russia Other Emerging Change in inventories Export OECD EU Emerging Import Stat error Source: OECD. Source: Rosstat. Note: Emerging EU economies include the six central European countries Note: *Q2 2015 are World Bank estimates based on official statistics. that are members of both the EU and the OECD: Czech Republic, Estonia, Hungary, Poland, Slovak Republic, and Slovenia. Other emerging economies include seven countries: Brazil, China, India, Indonesia, Mexico, South Africa and Turkey. OECD oil exporters include Australia, Canada, Chile, Netherlands, Norway and the United States. 2 Russia Economic Report | Edition No. 34 I. Recent Economic Developments Box 1 Global economic trends Global growth in the second quarter of 2015 was boosted by a moderate recovery in high-income countries. Following a sluggish first quarter, the US economy expanded by 2.3 percent in the second quarter. The US continues to show signs of an accelerating recovery, and the unemployment rate fell to 5.3 percent in July, its lowest level since April 2008. The US Federal Reserve is expected to begin gradually raising interest rates in the coming months, though the exact timing of any prospective increase remains uncertain. The renewed strength of the dollar could dampen export growth and slow an expected rise in core inflation. Euro zone growth reached 1.5 percent in quarter one and 1.2 percent in quarter two despite the uncertainty surrounding the Greek debt crisis. Albeit modest, this is the euro zone’s best semi-annual growth performance since 2012. Growth was supported by the European Central Bank’s quantitative easing program, which helped improve credit conditions, weakened the euro, and reduced contagion risks associated with Greek debt. Low oil prices and the tapering of fiscal consolidation policies continue to support the euro zone’s recovery. Growth is expected to slow in major emerging markets and most developing countries. High-frequency indicators suggest that emerging markets’ poor quarter one performance has extended into quarter two. Industrial production in a number of high- and middle-income countries is either struggling to gain momentum (Mexico, South Africa, Indonesia and Malaysia) or slowing (Brazil, Russia, the Philippines, Korea and Thailand).Purchasing Managers Index (PMI) data for July indicate further softness in the global secondary sector (Figure 3). A number of oil exporters (Russia, Colombia, Nigeria, Venezuela and Malaysia) are under acute pressure from deteriorating terms of trade, while countries that rely on non- energy commodity exports (Argentina, Indonesia, Chile, Peru, South Africa and Zambia) also face an adverse external environment. By contrast, India’s recovery appears to remain robust, although growth is expected to slow somewhat following an exceptionally strong quarter one. In China,quarter two growth was in line with World Bank projections at 7 percent, year-on-year, as stimulus measures mitigated the slowdown. However, manufacturing activity continued to decelerate;the July PMI deteriorated further, and exports and imports contracted significantly in July—both falling by over 8 percent from a year earlier. Global financing and exchange-rate pressures are building. Market risk aversion increased as a result of the Greek debt crisis, the collapse of Chinese equity prices, the depreciation of the renminbi, and the persistent weakness of commodity prices, all of which are putting upward pressure on borrowing conditions in emerging markets (Figure 4). The EMBI global sovereign bond spread has widened by 40 basis points since mid-May, especially for oil and other commodity exporters. However, the rise in borrowing costs has been more modest than it was during either the oil price collapse in 2014, or the so-called “taper tantrum” in 2013. Currency pressures have intensified. Since June,the currencies of Russia, Colombia, Brazil, Chile and Malaysia have all depreciated by more than 10 percent against the US dollar, due largely to weak commodity prices. Figure 3: Global industrial production and trade growth Figure 4: Gross capital flows to developing countries, US$ billions % change, 3m/3m saar 80 20 15 70 10 60 5 50 0 40 -5 30 -10 -15 20 -20 10 -25 0 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Developing Industrial Production Developing Country Exports High Income Industrial Production High Income Imports Syndicated bank lending Bond issuance New equity issuance Source: Datastream and World Bank Global Economic Prospects. Source: Dealogic and World Bank Global Economic Prospects. Russia Economic Report | Edition No. 34 3 I. Recent Economic Developments Box 2 Energy price trends Low energy prices continued from the first half of 2015 into the third quarter. Oil prices dropped to almost US$40 per barrel in late August, their lowest level since the 2008 financial crisis (Figure 5). The decline reflects an oversupplied global market, in part reflecting the resilience of US shale oil production despite large reductions in investment and drilling since October 2014. OPEC oil production continues to climb, rising by almost half a million barrels per day since May. Both Saudi Arabia and Iraq recently reached record production levels at 10.4 and 4.2 million barrels per day, respectively. The multilateral agreement with Iran over its nuclear program, if ratified, could increase Iranian oil exports by 0.5 million barrels per day by 2016. Global oil demand has responded positively to lower prices, and the International Energy Agency projects that demand will grow by 1.6 million barrels per day in 2016, the fastest pace in five years. However, there are concerns that slowing growth in China—the world’s second largest oil consumer—will prolong the surplus. Other sources of downward pressure on oil prices include a strong US dollar and continuously high OECD oil inventories. Until 2014, the rapid expansion of shale oil production in the United States was offset almost barrel-for-barrel by supply shortfalls in the Middle East and North Africa. The rapid growth of US oil production, combined with the partial resumption of supply from Libya and record output from Iraq, created a glut in the global oil market (Figure 6). In the past, a well-supplied oil market would be countered by OPEC—and especially Saudi Arabia, OPEC’s largest producer—which would move to constrain global oil supply. However, in the fall of 2014, OPEC decided not to engage in any form of supply management in order to protect its market share. This decision has led to the largest supply-driven price correction since 1986. Only twice have drops in oil prices of similar magnitude occurred in the recent past: just after the first Gulf War, when supply rebounded following a shock, and during the 2008 financial crisis, as demand among major economies temporarily dropped. Figure 5: Global energy prices Figure 6: Growth in crude oil supply US$/mmbtu mb/d, changes since 2010-Q4 25 5 Crude Oil 20 3 15 1 Thousands 10 Natural Gas (US) -1 5 Coal (Australia) -3 0 2010Q1 2011Q1 2012Q1 2013Q1 2014Q1 2015Q1 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Iran Libya Syria Yemen United States Net Changes Source: World Bank. Source: World Bank and International Energy Agency. Note: These are relative prices of different fuels in terms of energy units to ensure comparability. Russia, terms-of trade losses in 2015 are likely investment demand. The real exchange rate to amount to -6.9 percent, resulting in a drop in corrected households’ purchasing power. As a gross domestic income of 10.7 percent (Figure result, net exports began to rise during the first 7). Higher income volatility is a typical feature of quarter. Exports also grew, in part supported by oil-exporters and can pose additional challenges the weaker ruble, further boosting net exports. for macroeconomic management, especially These trends continued throughout the second if growth slows to significantly lower levels in quarter. Ultimately, however, the substantial the long-term. While periods of high oil prices improvement in net exports only partly offset lead to large cumulative terms-of-trade gains, in a sharp contraction in output. Investment was times of oil-price drops the terms-of-trade losses sharply negative in the first quarter, as firms dwarf the slowdown in GDP. reduced inventories in response to weaker- than-expected consumer demand compounded Imports dropped sharply during the first half by an uncertain policy environment, ongoing of 2015 as households adjusted to the income geopolitical tensions and the international shock, leading to weak domestic consumer and sanctions regime. Tight credit constraints 4 Russia Economic Report | Edition No. 34 I. Recent Economic Developments Figure 7: Gross domestic income growth, y-o-y, percent Figure 8: Quarterly GDP growth, y-o-y and q-o-qsa, percent 20 5 15 3 1.2 1.2 10 0.4 0.1 1 0.9 0.0 0.5 (0.3) 5 1.5 -1 0.8 0.5 0.3 0.3 0.4 0.3 0 (0.7) -5 -3 (1.6) (2.0) -10 -5 -15 Real GDP growth Terms-of-trade effect GDP growth, y-o-y GDP growth, q-o-q, sa Source: Rosstat, CBR, WITS and World Bank staff calculations. Source: Rosstat. and higher risk aversion of banks did little In the first quarter, consumption fell at its to improve the investment conditions. The fastest rate since the 1998 crisis, deepening financial sector continued its consolidation, and Russia’s recession. Meanwhile, inflation rose the stalling of the monetary-easing cycle did not sharply, eroding real wages and incomes. A high sufficiently lower interest rates. The contraction debt burden and elevated interest rates severely in investment is estimated to have accelerated restricted household credit growth, while during the second quarter. continued uncertainty regarding the length of the economic downturn made consumers cautious Russia’s economy formally entered a recession about drawing on their savings to compensate in the fourth quarter of 2014, with the seasonally for the drop in real income. The government’s adjusted quarterly growth rate dropping ability to intervene to support consumption—as below zero for two consecutive quarters. The it did during the 2008 global financial crisis—was recession deepened in the first half of this year, constrained by tight budgets and diminished as seasonally adjusted real GDP contracted by fiscal buffers. In 2015, pensions were indexed 2.0 percent in the second quarter, following a 1.6 far below the headline inflation rate, while the percent contraction in the first quarter, and a 0.7 indexation of public wages was put on hold. As a percent contraction in the final quarter of 2014 result, household consumption, which has been (Figure 8). The cumulative contraction in Russia’s the key growth driver in recent years, dropped real GDP in the first half of 2015 is estimated to by 9.0 percent, year-on-year, in the first quarter. be -3.5 percent. These quarterly growth trends With growth in government consumption near largely match the projections of the previous zero, total consumption dropped by 6.4 percent Russia Economic Report No. 33 (April 2015) and in the first quarter, cutting 5 percentage points are consistent with the current baseline outlook from overall growth (Table 1). High-frequency (see Part II). The leading indicators for domestic data indicate no improvement in consumption demand and economic confidence surveys for trends in the second quarter, and its negative the third quarter suggest a fragile stabilization contribution to growth is likely to remain similar in economic activity, indicating that the Russian to that observed in quarter one. economy may have hit bottom. However, further downward adjustments in oil prices and/or an increase in exchange-rate volatility could delay the return of sustained growth. Russia Economic Report | Edition No. 34 5 I. Recent Economic Developments Table 1: Contribution to growth by demand components, percentage points 2007 2008 2009 2010 2011 2012 2013 2014 1Q2015 GDP growth, percent 8.5 5.2 -7.8 4.5 4.3 3.4 1.3 0.6 -2.2 Consumption 7.4 5.7 -2.6 2.6 3.7 4.3 2.7 0.7 -5.0 Households 6.9 5.1 -2.5 3.0 3.4 3.8 2.5 0.7 -5.0 Government 0.5 0.6 -0.1 -0.3 0.3 0.5 0.2 0.0 0.0 Gross capital formation 4.7 2.5 -10.5 5.4 4.7 0.8 -1.8 -1.7 -4.0 Fixed capital investment 3.9 2.2 -3.2 1.3 2.0 0.5 0.2 -0.4 -1.2 Change in stocks 0.8 0.3 -7.2 4.1 2.8 0.3 -2.0 -1.2 -2.8 Exports 2.1 0.2 -1.5 2.0 0.1 0.3 1.4 0.0 1.4 Imports -5.5 -3.2 6.7 -5.3 -4.3 -1.9 -0.8 1.8 5.6 Source: Rosstat and World Bank staff calculations. Box 3 Trends in business and consumer confidence Business confidence deteriorated during the first half of 2015 due to weak domestic demand and continued policy uncertainty. Rosstat’s Producer Confidence Index and HSBC’s PMI both indicated that business confidence in the manufacturing sector declined further since last year (Figure 9). For example, the Rosstat manufacturing index averaged –6.3 in the first half of 2015, down from –3.3 in the first half of 2014. A similar trend was observed in the resource sector, where the average index dropped from -1.5 to -4.5 over the same period. The Rosstat survey also revealed that weak domestic demand and policy uncertainty were the two most important factors that negatively affected business confidence in the first half of 2015 (Figure 10). The importance of policy uncertainty rose sharply in 2015, with about half of all respondents citing it as a significant constraint to doing business, compared to 34 percent in 2014. Both the PMI and the Rosstat surveys continue to rank weak domestic demand as the most frequently cited constraint. Consumer confidence also sharply deteriorated in the first quarter of 2015, yet it showed signs of rebounding in the second quarter. Rosstat’s consumer confidence index dropped from -11 in the first quarter of 2014 to -32 in the first quarter of 2015, close to the record low of -35 registered in Q1 of 2009. However, consumer confidence improved somewhat in the second quarter, though high-frequency statistics have not yet shown any improvement in consumption. The ruble’s stabilization and appreciation in mid-May and the slowdown in inflation observed since April may have bolstered consumer confidence. Figure 10: Key constrains to manufacturing, Figure 9: Business confidence surveys in manufacturing Rosstat business survey, percent 1 4 0 Lack of financial resources 3 -1 2 -2 High interest rates 1 -3 0 -4 High policy uncertainty -1 -5 -2 -6 High tax level -7 -3 -8 -4 Weak domestic demand -9 -5 Apr-14 Apr-15 Apr-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Jul-14 Oct-14 Jan-15 Jul-15 Jan-12 Jul-12 0 10 20 30 40 50 60 Business Confidence PMI Jan-Jun, 2015 Jan-Jun, 2014 Source: Rosstat and HBSC. Source: Rosstat. 6 Russia Economic Report | Edition No. 34 I. Recent Economic Developments Investment demand continued to contract in the first quarter (Figure 11). International for a third consecutive year despite some sanctions and Russia’s continued restrictions front-loading of public investment in the first on food imports from Western countries, quarter. Front-loaded public spending focused implemented in August 2014, further reduced on capital goods, including military equipment. imports. At the same time, the depreciation of However, increased public investment could the ruble improved export performance in some not compensate for an accelerating decline in sectors (Box 4). Exports to countries outside the private investment spurred by economic policy Commonwealth of Independent States (CIS) uncertainty, evaporating consumer demand and increased in the mining, chemical and machine- limited credit access (Box 3), which squeezed building sectors. As a result, Russia’s total export corporate profit margins. Falling consumer volume grew by 4.5 percent in the first quarter, demand in the first quarter led to a massive year-on-year. Due to the concurrent decline in destocking of inventories. As a result, fixed imports net exports contributed 7 percentage investment contracted by 8.8 percent and points to GDP, limiting the first quarter GDP gross capital formation dropped by 28.5 contraction to 2.2 percent, year-on-year. percent. This cut 4 percentage points from Figure 11: Real Effective Exchange Rate and oil price (Brent), overall growth in quarter one, well above the Q4 2007 = 100 1.1 percentage points cut in quarter four of 120 150 2014. Fixed-investment demand is estimated to 140 115 have decreased further in the second quarter, 110 130 while the pace of destocking slowed due to the 105 120 110 stabilization of consumer demand. 100 100 95 90 80 A sharp contraction in imports and robust 90 70 export volume growth increased the positive 85 60 contribution of net exports to GDP, limiting 80 50 the first quarter output contraction. The rapid depreciation of the real effective exchange rate Real Effective Exchange Rate (4Q 2007 = 100) (REER) was a major cause of falling domestic Oil price (Brent), (4Q 2007 = 100) demand and contributed to the 25 percent Source: CBR and Bloomberg. year-on-year contraction in imports observed Russia Economic Report | Edition No. 34 7 I. Recent Economic Developments Box 4 The effect of the REER adjustment on Russia’s tradable sector The positive impact of the ruble’s depreciation on Russia’s tradable sector has been so far limited and uneven. The REER’s sharp drop in the first quarter created a price advantage for the tradable sector. This boosted output and exports in a few selected sectors, spurred investment (Figure 12) and marginally increased employment (Figure 13). Mineral extraction and chemical production grew significantly, while agricultural output and foodstuff production were supported not only by the depreciation, but also by Russia’s ban on food imports. However, the relative improvement in prices did not significantly impact output or exports for most of Russia’s manufacturing sector, and many of the country’s industrial products remained uncompetitive on international markets. Indeed, overall manufacturing output contracted by 2.0 percent in the first half of 2015, whereas it had grown by 3.5 percent over the same period in 2014 (Figure 14). Investment data confirm the limited degree of natural substitution to date in Russia’s tradable sector. Investment increased in the chemicals, rubber, plastics, electronics and machine-building industries, presenting cause for cautious optimism. Despite the modestly positive effects from the REER adjustment, during the first half of 2015 the tradable sector contributed negatively to growth for the first time since 2009. The decline of the tradable sector trimmed total output by 0.1 percentage points during the first half of 2015. However, a far worse performance by the nontradable sector drove the contraction in GDP, as consumer demand dropped sharply, cutting 3.1 percentage points from overall growth in the first half of the year (Figure 15). Retail and wholesale trade—the Russian economy’s largest sector—contracted by 9.3 percent, year-on-year, in the first half of 2015 after growing by an anemic 0.6 percent in the first half of 2014. The financial sector, a key driver of growth in recent years, contracted by 4.5 percent in the first half of 2015 after growing by 11.2 percent during the same period in the previous year. Figure 12: Fixed investment growth by sector, Figure 13: Employment growth by sector, H12015, y-o-y, percent H12015, y-o-y*, percent, 30 4 23.1 3 20 18 14.9 2 9.6 10 1 0.2 0 0 -10 -5.9 -1 -10.7 -14.1 -2 -20 -20.6 -3 -30 -27.3 on oc n e g ti er t g c cti re g g du ti sin ad (to rin o in in uc ap M pro plas Co on Ag al) ne cts od ucti du tu Tr to es in ild od p ul ro M ac tr bu pr and ric d lp ns uf an pr ica an lp er hi Pu M em bb Fo ac Ru Ch Sectors Average Source: CBR and Haver Analytics. Source: Rosstat, Haver Analytics and World Bank staff calculations. Note: *2015 data includes Crimea, largely explaining the increase in total employment. Figure 14: Growth in tradables, value-added, Figure 15: Contribution to GDP growth y-o-y, percent by sector, percent 20 5.0 0.2 15 0.1 3.0 2.7 2.2 4.9 10 3.0 0.8 2.0 1.3 0.4 1.0 1.6 0.5 0.4 0.6 0.6 0.0 5 0.0 0.0 -0.2 0.0 0.0 0.0 -0.1 -1.0 -2.8 0 -3.1 -3.0 -5 -3.5 -10 -5.0 -0.4 -15 -7.0 2008 2009 2010 2011 2012 2013 2014 H1 2015 2008 2009 2010 2011 2012 2013 2014 H1 2014 H1 2015 Agriculture Mineral extraction Manufacturing Tradable Non-tradable Public sector Source: Rosstat. Source: Rosstat. 8 Russia Economic Report | Edition No. 34 I. Recent Economic Developments 1.2 Balance of Payments Despite the worsening external environment, Russia’s current account remained in surplus, and the vulnerability of its balance of payments decreased as imports adjusted to reflect the depreciation of the REER. Deleveraging continued at a rapid pace as economic sanctions limited access to international financial markets. However, capital outflows moderated as the private sector sharply reduced its net acquisition of foreign assets. R ussia’s balance of payments remained stable in the first half of 2015 despite lower commodity prices and elevated capital The flexible exchange rate enabled the REER to depreciate by 17.4 percent in the first half of 2015, prompting a swift downward adjustment outflows. The current-account surplus continued in import demand. Due in part to Russia’s ban on to improve, nearly doubling from 4.1 percent food imports, overall imports decreased by 38 of GDP (US$37.9 billion) in 2014 to 8 percent of percent, year-on-year, in the first six months of GDP (US$48.1 billion) in the first half of 2015. 2015. However, the depreciation of the REER has Meanwhile, the nonoil current-account deficit thus far failed to generate an overall increase in narrowed from 14.4 percent of GDP (US$135.2 non-energy exports. Some non-energy exports billion) to 10.3 percent of GDP (US$61.8 billion), to non-CIS countries rose in real terms (e.g. decreasing the vulnerability of the balance fertilizer, processed wood, aluminum, machines of payments to external shocks (Table 2). The and equipment, and transport vehicles), yet the current account was bolstered by a reduction total value of non-energy exports fell to US$72.6 in imports coupled with improvements in the billion in the first half of 2015, down 12 percent investment-income balance (Figure 16). Although from the previous year. The service sector’s trade exports grew in real terms, export values dropped balance improved, as service imports (especially by 30 percent year-on-year in in the first half tourism) decreased, offsetting a decline in of 2015 due to lower oil prices. As a result the service exports. trade balance weakened only slightly, falling from US$102.2 billion (10.9 percent of GDP) in 2014 A favorable investment income balance and to US$88.6 billion (14.8 percent of GDP) as the declining remittance outflows bolstered the drop in exports was almost completely offset by current account. The investment income balance a decline in imports (Figure 17). improved due to the continued deleveraging of Figure 16: The current-account balance percent of GDP Figure 17: The overall trade balance, the services trade balance, the investment income balance, and oil prices 140 60 12 50 9 120 40 30 6 100 20 3 10 80 0 0 60 -10 -3 -20 -6 40 -30 13 13 13 3 4 4 4 4 5 5 -1 -1 -1 -1 -1 -1 -1 -9 - - - Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q1 Q2 2008 2009 2010 2011 2012 2013 2014 1H-2014 1H-2015 Crude oil, Brent, $/b (left axis) Services balance, bln USD (right axis) Goods Services Transfers Trade balance, bln USD Investment income balance, bln USD Compensation of employees Investment income Current account balance (right axis) (right axis) Source: CBR. Source: CBR and Bloomberg. Russia Economic Report | Edition No. 34 9 I. Recent Economic Developments external debt (Figure 18 and Table 3). As long the depreciation of the ruble and the contraction as sanctions on the financial sector are in place1 in economic output, further improving the access to international capital market will remain current account (Box 5). limited. Low commodity prices not only dampen Russia’s growth prospects, they also elevate The moderation of capital outflows in the borrowing costs for Russian firms. While credit- first half of 2015 led to a small recovery in default swap (CDS) spreads for 5-year bonds the financial account and eased pressure decreased from a record 613 points in February on international reserves. Russia’s financial- 2015 to 340 at the end of June, they remain account deficit decreased to US$51.8 billion much higher than the 170 points observed at the (8.6 percent of GDP) in the first six months of beginning of 2014 (Figure 19). High rates of new 2015, down from US$74.7 billion (8.0 percent of borrowing and less debt rollover are reflected GDP) in the first half of 2014. Despite continued in the decrease in Russia’s external debt stock, deleveraging net capital outflows from the which fell from US$762.8 billion (16.2 months private sector slowed to US$52.5 billion (Table of exports) in 2014 to US$556.2 billion (15.3 4) in the first half of 2015, down from US$69.4 months of exports) in the first half of 2015. billion a year earlier, due to a massive decrease External government debt declined substantially, in the net acquisition of foreign assets (Figure 22 dropping from US$57.1 billion in 2014 to 35 and Figure 23). Some foreign assets were shed to billion at the end of June as non-residents sold off service external debt, as financial sanctions and government bonds.2 Banking sector debt shrank the depreciation of the ruble increased the cost by nearly a third, from US$209 billion to US$149 of debt rollover. However, a modest resurgence billion, while non-financial corporations reduced in confidence in the ruble may be curbing this their debt by about a fifth, from US$450.6 billion trend. The government’s recent efforts to to US$361.8 billion. This massive deleveraging discourage offshoring,3 along with other indirect caused the investment-income deficit to narrow capital-control measures,4 also contributed to by US$12.6 billion to US$18.5 billion (3.1 percent the reduction in the acquisition of foreign assets. of GDP) in the first half of 2015, year-on-year. Outbound non-banking-sector foreign direct Outbound remittances dropped sharply due to investment (FDI) fell to US$7.3 billion in the first Figure 18: External debt stock, US$ billions Figure 19: CDS spreads for 5-year bonds 800 700 700 600 600 500 500 400 400 300 300 200 200 100 100 0 Aug-13 Oct-13 Aug-14 Oct-14 Apr-15 Jun-15 Apr-12 Jun-12 Aug-12 Oct-12 Dec-12 Apr-13 Jun-13 Dec-13 Apr-14 Jun-14 Dec-14 Feb-15 Dec-11 Feb-12 Feb-13 Feb-14 0 Jan-14 Feb-14 Mar-14 Arp-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Banks Non-financial corporations State Total debt Source: CBR. Source: Bloomberg. 1 In June 2015, the EU extended its sanctions until end-January 2016. In March 2015, the US extended its sanctions by one year. 2 The government previously cancelled all external borrowing plans for 2014 and 2015, but it now plans to borrow US$7 billion from international markets in 2016 and 2017. 3 The de-offshorization law was adopted at the end of 2014. However, several procedures accompanying this law are still being developed, which creates uncertainty for the business community and some companies have already decreased foreign assets acquisition to preempt any risk. 4 For example, the five major oil-exporters had to cut their net foreign assets by March 1 back to the level of October 1, 2014. 10 Russia Economic Report | Edition No. 34 I. Recent Economic Developments Box 5 Remittance trends The ruble’s depreciation significantly reduced remittance outflows in the first quarter of 2015. Outbound remittances declined by 42 percent, year-on-year, to US$3.38 billion. 73 percent of remittances went to CIS countries, including Uzbekistan (US$634 million), Tajikistan (US$434 million), Ukraine (US$377 million), the Kyrgyz Republic (US$284 million), and Armenia (US$207 million) (Figure 20). Remittance inflows during the same period totaled US$1.65 billion, down 5 percent from a year ago. Of these, CIS countries accounted for 34.1 percent of total remittance inflows, led by Kazakhstan (US$215 million) and Uzbekistan (US$105 million) (Figure 21). Figure 20: Remittance outflows, Q1-2015 Figure 21: Remittance inflows, Q1-2015 13.06% 26.87% 6.38% Kazakhstan 18.74% Uzbekistan Uzbekistan Tajikistan 2.92% Kyrgyz Republic Ukraine Azerbaijan Kyrgyz Republic 2.86% Ukraine 0.09% Armenia 12.83% Armenia Moldova 2.13% Tajikistan 1.66% Azerbaijan 2.13% Moldova Belarus 3.96% Belarus Kazakhstan 1.76% Turkmenistan Turkmenistan 4.58% Non-CIS Non-CIS 1.34% 11.14% 65.92% 5.62% 0.67% 0.85% 6.12% 8.39% Source: CBR. Source: CBR. Figure 22: Net capital flows in the banking sector, billion US$ Figure 23: Net capital flows in the non-banking sector, billion 25 20 15 10 0 5 -10 -5 -20 -15 -30 -25 -40 -35 -50 -45 -60 Q4-2013 Q1-2014 Q2-2014 Q3-2014 Q4-2014 Q1-2015 Q2-2015 Q4-2013 Q1-2014 Q2-2014 Q3-2014 Q4-2014 Q1-2015 Q2-2015 Non-banking sector change in FA (- - increase) Banking sector change in FA (-- increase) Banking sector change in NL (+ - increase) Non-banking sector change in NL (+ - increase) Source: CBR. Source: CBR. half of 2015, down from US$27.1 billion a year As the exchange rate began to stabilize earlier. Meanwhile, households and the non- and external shocks subsided central bank banking sector reduced their foreign-exchange interventions became rarer in the first half of cash holdings by US$5.5 billion, a dramatic shift 2015.5 By the end of June, international reserves from the US$13.6 billion increase observed in stood at US$361.6 billion (14.8 months of the first six months of 2014. imports), well below the US$478.3 billion (13.4 5 CBR direct interventions during the first half of 2015 consisted of US$2.3 billion spent in January to support the ruble and purchases of US$6.4 billion in May-June as part of the Reserve Replenishment Program. Russia Economic Report | Edition No. 34 11 I. Recent Economic Developments months of imports) observed in June 2014 and of its reserves. Its program of one-year loans the US$385.5 billion (10.8 months of imports) was suspended in June, but in August the central observed at the end of the year. In the first half bank expressed its intention to relaunch the of 2015, the central bank continued to provide program in response to the large amount of debt foreign-currency loans to support large banks’ payments due in the second half of the year and external debt payments, spending US$8.8 billion the renewed volatility of oil prices (Table 5). Table 2: Balance of payments, 2010-2015, billion US$ 2010 2011 2012 2013 2014 H1 2014 H1 2015 Current account balance 67.5 97.3 71.3 34.8 58.4 37.9 48.1 Trade balance 120.9 163.4 145.1 123.7 134.5 102.2 88.5 Non-oil current account balance -186.6 -244.5 -275.5 -316.1 -265.5 -135.2 -61.7 Capital and financial account -21.6 -76.0 -30.9 -45.4 -146.6 -75.0 -51.8 Errors and omissions -9.1 -8.7 -10.4 -10.8 3.4 -0.6 -8.5 Change in reserves (- = increase) -36.8 -12.6 -30.0 22.1 86.5 37.7 12.3 Memo: average oil price (Brent, US$/barrel) 79.7 111.1 112.0 108.9 98.8 108.9 58.0 Source: CBR. Table 3: Net capital flows, 2010 -2015, billion US$ 2010 2011 2012 2013 2014 H1 2014 H1 2015 Total net capital inflows to the private sector -30.8 -81.4 -53.9 -61.0 121.9 69.4 52.5 Net capital inflows to the banking sector 15.9 -23.9 18.5 -7.5 64.8 36.2 28.6 Net capital inflows to the non-banking sector -46.7 -57.4 -72.4 -53.5 57.1 33.2 23.9 Source: CBR. Table 4: Russia’s external debt stock, 2013-2015, billion US$ Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Total debt 707.8 716.3 728.9 715.9 732.8 680.9 599.0 555.9 556.2 Corporate 632.9 636.0 651.2 646.8 659.4 615.7 546.8 510.6 510.7 Banks 211.9 207.1 214.4 214.0 208.9 192.3 171.5 154.2 149.0 of which Private Banks 82.4 79.4 81.4 76.3 73.5 69.1 63.4 53.6 - Non-financial corporations 420.9 428.9 436.8 432.7 450.6 423.4 375.4 356.5 361.8 of which Private Non- 259.3 265.3 271.6 264.1 279.7 260.2 230.8 223.7 - fin. Corporations Source: CBR. Table 5: Russia’s external debt service schedule, 2015-2017, billion US$ 2q 2015 3q 2015 4q 2015 1q 2016 2q 2016 3q 2016 4q 2016 1q 2017 Government 0.8 0.8 1.0 1.0 0.6 1.0 1.0 0.7 Banks 8.0 9.8 11.0 6.3 6.5 4.5 5.2 7.0 Non-banking sector 19.1 21.2 28.6 13.7 17.2 11.2 18.9 13.3 Total 29.1 31.8 40.6 21.0 24.3 16.7 25.1 21.1 Source: CBR. 12 Russia Economic Report | Edition No. 34 I. Recent Economic Developments 1.3 Monetary Policy and the Financial Sector Despite the deepening recession, controlling runaway inflation became the central bank’s most critical policy challenge during the first half of 2015. The pass-through effect of the ruble’s depreciation in December 2014 pushed inflation to levels not seen since 2002. Due to persistently high inflation, the central bank gradually moderated the monetary easing cycle it had started in early 2015 and discontinued it in September. Measures to support the financial sector appear to have contained systemic risks, and there are early signs of stabilization. The central bank successfully transitioned to a free-floating exchange rate, but in May it resumed marginal interventions to replenish its foreign- currency reserves. C onsumer price index (CPI) inflation slowly declined from a peak of 16.9 percent in March as the ruble stabilized and the rise in inflation had accelerated to 15.8 percent due to an increase in utility tariffs and a weaker ruble, while food-price inflation remained high at more food-price inflation subsided. The central bank than 18 percent. discontinued its monetary tightening policy in December 2014 and started a monetary easing High inflation rates combined with negative cycle in January. However, due to the pass- growth presented a serious monetary policy through effect of the ruble’s depreciation and challenge, and persistently high core inflation Russia’s ban on food imports, both food-price and ultimately prompted the central bank to slow core inflation uninterruptedly outpaced headline its monetary easing cycle. This cycle began on inflation, while non-food inflation continued January 30, when the central bank increased to accelerate (Figure 24). Food-price inflation its key policy rate by 200 basis points to 15 is hitting poor households particularly hard; by percent as the impact of the ruble’s depreciation February food prices had risen by 23.3 percent, subsided and financial stability was largely year-on-year, following an increase of 15.4 restored (Figure 25). As inflation began to slowly percent in 2014. Overall inflation moderated in moderate, the central bank continued a gradual the second quarter due to weakening consumer process of monetary easing, cutting the policy demand, while seasonal declines in fruit and rate in March (100 basis points), April (150 vegetable prices and robust agricultural growth basis points) and June (100 basis points) in an helped curb food-price inflation. By August, CPI effort to boost the credit supply and accelerate Figure 24: CPI inflation components, y-o-y, percent Figure 25: Central Bank key policy rate 25 18 16 20 14 15 12 10 10 8 5 6 0 4 1401 1402 1403 1404 1405 1406 1407 1408 1409 1410 1411 1412 1501 1502 1503 1504 1505 1506 1507 1508 Sep-2013 Mar-2014 Apr-2014 Jul-2014 Nov-2014 Dec-2014 Feb-2015 Mar-2015 May-2015 Jun-2015 Aug-2015 Core inflation CPI inflation Food inflation Non-food inflation Services inflation Source: Rosstat. Source: CBR. Russia Economic Report | Edition No. 34 13 I. Recent Economic Developments economic growth. Persistently high core inflation program in May, which involved daily purchases rates of 16-17 percent led the central bank to of US$200 million with the goal of increasing slow the monetary easing cycle in July (50 basis foreign-currency reserves to US$500 billion by points) to 11.0 percent, and on September 11 it 2018. Depreciation pressures intensified in June, discontinued the cycle altogether. as oil prices once again began to slide, and by mid-September the ruble had lost about 22.0 Foreign-exchange liquidity concerns subsided percent of its value against the dollar, falling to in the first half of 2015, and the successful 66.48 RUB/US$, close to its February low. transition to a free float helped improve exchange-rate alignment. From February to Monetary easing in the first half of 2015 June, the free-floating ruble benefited from marginally accelerated the growth of credit to a marginal recovery in oil prices, before a the private sector in the second quarter, yet renewed price drop reversed this trend (Box banks remain risk-averse. Funding costs on the 6). By May, the ruble had appreciated by interbank market fell substantially as the central around 30 percent against the dollar, and the bank cut its key policy rates by a cumulative 600 exchange rate rebounded to around 50 RUB/ basis points. For example, the 6-month MosPrime US$ from a low of 69.7 RUB/US$ in February. rate was just 12.0 percent in mid-September, As concerns about the private sector’s access down from 16.4 percent in March and 22.3 to foreign-currency liquidity eased, the central percent in January. Beginning in May, credit to bank discontinued its repo auctions in foreign the private sector grew for three consecutive currency. The ruble’s modest appreciation also months, due in part to the reevaluation of presented an opportunity for the central bank foreign-currency loans as the ruble weakened. to launch a medium-term reserve-replenishing However, banks continued downsizing their Box 6 Oil prices and exchange-rate dynamics Oil prices remain the key determinant of the ruble’s Figure 26: Oil prices and ruble exchange rate exchange rate, yet rising geopolitical tensions and central bank policies have also affected exchange-rate dynamics. There were two distinct periods during 2015 5 3.5 when the correlation between oil prices and the exchange 4.8 3.6 rate weakened: in February and in May-June (Figure 26). In February, the burgeoning crisis in Ukraine intensified 4.6 3.7 pressure on the ruble, which was compounded by large 3.8 external debt payments by the private sector during 4.4 the first quarter. In February, oil prices rebounded by an 3.9 average of 18 percent, month-on-month, yet the ruble 4.2 4 appreciated by an average of only 1.3 percent against the 4 dollar. Geopolitical tensions gradually subsided in March, 4.1 following the Minsk agreement on Eastern Ukraine, 3.8 4.2 while rising oil prices, a sharp drop in imports and lower external debt payments shifted the external accounts in 3.6 4.3 the ruble’s favor. Commercial banks continued to borrow foreign exchange through the central bank’s repo facility, taking advantage of the high margin offered by Russian Oil price (Brent), ln Rub/USD, ln (rhs, reverse order) treasury bonds. This fueled the ruble’s rally, which started in mid-March and continued through most of April, prompting the central bank to increase the rate on Source: Haver Analytics and CBR. foreign currency repos on April 10 and again on April 20. The reduction in key policy rates by 150 basis points at the end of April and the cancellation and discontinuation of the 1-year foreign-exchange repo facilities improved the exchange rate’s alignment with oil prices. The central bank’s daily purchases of US$200 million, which began on May 15, led to some temporary volatility in the foreign-exchange market, but in the second half of June the alignment between the ruble and oil prices was restored. In July, a renewed decline in oil prices intensified depreciation pressures, while large external debt payments and the start of the tourist season increased demand for dollars, prompting the central bank to postpone further foreign-exchange purchases. 14 Russia Economic Report | Edition No. 34 I. Recent Economic Developments consumer-credit portfolios, significantly reducing stabilization of the ruble this appears to have the stock of non-collateralized consumer loans. helped the banking sector adjust to a worsening Credit to households contracted by 0.8 percent economic environment. The central bank also in July, year-on-year, after growing at a rate of continued the tight supervisory policy it began 13.8 percent at end-2014 (Figure 27). Household in 2013 and suspended the licenses of 55 banks lending remains high-risk due to the recent in the first eight months of 2015, most for drop in real wages and incomes, which is likely unacceptably low capital-adequacy ratios or for to further constrain household credit. Despite excessively risky or suspicious credit operations. bank recapitalization, international sanctions Rossiyskiy Credit, Russia’s 45th largest bank by are limiting access to low-cost medium-term assets, was the largest institution to have its financing, which is keeping banks’ funding costs license revoked. Regulatory forbearance policies relatively high and their profit margins low. introduced in December 2014 and extended Increased provisioning for nonperforming loans through the end of 2015 may be obscuring the is also reducing profits. Banks have responded by true state of the banking system. However, adopting more risk-averse lending behavior. recapitalization helped sustain capital adequacy at around 13 percent through the first half of The health of the financial sector remains 20156 and by June major macro-prudential and difficult to assess due to the regulatory profitability indicators were either weakening forbearance implemented by the central bank in at a slower pace or beginning to improve. The 2014 to stabilize the banking system. Monetary share of nonperforming loans (NPLs) stabilized easing substantially reduced bank funding costs, at around 8.2 percent in June (Figure 28). and together with the recapitalization and Figure 27: Credit growth, y-o-y, percent Figure 28: Profitability and credit risk, percent 60 20 3 50 18 2.5 16 40 14 2 30 12 20 10 1.5 10 8 1 6 0 4 0.5 -10 2 -20 0 0 Apr-13 Oct-13 Jan-14 Apr-14 Apr-15 Jul-14 Oct-14 Jan-15 Jul-15 Apr-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Jul-13 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Jul-11 De 8 09 De 0 11 De 2 De 3 Ja 4 Fe 5 15 Ap 5 M 5 Ju 5 15 0 1 1 1 1 1 -1 r-1 -1 c- c- c- c- c- c- c- n- b- n- ar ay De De De M Non-financial Organisations Households Return on Equity Share of NPLs (total) Return on Assets (RHS) Source: CBR. Source: CBR. 6 At the end of December 2014, the government began the RUB1.0 trillion recapitalization program through issuing treasury bonds to be invested in the capital of systemically important banks. At the same time, the State Duma approved the law allowing investing up to 10 percent of the National Wealth Fund in subordinated deposits and bonds of Russian banks. On May 13, 2015, the government approved recapitalization of four banks: Rossia, Severnii Morskoi Put, Sodeistvie Obshestvennim Initsiativam, and Rossiiski Natsionalni Kommercheski Bank through the provision of subordinated loans in the total amount of RUB20.1 billion.On August 10, the government also approved RUB 8.5 billion recapitalization plan for 10 regional banks. Russia Economic Report | Edition No. 34 15 I. Recent Economic Developments 1.4 The Government Budget The Russian government is facing a fiscal consolidation challenge. The federal budget balance weakened during the first half of 2015 as revenues dropped and expenditures increased in real terms. The officially projected federal deficit of 3.7 percent is being financed primarily by the Reserve Fund, which will deplete its resources by an estimated 50 percent by end-2015. L ow oil prices have exerted substantial downward pressure on federal revenues over the past seven months. Overall federal revenues Real federal public spending rose in the first seven months of 2015 due to expenditure frontloading and the government’s anti-crisis fell from 20.8 percent of GDP in 2014 to 19.2 in measures. In the first seven months of 2015, 2015 as oil and gas revenues decreased from government expenditure priorities favored 10.8 percent of GDP to 8.6 percent, year-on-year national defense and social programs, and (Figure 29). The average Urals oil price dropped spending in these categories rose by 34.8 percent from US$107 per barrel in the first half of 2014 and 26.5 percent, year-on-year, respectively. to just under US$57 in the first half of 2015, Meanwhile, economic subsidies increased by prompting the government to sharply revise 24.7 percent, year-on-year. This was part of the the oil-price assumption underpinning the 2015 government’s anti-crisis plan which aimed to budget law (Table 6). The new reference price provide some additional support to parts of the is US$50 per barrel, half the original price of economy, regional budgets and social purposes. US$100 per barrel. Higher one-off VAT receipts However, total primary expenditures are from the spike in durable-goods purchases by expected to decline by 5 percent in real terms by households during the December currency crisis end-2015. The procyclical spending cuts included boosted nonoil revenues from 9.8 percent in July in the amended budget law are part of a fiscal 2014 to 10.5 in July 2015, but this was neither consolidation strategy and are appropriate given sufficient to offset the drop in oil revenues nor to the expansionary policies pursued in the past, finance the increase in expenditures. yet important decisions on the restructuring Figure 29: Federal budget revenue and budget balances, Figure 30: Primary federal budget expenditures, 2014, 2007-2015, percent of GDP percent of GDP 25 10 24.4 21.4 19.1 20.2 19.6 20.2 5.9 20 17.6 18.0 20 4.1 5 15.3 15.3 0.6 0.8 -0.1 15 -0.5 -0.5 0 -4.1 -2.8 10 10 -5.9 -5 -6.4 -9.6 -10.4 -10.3 5 -12.7 -10.9 -11.4 -10 -13.5 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0 -15 Social policy (inc. transfers to Pension Fund) National economy 2007 2008 2009 2010 2011 2012 2013 2014 2015* National defense National security State administration Intergovernmental transfers Oil revenues, percent of GDP Non-oil balance, percent of GDP (RHS) Education Health & sports Non-oil revenues, percent of GDP Total balance, percent of GDP (RHS) Other Federal budget primary expenditures Source: Ministry of Finance. Source: Ministry of Finance Note: *January-July. 16 Russia Economic Report | Edition No. 34 I. Recent Economic Developments of expenditures are still pending. Over the last high borrowing costs. Weaker-than–expected decade, the share of the largest expenditure oil revenues are projected to push the nonoil items—national security and defense, economic deficit to over 11 percent of GDP, its highest level subsidies and social spending—expanded as oil since 2011. In the first seven months of 2015 the revenues rose (Figure 30). Due to persistently nonoil deficit widened to 11.4 percent of GDP, low oil revenues the planned expenditure up from 9 percent in July 2014. This underscores consolidation will not prevent budget deficits in Russia’s fiscal dependence on oil revenues and 2015 and in subsequent years. its consequent vulnerability to the vicissitudes of the global oil market. The government is The federal budget deficit widened to 2.8 drawing on the National Welfare Fund (NWF) percent in the first seven months of 2015, a to recapitalize banks and finance its efforts to sharp reversal from the 1.9 percent surplus revive investment demand. The government’s recorded a year ago. The amended 2015 anti-crisis plan from January 2015 called for a budget anticipates a 3.7 percent deficit by the portion of its financing to come from the 2015 end of the year (Box 7), far larger than the 0.6 budget (Box 8), exacerbating the increase in the percent deficit originally projected. Much of the deficit, but cushioning otherwise somewhat the shortfall will be financed by the Reserve Fund, effects of a difficult fiscal consolidation. and no external financing is planned due to Box 7 Amendments to the 2015 Federal Budget The Ministry of Finance produced a draft 2015 budget and a prospective 2016–2017 budget in mid-2014, before the full impact of the recent terms-of-trade shocks had registered. Federal budget projections were based on an anticipated average oil price of US$100 per barrel. By the end of the year, when the oil price had dipped to US$70 per barrel, the government decided to delay the adjustment of budget parameters. As a result, the budget that took effect in December 2014 was based on outdated price projections and an obsolete macro-fiscal framework. The government began adjusting the budget during the first quarter of 2015, and on April 20 it was amended to reflect the new macroeconomic context. However, these amendments only apply to the 2015 federal budget, and the prospective 2016 and 2017 budgets remain unchanged. In August, the Ministry of Finance decided to continue its one-year planning horizon through 2016. Consequently, there is no medium-term budget perspective to guide federal agencies, increasing policy uncertainty. The same situation occurred during the 2008 global financial crisis, when the government abandoned medium-term budgeting. The amended budget halves the expected average oil price to US$50 per barrel and revises GDP growth downward from 1.2 percent to negative 3 percent. Meanwhile, estimates of CPI inflation and exchange-rate depreciation rose from 5.5 to 12.2 percent and from 37.8 to 61.5 percent, respectively. Table 6: The federal budget of 2013-2015, percent of GDP 2014, Jan.- 2015, Jan.- 2013 2014 Jul. Jul. 2015 2015 Amended Execution Execution Execution Execution Budget Law Budget Law Expenditures 20.0 20.8 18.9 21.9 20.1 20.8 Revenues 19.5 20.3 20.8 19.2 19.6 17.1 Primary Balance 0.1 0.1 2.4 -2.0 0.0 -2.9 Balance -0.5 -0.5 1.9 -2.8 -0.6 -3.7 Oil Revenues 9.8 10.4 10.8 8.6 10.0 7.8 Non-Oil Revenues 9.7 9.9 9.9 10.5 9.6 9.3 Non-Oil Balance -10.3 -10.9 -9.0 -11.4 -10.6 -11.4 Urals oil price, US$/barrel 106.4 97.6 107 56.8 100.0 50.0 Source: Ministry of Finance, Economic Expert Group and World Bank staff calculations. Russia Economic Report | Edition No. 34 17 I. Recent Economic Developments Box 8 The government’s anti-crisis plan and its implementation On January 27, 2014 the government adopted an anti-crisis plan totaling RUB2.4 trillion. The bulk of the plan was designed to support the financial sector, but other parts of the economy, as well as regional budgets and social programs, were also targeted (Figure 31). The plan was to be financed by Treasury bonds issued in December to recapitalize the financial sector, along with resources from the 2015 budget and the NWF (Figure 32). About 67 percent of the plan’s funds were earmarked for bank recapitalization. Treasury bonds worth RUB1 trillion were transferred to the Deposit Insurance Agency in December 2014, and 28 banks7 are currently eligible for recapitalization. In order to qualify, banks were required to commit to increasing mortgages, loans to small and medium enterprises, loans to regional budgets or loans to key economic sectors by 1 percent per month over the next three years, and to increase their own capital by at least half of the amount received from the Deposit Insurance Agency. Banks were also required to implement a three-year wage freeze. As of September, eleven banks8 had been recapitalized at a total cost of RUB598.5 billion. In August the government approved a list of regional banks9 to be recapitalized in the amount of RUB 8.5 billion through the Rossiisky Capital Bank. The RUB1 trillion originally allocated to support commercial banks was reduced by RUB162 billion, which the government redirected to support state-owned companies. Federal bonds in the amount of RUB100 billion were transferred to the state-owned company United Airconstruction. The State Transport Leasing Company received RUB30 billion in federal bonds, and the state-owned energy company Lenenergo received RUB32 billion.10 The NWF is investing up to RUB250 billion in subordinated deposits and bonds in systemically important banks that have capital assets of at least RUB100 billion (US$1.6 billion). In October 2014, nine banks met these criteria. The interest rate on these deposits will at least equal the CPI inflation rate. Banks that receive deposits from the fund are expected to finance government-approved investment projects. As of September, RUB 64.4 billion in fund assets had been deposited into commercial banks. In March, RUB 26 billion was deposited in the state-owned bank VTB to finance infrastructure projects. In April, the government deposited RUB38.4 billion in the state-owned Gazprombank to finance the construction of the new Central Ring Road. Finally, the government plans to deposit an additional RUB300 in the NWF resources in the state-owned Vnesheconombank to provide credit to the economy, but this transaction has not yet taken place. About 13.9 percent of the anti-crisis plan’s funding (RUB320 billion) was earmarked for direct support to the economy. This includes RUB200 billion in state guarantees for systemically important companies, RUB50 billion to support agricultural enterprises and RUB10 billion to support the transportation sector. The government has approved a list of 199 firms eligible for state guarantees, which includes all major Russian companies. The firms on the list together produce about 70 percent of Russia’s GDP. In September, RUB17 billion in state guarantees were issued to the state-owned company Uralvagonzvod.11 In the first seven months of 2015 federal spending on the agricultural sector reached RUB124.4 billion (59.6 percent of the budgeted amount), up 50 percent from the previous year. Another 12.9 percent of the anti-crisis plan’s resources (RUB296 billion) was earmarked for social support. This includes RUB188 billion to offset the decline in real pension payments, up to RUB52.2 billion for labor market policies, RUB30 billion for unemployment compensation, and RUB16 billion for the health sector. The government increased labor pensions by 11.4 percent in February and social pensions by 10.3 percent in April. During the first seven months the government also distributed 83 percent of the RUB2.5 billion in regional subsidies earmarked for labor market policies and RUB25.9 billion in regional transfers earmarked for unemployment compensation, 68 percent of the budgeted amount. About 7.0 percent (RUB160 billion) of the plan’s resources are to be transferred to regional governments through budgetary loans. As of August, budgetary loans to regional governments increased by RUB123.5 billion to a total of RUB771 billion. Figure 31: The anti-crisis plan by expenditure category, Figure 32: The anti-crisis plan by financing sources, billion rubles billion rubles 160 87 296 600 1,000 320 1,550 713 Bank recapitlization Support to the economy Social support Support to the regions Budget 2014 Budget 2015 NWF Other Source: Ministry of Finance. Source: Ministry of Finance 7 As of January 1, 2015 the combined capital assets of these bank exceeded RUB25 billion. 8 Sovkombank, Bank Petrokommerc, FK Otkrytie, AK Bars Bank, Moscow Credit Bank, Novikombank, Absolyut Bank, VTB, Promsvyazbank, Gazprombank, Binbank, Bank Zenit. 9 Urals Bank Reconstruction and Development, Tatfondbank, Asian-Pacific Bank, Western-Siberian Commercial Bank, St. Petersburg international Bank, Surgutneftegaz Bank, Kuban Credit, Chelyabinvestbank, First United Bank, Sarovbusinessbank. The capital of these banks exceeded RUB5 billion as of January 1, 2015. 10 One of the largest electricity distribution companies in Russia. 11 Uralvagonzavod is a state-owned company that produces military hardware, railway cars and road construction machines. The company was hit hard by international sanctions, as its projects with foreign partners were halted and demand for railway cars fell. 18 Russia Economic Report | Edition No. 34 I. Recent Economic Developments The National Welfare Fund is increasingly investment decisions must follow transparent committed to supporting large banks and processes supported by adequate oversight and providing off-budget stimulus. The fund accountability mechanisms. currently holds almost RUB4.4 trillion, or 6 percent of GDP, reflecting an increase of RUB10 Russia’s fiscal buffers are not sufficient billion since the beginning of the year. In 2015, to cover successive budget deficits, and a the government invested RUB75 billion from prolonged period of oil prices at current levels the fund in bonds to finance a gas-extraction will necessitate a significant expenditure project in the Yamal Peninsula. The government adjustment in 2016 and beyond. In 2015, the deposited RUB26 billion at the state-owned government has relied heavily on its fiscal buffers bank VTB, at 8 percent interest, for a major road to finance the budget deficit. In August the project, which it had initially planned to finance Reserve Fund was not replenished, as it normally though a bond issued by the state-owned road- is each year, because the fiscal rules only require building company RosAvtoDor. The government its replenishment when oil prices exceed budget invested RUB50 billion in privileged shares of forecasts. This highlights the critical importance Russian Railways to support the modernization of updating the fiscal rule (Box 9) to restore its of the Baikalo-Amur and Trans-Siberian Railways. usefulness as a fiscal policy instrument. The It also invested RUB57.5 billion into privileged financing demands of the federal budget deficit stocks of the Atomenergo for the construction (RUB 900 billion or 1.3 percent of GDP) coupled of the Hanhikivi-1 nuclear power station in with the depreciation of the ruble reduced the Finland. Moreover, the government provided Reserve Fund from US$87.9 billion in January direct support to certain state-owned banks, to US$72 billion as of September 1. Based on including a RUB38.4 billion recapitalization of current budget trends the deficit is expected to Gazprombank. Altogether, the NWF has invested halve the Reserve Fund by the end of the year. RUB787.7 billion in domestic financial assets. This means that previous savings are being used Productive investments are critical to Russia’s now to prevent fiscal distress, and that no new long-term growth, and the National Wealth savings are being amassed for future generations. Fund could potentially play an important role in Policymakers have yet to develop a permanent building economic assets that provide sufficient solution to the long-term structural deficit, returns to cover future pension liabilities, as per which will be exacerbated by the aging of the its original purpose. For that to happen, however, population (see Part III). Without major reforms Box 9 Russia’s fiscal rule In 2012, the government introduced an oil-price–based fiscal rule to manage its revenues from natural resources more effectively. Before 2012, the fiscal tool to guide resource-based spending was a 4.7 percent target for the nonoil budget deficit. The new rule establishes a benchmark price based on a backward-looking moving average of actual Urals oil prices, which is used to calculate how much of a given year’s resource revenues can be devoted to public spending. The benchmark price is equal to the average price of the previous three years, but only if oil prices have been decreasing for more than three consecutive years. If prices have not consistently decreased, then the benchmark price is equal to the average price for the previous 10 years. If actual oil prices are above the benchmark price in a given year, the difference is saved, and if they are lower than the benchmark price, previous savings are used to finance the difference. Savings are managed through a two-tier institutional structure. Initial savings are deposited into the Reserve Fund; once the Reserve Fund balance reaches 7 percent of GDP, half of all additional savings are allocated to the NWF and half to infrastructure projects. Balances in the NWF are earmarked for future pension liabilities and in the latter are used for current infrastructure projects. In principle, this mechanism stabilizes public spending through the buffers deposited in the Reserve Fund and saved for future generations through the National Wealth Fund. The fiscal rule and two-tier sovereign wealth funds savings mechanism could effectively smooth revenue volatility that would otherwise be transferred from natural resource prices to public spending. However, the government is currently planning to use savings from the Reserve Fund to finance budget deficits over the next one-to-three years and has committed much of the NWF. This is a serious concern, as the simulations presented in Annex 1 show that over the long run NWF resources will not be adequate to cover the fiscal deficits generated by the aging of the Russian population. Russia Economic Report | Edition No. 34 19 I. Recent Economic Developments to limit public liabilities or boost revenues future Consolidated government expenditures grew fiscal balances will not be sustainable. from 35.4 percent of GDP in the first half of 2014 to 40.0 percent in the first half of 2015 In the first six months of 2015, the consolidated as spending on social programs and national government budget shifted from surplus to defense rose by 3.9 and 1.6 percent of GDP, deficit due to imbalances in the federal budget respectively. Increasing imbalances in extra- and in the use of extra-budgetary funds. budgetary funds are negatively impacting the The consolidated budget encompasses all consolidated budget. Rising expenditures, public spending, including the federal budget, especially from the Pension Fund, have pushed subnational budgets and all extra-budgetary the extra-budgetary funds into deficit, which funds (Table 7). The trajectory of overall revenues presents a growing fiscal risk. At end-June, the and expenditures largely reflects trends in the consolidated budget deficit stood at 2.6 percent federal budget, and when oil revenues dropped of GDP, down from a surplus of 3.3 percent a in the first half of 2015 consolidated government year ago. By December the consolidated deficit revenues fell from 38.7 to 37.4 percent of GDP. is expected to widen to 5.5 percent of GDP, with This occurred despite increases in income tax deficits projected at all budgetary levels. revenue, social contributions and VAT receipts. Table 7: The consolidated budget of 2012-2015, percent of GDP 2012 2013 2014 2013 H1 2014 H1 2015 H1 2015 Execution Execution Execution Execution Execution Execution Forecast Consolidated budget Expenditures 37.3 38.2 38.7 36.0 35.4 39.6 40.8 Revenues 37.7 36.9 37.5 37.4 38.7 37.0 35.3 Balance 0.4 -1.3 -1.2 1.4 3.3 -2.6 -5.5 Consolidated subnational budget Expenditures 13.4 13.3 13.1 12.1 12.1 12.0 13.4 Expenditures w/t int. Payments 13.3 13.2 12.9 12.0 11.9 11.8 Revenues 13.0 12.3 12.5 12.2 12.4 13.1 12.5 Revenues w/t extra budgetary transfers 10.4 10.0 10.1 10.0 10.1 10.8 10.5 Balance adj. For interest payments -0.3 -0.8 -0.5 0.1 0.4 1.3 Balance -0.4 -1.0 -0.6 0.0 0.3 1.1 -0.9 Subnational debt 1.6 2.6 3.6 Extra budgetary funds Expenditures 11.1 12.1 11.2 11.5 10.3 13.5 13.8 Revenues 12.0 12.2 11.2 11.9 11.1 12.0 12.7 Balance 0.9 0.2 0.0 0.4 0.8 -1.5 -1.1 Federal budget Expenditures 20.7 20.2 20.8 19.4 19.5 21.5 20.8 Interest payments 0.5 0.5 0.6 0.6 0.6 0.8 0.8 Expenditures w/t int. payments 20.2 19.6 20.2 18.8 18.9 20.8 20.0 20.2 19.6 18.8 18.8 18.9 20.8 20.0 Revenues 20.7 19.7 20.3 20.6 21.7 19.2 17.1 Primary balance 0.5 0.1 0.1 1.8 2.8 -1.6 -2.9 Balance -0.1 -0.5 -0.5 1.2 2.2 -2.3 -3.7 Source: Ministry of Finance and Rosstat. Extra budgetary funds include the Pension Fund, the Social Security Fund, and the Federal Fund for Mandatory Health Insurance. 20 Russia Economic Report | Edition No. 34 I. Recent Economic Developments Subnational budgets are less vulnerable to end-2015. Subnational debts currently total 3.3 external shocks, because most oil revenues percent of GDP, up from 2.4 percent in the first flow through the federal level. As of end-June, half of 2014. Subnational indebtedness could the aggregate subnational budget registered a increase if the anticipated deficit is financed surplus of 1.1 percent of GDP, yet this is expected through domestic borrowing in an environment to become a deficit of 0.9 percent of GDP by of high interest rates. 1.5 Income and Poverty Trends The dramatic contraction in real wages and income observed in the first half of 2015 illustrates the depth of the recession and its negative impact on household consumption. The decline in real wages was the main channel through which the labor market adjusted to lower demand, and as a result unemployment increased only slightly during the past year. However, the drop in real income significantly increased poverty rates and exacerbated the vulnerability of households in the lower 40 percent of the income distribution. R eal wages have tumbled since the recession began, as inflation spiked while labor demand receded. In the first six months of 2015 for public sector wages while inflation remained in double-digits throughout the first half of the year. Civil servants comprise a large part of the real wages fell across all sectors of the economy Russian middle class, and as their real wages (Figure 33), dropping by an average of 8.5 fell by 10 percent in first half of 2015 (Figure 34) percent. This contraction followed a growth rate private consumption dropped rapidly. of 3.4 percent in the first half of 2014. As lower oil prices increased fiscal constraints the budget The decline in real wages enabled the labor could not support the continued growth of public market to adjust without shedding a large sector wages at the pace observed in 2012- number of jobs. As a result, the unemployment 2013 (15 percent in real terms). The recession rate increased only slightly from 5.3 percent in hit civil servants especially hard as the original the first half of 2014 to an average of 5.6 percent 2015 federal budget provided zero indexation in the first half of 2015 (Box 10). The decline in Figure 33: Contribution to real wage growth, Figure 34: Real wage growth by sector, y-o-y, percent y-o-y, percent 15 25 20 10 15 5 10 0 5 -5 0 -5 -10 -10 -15 -15 2009 2010 2011 2012 2013 2014 2015 2009 2010 2011 2012 2013 2014 2015 Public Non-Tradables Tradables Total Total Tradables Non-Tradables Public Source: Rosstat and World Bank estimates. Source: Rosstat and World Bank estimates. Russia Economic Report | Edition No. 34 21 I. Recent Economic Developments Box 10 Labor market trends Labor demand started to decline in the first half of 2015. As the economy contracted the vacancy rate dropped to 2.5 percent, year-on-year (Figure 35). Meanwhile, the unemployment rate rose from 5.3 to 5.6 percent, representing an additional 200,000 unemployed workers. Although the labor supply has declined gradually since 2012, due to the aging of the population, the employment ratio has remained close to 65 percent (Figure 36). Male unemployment, at 6.0 percent, exceeds female unemployment, at 5.3 percent, up slightly from 5.7 and 4.8 percent in 2014. Urban unemployment increased from 4.4 percent to 5.0 percent, year-on-year, while rural unemployment decreased from 8.2 percent to 7.9 percent. Figure 35: Beveridge curve Figure 36: Employment and economic activity rates, percent 70 2Q14 3.00 1Q 14 69 3Q 14 4Q 14 68 2.80 67 3.2 2.60 66 4Q 13 Vacancy rate, % 4Q 12 1Q 15 2Q 15 65 2.40 4Q 14 2.7 5.1 5.6 64 4Q 11 63 62 2.2 4Q 10 4Q 09 61 60 1.7 2011 2012 2013 2014 2015 5.0 6.0 7.0 8.0 9.0 Activity rate Employment rate Unemployment rate, % Activity rate, SA Employment rate, SA Source: Rosstat and World Bank staff calculations. Source: Rosstat, Haver Analytics and World Bank staff calculations. Russia has a long history of making labor-market adjustments through wage corrections, and several other factors have contributed to its low unemployment rate. A slightly higher degree of labor mobility facilitated the reallocation of human resources to expanding sectors, while public employment—particularly in public administration, education and state- owned enterprises—also appears to have increased. Meanwhile, the partial replacement of migrant workers by domestic workers in sectors such as construction and agriculture helped contain unemployment. Tajikistan, Uzbekistan and Moldova have all reported an increase in the number Figure 37: Foreign citizens residing in the Russian Federation of returning migrant workers from Russia, and Russia’s as of August 2015 outbound remittances decreased substantially. Limited Others (227) unemployment benefits, a large amount of informal 1,502,313 13.7% Ukraine employment and a high share of variable compensation China 2,631,638 278,777 all exerted downward pressure on the unemployment 2.5% 24.0% rate. There is little evidence of employers“hoard labor”by Kyrgyz Republic switching employees to part-time work or putting them on 518,993 unpaid leave. 4.7% Armenia A sudden decrease in the total number of foreign citizens 535,135 4.9% residing in Russia at the end of 2014 sparked a debate as Moldova to how the economic downturn and a stricter migratory 535,163 framework is affecting migrant workers in Russia. During 4.9% the first seven months of 2015, the number of migrants Azerbaijan Uzbekistan fell by 2 percent, year-on-year. Ukraine became the top 554,364 5.1% 2,125,943 19.4% source of incoming migrants, accounting for 24 percent of Belarus the total (a 41 percent increase, year-on-year) (Figure 37). 592,451 Meanwhile, Uzbekistan saw its share of migrants decline 5.4% Kazakhstan 701,133 Tajikistan 985,416 to 19 percent of the total, (a 16 percent decrease, year-on- 6.4% 9.0% year). The share of migrants from the Eurasian Economic Union rose to 21 percent of total migrants (a 17 percent Source: Federal Migration Service of the Russian Federation. increase, year-on-year). labor demand is also being partially offset by Nonwage income sources such as transfers demographic aging, and the gradual shrinking and pensions have failed to compensate for of the working-age population has measurably the drop in real wages, as they did during the impacted the labor market since 2012. 2008 global financial crisis, causing an overall 22 Russia Economic Report | Edition No. 34 I. Recent Economic Developments decrease in real income. Falling oil revenues Savings dipped temporarily at end-2014 as the constrained the government’s ability to use ruble depreciated and households converted fiscal transfers to offset the erosion of real cash savings into durable goods, but it has wages. Pensions were indexed by 11.4 percent since rebounded. in February, and social benefits were indexed at 5.5 percent, both well below the headline The decline in real income in the first half of inflation rate (Box 11). Combined with the drop 2015 had a deeply negative impact on the in real wages this accelerated in the first half of poverty rate, which climbed to 15.1 percent, 2015 the contraction of real disposable income representing 21.7 million people. This is an to 3.1 percent from 1.0 percent in the first half increase of two percentage points, or 2.8 million of 2014 (Figure 39). people, from a year ago, and the average 2015 poverty rate is now estimated to be close to its The growth of consumer credit stalled in June, 2011 level (Table 8). This accelerated an already and the consumer debt stock remains high at troubling trend in poverty rates, which rose from around 25 percent of total household income. 10.8 percent in 2013 to 11.2 percent in 2014. The Interest rates on consumer debt also remained increase in poverty rates was driven not only by elevated at close to 25 percent. This not only the decline of real income but also by food-price discourages the acquisition of new loans, but inflation, which continuously outpaced headline also negatively impacts consumers seeking to inflation. Poverty rates vary enormously by region roll-over existing debts, which are typically on (Figure 43), with the highest rates observed in a very short (often one-year) maturity. The cost the Siberian Federal District, led by the Tuva of servicing the large stock of consumer debt Republic at 35.2 percent. The lowest rates are is a significant burden for households, which found in the resource-rich regions of Tatarstan contributed to the drop in consumption. Finally, Republic and Yamalo-Nenetskiy Autonomous most households do not appear to have drawn District, both of which have poverty rates close on their savings to support consumption in to 7 percent, followed by Belgorod Province (7.5 the first half of 2015, and the savings rate percent) and Moscow (7.7 percent). fluctuated at close to its 2014 level (Figure 40). Box 11 Channels of fiscal income support for lower-income households Beginning in the mid-2000s social transfers and public Figure 38: Social expenditures, percent of GDP wages played a significant role in raising the incomes of poorer households. After the 2008-2009 crisis, and 25 especially in 2010, pensions were the main channel for 21.4 21.0 21.1 20.5 20.5 fiscal redistribution and dominated social protection 19.4 spending.12 Without pensions the social system had very 20 3.8 3.8 4.3 16.8 16.9 4.4 3.7 little redistributive effect. During 2008-2009 pension 16.1 16.2 3.8 indexation reached 10-20 percent in real terms. In 2010 15 2.2 2.7 2.9 2.5 a major increase (through valorization) boosted pensions 8.3 8.9 by 35 percent in real terms. Pensions and other forms of 9.6 7.8 8.1 8.6 5.9 6.2 social security led the expansion of overall social spending 10 6.6 6.2 (Figure 38). 4.2 4.3 4.0 3.8 3.9 3.7 3.6 3.7 3.7 3.7 Although common among countries in the region, 5 redistribution through pensions is not very efficient. 3.7 3.9 4.0 4.0 4.6 4.1 4.0 4.1 4.4 4.3 It is an expensive way to protect the poor and raises 0 sustainability concerns (see Part III). Going forward there 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 is significant scope for Russia to expand the means- Education Health Total social spending tested component of social assistance and improve Pensions Other socail securiy program targeting. Reducing leakages to relatively richer households would help maximize the poverty-reducing Source: Ministry of Finance, Rosstat and World Bank staff calculations. impact of social transfers. 12 Lustig, N. Lopez-Calva, L.F, M. Matytsin and D. Popova, 2015. Who Benefits from Fiscal Redistribution in Russia? Mimeo, World Bank. Lustig, N. Lopez-Calva, L.F, M. Matytsin and D. Popova, 2015. Who Benefits from Fiscal Redistribution in Russia? Mimeo, World Bank. Russia Economic Report | Edition No. 34 23 I. Recent Economic Developments Figure 39: Contribution to overall real income growth, Figure 40: Credit growth to households and household y-o-y, percent savings rates 10 50 20 8 45 19 6 40 18 4 17 35 2 16 30 0 15 25 -2 20 14 -4 15 13 -6 10 12 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 5 11 0 10 2009 2010 2011 2012 2013 2014 2015 2011 2012 2013 2014 2015 Others Business and property Total Public wages and transfers Market wages Consumer credit growth, percent Savings rate*, percent (right axis) Source: Rosstat and World Bank estimates. Source: Rosstat, Haver Analytics and World Bank estimates. Note: *Seasonally adjusted, 6-months moving average. Table 8: Poverty trends, 2010-2015 Q1 Q2 Q3 Q4 Q1 Q2 2010 2011 2012 2013 2014 2014 2014 2014 2015 2015 Poverty rate, cumulative 12.5 12.7 10.7 10.8 13.8 12.1 12.1 8.5 15.9 15.1 Number of poor, million people 17.7 17.9 15.4 15.5 19.8 18.9 18.0 16.1 22.9 21.7 Source: Rosstat and World Bank staff calculations. Rising poverty rates threaten Russia’s income distribution. In 2014, real income impressive achievements over the past decade growth among households in the lower 40 in promoting shared prosperity. Poor and low- percent did not exceed the national average income households are especially dependent (Figure 41), preventing a further expansion of on pensions and social transfers, both of which the middle-class13 (Figure 42). Instead, Russia’s were eroded by inflation in 2015. This has middle class has remained close to its 2013 significantly increased the vulnerability of level (70 percent), failing to grow for the first households in the lower 40 percent of the time since the global financial crisis. Figure 41: Real income growth by income quartiles, Figure 42: Population shares by income level and the size of y-o-y, percent the middle class, percent 15 100 90 10 80 70 5 60 50 0 40 -5 30 20 -10 10 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 0 2009 2010 2011 2012 2013 2014 01 02 03 04 05 06 07 08 09 10 11 12 13 14 20 20 20 20 20 20 20 20 20 20 20 20 20 20 More than 50 USD/day 25-50 USD/day 10-25 USD/day Average Bottom 40 percent 5-10 USD/day Less than 5 USD/day More than 10 USD/day Source: Rosstat and World Bank staff calculations. Source: Rosstat and World Bank staff calculations. 13 The middle class is defined here as share of population with per capita income above 10 USD per day in 2005 PPP terms. 24 Russia Economic Report | Edition No. 34 Figure 43: Poverty rate by regions, 2014, percent LIST OF REGIONS 1 Yaroslavl 7 Tula 13 Chuvashia 21 Volgograd 27 North Ossetia 2 Kaluga 8 Nizhniy Novgorod 14, 16 Tatarstan 22 Kalmykia 28 Chechnya 3 Vladimir 9 Ryazan 15 Penza 23 Adygea 29 Ingushethia 4 Ivanovo 10 Mari El 17 Ulyanovsk 24 Stavropol 5 Perm 11 Udmurtia 18 Saratov 25 Karachaevo-Cherkessia 6 Moscow-city 12 Mordovia 19, 20 Samara 26 Kabardino-Balkaria LEGEND 7.0, 9.1 9.1, 11.2 11.2, 12.4 I. Recent Economic Developments 12.4, 14.4 14.4, 17.1 17.1, 35.2 No Data Russia Economic Report | Edition No. 34 Source: Rosstat and World Bank staff calculations. 25 26 Russia Economic Report | Edition No. 34 PART II Economic Outlook: High Uncertainty Prevails A dverse external conditions pose a serious challenge to Russia’s short-term growth prospects. The continued impact of the adjustment to lower oil prices in a context of ongoing international sanctions will cause the Russian economy to contract in 2015. Medium-term growth prospects depend on how Russia will brave the difficult adjustment to this new economic reality, but high policy uncertainty prevails. In the longer term, there is an opportunity for Russia to benefit from a structural transformation of its economy. The baseline scenario anticipates a contraction of 3.8 percent in 2015 and 0.6 percent in 2016, before the economy rebounds to a modest growth rate of 1.5 percent in 2017. Given renewed concerns regarding oil-price volatility compounded by downside risks to the global economic outlook, Russia’s upper-bound and lower-bound oil price scenarios differ markedly. For projections purposes, it is assumed that sanctions remain in force in all three projection scenarios. The continuing macro-fiscal adjustment process heightens risks related to financial stability and fiscal sustainability. Due to the severity of the projected contraction and the vulnerability of lower-income households to growth shocks, poverty rates are projected to increase sharply. Russia Economic Report | Edition No. 34 27 II. Economic Outlook 2.1 Growth and Poverty Dynamics Given the volatility of the international oil market and Russia’s economic sensitivity to changes in oil prices, the World Bank has based its medium-term growth projections around three scenarios: the baseline, an upper-bound oil price scenario, and a lower-bound oil price scenario. For projections purposes it is assumed that sanctions remain in force in all three projection scenarios. The current recession is expected to substantially reverse recent progress in poverty reduction, and poverty levels are projected to increase sharply in all scenarios. A combination of persistently low global oil prices and ongoing international sanctions is exerting a profoundly negative influence on due to the tight domestic credit market and international financial restrictions, borrowing would become prohibitively expensive for most Russia’s growth prospects. The World Bank’s investors and households. baseline growth outlook for 2015 anticipates that the Russian economy will contract by 3.8 Geopolitical tensions continue, and both percent in 2015 (Figure 44), with real GDP sanctions and counter-sanctions were renewed slipping below its 2012 levels (Figure 45). This in 2015. As a result, external borrowing cost are reflects the continued impact of the economy’s expected to remain elevated, with restricted adjustment to lower oil prices in a sanctions access to international financial markets environment. Oil prices are projected to remain suppressing investment and capital formation at an average of US$53 per barrel in 2015, rates through 2015. A slow and uneven global unchanged from the 2015 price forecast used recovery is marked by continued weaknesses in the previous Russia Economic Report (April). in trade dynamics. Growth in large emerging The upper-bound and lower-bound scenarios economies is projected to decline, capital flows primarily reflect how changing oil prices would are being reduced and volatility in equity prices affect other macroeconomic variables. A 50 increased world-wide. But by far most dominant percent drop in average oil prices prompted a for Russia is the projected softness in commodity sharp depreciation in the ruble coupled with prices which could spark additional selloffs in a steep rise in inflation rates, which would the currency and equity markets of emerging have a profoundly negative impact on income economies, further increasing international and consumption levels in 2015. Meanwhile, borrowing costs (Box 12). Figure 44: Real GDP growth projection, y-o-y, percent Figure 45: Real GDP projection, percent, 2012=100 102 3.4 101.6 3 101.9 1.7 101 2 101.3 99.9 1.3 1.5 100 1 1.3 100.0 98.6 99 98.9 0.6 98.0 0 98 97.4 -0.6 0.0 -1 97.5 97 -2 -3.2 96 -3 -3.8 -2.8 95 94.8 -4 -4.3 94 94.8 -5 93 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017 Lower-bound scenario Baseline scenario Upper-bound scenario Lower-bound scenario Baseline scenario Upper-bound scenario Source: Rosstat and World Bank staff estimates. Source: World Bank staff estimates. 28 Russia Economic Report | Edition No. 34 II. Economic Outlook Box 12 The global economic outlook Global growth is expected to strengthen gradually over the medium term, spurred by an accelerating recovery in high-income countries (Table 9). Low commodity prices and generally benign financial conditions (notwithstanding the expected tightening of US monetary policy) will support a continued increase in global economic activity. The recovery among high-income countries is expected to gather momentum, with aggregate growth rising from 1.8 percent in 2014 to an estimated 2 percent in 2015 and a projected average of 2.3 percent over 2016–17. Performance gaps between major economies will narrow in 2015-2016, as growth rates plateau in the United States while increasing in the euro zone and Japan. Global growth is expected to reach 2.8 percent in 2015, up slightly from 2014, before accelerating to 3.2 percent in 2016–2017. Developing and emerging economies will continue to face a difficult economic environment. Tighter financial markets, slowing growth in China, continued weakness in commodity prices and a strong US dollar will all present significant challenges. The protracted slump in global commodity prices has especially negative implications for growth in developing countries, as commodities account for about one-third of their aggregate GDP. Slowing growth among developing countries has adverse spillover effects for Russia, which maintains close trade, finance and remittance links with a number of developing economies. Meanwhile, countries that rely heavily on foreign capital inflows may be negatively affected by rising borrowing costs as the US Federal Reserve raises its policy interest rates. In addition, many developing and emerging economies have experienced a structural economic slowdown as demographic change has lowered the growth rate of their working-age populations. Nevertheless, rising productivity in South and East Asia should continue to support rapid regional growth, though at a somewhat slower pace than in previous years. Overall, aggregate growth in developing countries is expected to slow to 4.4 percent in 2015 before rising to 5.4 percent by 2017. Table 9: Global GDP growth, percent 2009 2010 2011 2012 2013 2014 2015f 2016f 2017f World -1.8 4.3 3.1 2.4 2.5 2.6 2.8 3.3 3.2 High income -3.5 3 1.9 1.4 1.4 1.8 2.0 2.4 2.2 Developing countries 3.0 7.8 6.3 4.9 5.1 4.6 4.4 5.2 5.4 Euro area -4.5 2.0 1.7 -0.7 -0.4 0.9 1.5 1.8 1.6 Russia -7.8 4.5 4.3 3.4 1.3 0.6 -3.8 -0.6 1.5 Source: World Bank Global Economic Prospects and World Bank Russia team estimates. Russia’s medium-term growth prospects will to inflation targeting in the context of a flexible hinge not only on the evolution of external exchange-rate regime. This will continue to factors but also on its internal capacity to support timely REER adjustments. Similarly, adjust to an increasingly adverse macro-fiscal measures to shore up financial sector stability context. In 2016, growth is projected below zero will need to be managed carefully and with as Russia will continue chartering the waters continuous monitoring, as it is likely that of a difficult adjustment process. Maintaining declining asset values will continue to expose fiscal sustainability will become an especially weaknesses in bank balance sheets in Russia’s pressing challenge as fiscal buffers are further still-overcrowded financial sector. With no major depleted over time while oil prices remain low structural reforms expected before the 2018 at a projected average of US$53 per barrel. This presidential election, a marginal improvement will require difficult policy choices during the in average oil prices to US$57 per barrel in 2017 expected revision of the 2016 budget proposal. would support a modest recovery to 1.5 percent Expenditure priorities will need to be reassessed, growth in the baseline scenario. and a renewed discussion of adjustments to the fiscal rule is anticipated. While Russia’s economy faces serious short- term adjustment challenges, there is also a Russia’s recent monetary policy actions valuable opportunity to enhance the country’s successfully prevented costly delays in relative long-term growth prospects by restarting price adjustments. To sustain progress on this progress on the structural reform agenda. front the central bank must remain committed Adapting to adjustments in relative prices and Russia Economic Report | Edition No. 34 29 II. Economic Outlook the shifting of productive factors to new growth central bank policy that could significantly affect sectors is a difficult process, but policies that how changing oil prices impact the economy. The facilitate Russia’s structural transformation could central bank is expected to adhere to its inflation- have lasting positive effects. Efforts to renew targeting regime and relax monetary conditions investor confidence will be especially critical as inflationary pressures ease. At the time of to Russia’s medium-term outlook. Conversely, this report’s publication government fiscal policies that attempt to slow Russia’s structural policies were still in the drafting stage, following transformation in an effort to mitigate the the Minister of Finance’s announcement on disruptive influence of the macroeconomic September 2 that a new 2016 budget proposal adjustment process could push the country would be submitted to the State Duma on toward a persistent low-growth equilibrium. October 25, replacing the prospective 2016- 2018 budget proposal submitted in June. In light Two key factors influence the economic of the rapidly evolving macroeconomic situation forecasts for Russia presented in this analysis, the Duma was requested not only to extend the the duration of international sanctions and the deadline for submitting the 2016 budget, but to trajectory of global oil prices, but only the latter also approve a reduction in the 2016 budget- differs in the three scenarios. For projections planning horizon from three years to one. purposes, it is assumed that sanctions remain in Low oil prices are expected exert considerable force in all three projection scenarios. Russia’s pressure on the fiscal accounts over the next medium-term growth outlook is also heavily two years. The revenue shortfall caused by dependent on trends in oil prices, and the lower oil export receipts, falling import duties baseline scenario reflects the Bank’s most recent and the contraction in GDP is not expected to oil-price projections (Box 13). The World Bank be offset by the government’s current fiscal projects in the baseline scenario steady oil prices policy, which calls for a five percent decline in for 2015 and 2016 at US$53 per barrel and for real public spending and another year of zero 2017 at US$55. However, the global oil market indexation for public wages. Either a more continues to exhibit significant volatility as OPEC significant fiscal consolidation will take place and non-OPEC producers compete for market in 2016 and 2017 or higher fiscal deficits are shares. Because current oil-price forecasts are likely in the coming years. subject to both upside and downside risks, the projections presented here include both a Worsening macroeconomic conditions are lower-bound and an upper-bound scenario. The expected to generate a substantial increase lower-bound scenario assumes that oil prices in the poverty rate, which is projected to rise will average US$50 per barrel in 2015 and US$40 from 11.2 percent in 2014 to 14.2 percent in per barrel in 2016 and 2017. The upper-bound 2015 in the baseline scenario. This would be the scenario assumes that oil prices will average first significant increase in the poverty rate since US$53 per barrel in 2015, US$58 in 2016 and the 1998-1999 crises (Figure 48). During the US$67 in 2016. 2008 global financial crisis a large fiscal stimulus package supported household consumption, and All forecasts assume that government and as a result the poverty rate did not increase and central bank policies will continue to support disposable income continued to grow. In 2015, Russia’s macroeconomic adjustment over however, the erosion of real incomes due to the projection period, but policy uncertainty inflation and exchange-rate effects combined remains very high. The projections do not with tight credit constraints is expected to anticipate any major shifts in government and drive a decline in consumption and a rise in 30 Russia Economic Report | Edition No. 34 II. Economic Outlook Box 13 Global Oil-Price Forecasts Robust supply growth coupled with slowing demand led to a substantial built-up in global oil inventories. OECD inventories exceeded 2.9 billion barrels in June, the highest level in recent history (Figure 46). Meanwhile, OPEC increased its output, as Saudi Arabia and other OPEC producers attempted to protect their market shares. As a result, OPEC’s excess production capacity narrowed from 4.3 million barrel per day in March to 3.2 million barrel per day in August, down from almost 5 million barrels per day at end-2013. OPEC established this strategy of increasing output in the face of weak global demand at its November 2014 meeting and reaffirmed its commitment in June 2015. Sustained low oil prices could lead in the long-term to a readjustment in oil supply and increasing again the share of traditional oil producers. The World Bank projects that oil prices will average US$53 per barrel in 2015,a 45 percent decrease from 2014. This projection assumes that OPEC will continue to refrain from any form of supply management (the next OPEC meeting will take place on December 4, 2015) and that there will be no further deterioration in the global economic environment. This forecast assumes the maintenance of OPEC’s current policy, the easing of geopolitical tensions, further supply increases (including rising oil exports from Iran), and moderate growth in global demand (Figure 47). These factors, combined with the extent of existing production capacity—especially shale-oil output in the United States—suggests that oil prices will remain low at an average of US$53 per barrel in 2016. Low oil prices have also impacted other energy markets, especially European and Asian markets for natural gas. These spillover effects have additional negative implications for Russian energy exports. Figure 46: Global oil spare capacity and inventories Figure 47: The growth of global oil demand, percent mb/d million bbl mb/d, growth year over year 8 2,950 4 OPEC spare capacity (LHS) 6 2,850 2 0 4 2,750 -2 2 2,650 OECD crude oil inventories (RHS) -4 0 2,550 2007Q1 2009Q1 2011Q1 2013Q1 2015Q1 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 China OECD Other Non-OECD Source: International Energy Agency. Source: World Bank and International Energy Agency. poverty rates. In particular, the high projected In all three scenarios, the poverty rate is rate of food-price inflation, which is already projected to rise above 14 percent in 2015, or outpacing headline inflation, will adversely close to 20.5 million people. However, poverty impact households in the bottom 40 percent of trends in 2016 and 2017 vary by scenario. Under the income distribution, as poorer households the baseline scenario the poverty rate is expected spend a larger share of their income on food. to increase slightly to 14.6 in 2016 (20.9 million) Moreover, given the government’s tight 2015 and decrease to 14.0 percent (20.1 million) in budget and the anticipated fiscal consolidation 2017. In the lower-bound scenario, the poverty in 2016 and 2017, public wages, pensions and rate is projected to increase to 15.8 percent other transfers are likely to decline in real terms. (22.6 million people) in 2016 and 16.5 percent Households in the bottom 40 percent of the (23.5 million people) in 2017, erasing all gains income distribution depend heavily on public since 2006. In the upper-bound scenario, the transfers, and this, combined with projected poverty rate is projected to fall faster from its trends in inflation, threatens to reverse Russia’s 2015 peak but by 2017 it would still be above substantial achievements in reducing poverty its 2014 level at close to 11.7 percent (16.8 and promoting shared prosperity. million people). Russia Economic Report | Edition No. 34 31 II. Economic Outlook Figure 48: Poverty Rate Projections, Percent initially projected. Finally, the new baseline 17 0.424 scenario assumes that investment demand will 16.5 15.8 not recover until 2017, slightly later than in the 16 0.422 15.2 14.6 previous projection, due to continuing sanctions 15 0.42 14.5 and static oil prices throughout the projection 14.0 14 13.3 14.2 0.418 period. Business and consumer confidence 13 13.4 13.0 12.7 14.1 0.416 are expected to remain weak due to policy 12 12.5 13.0 0.414 uncertainty. As a result, domestic demand is 11.7 expected to contract in 2015 and 2016, with net 11 0.412 10.7 10.8 11.2 exports remaining the sole factor supporting 10 0.41 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 growth until 2017, when investment and Baseline scenario Lower-bound oil price scenario consumption growth are projected to become Upper-bound oil price scenario Gini (rhs) positive again. Source: Rosstat and World Bank staff estimates. The baseline scenario includes a number of The Baseline Scenario monetary and fiscal policy assumptions. While I n the baseline scenario Russia’s real GDP is projected to contract by 3.8 percent in 2015 and 0.6 percent in 2016, before recovering the central bank is expected to adhere to its inflation-targeting regime, continuing fallout from the ruble devaluations in end-2014 and to a modest 1.5 percent growth rate in 2017 mid-2015 is expected to keep both headline and (Table 10). This baseline is closely aligned with core inflation in double digits through the second the outlook presented in the April 2015 issue of half of 2015, resulting in an average inflation the Russia Economic Report as oil-price forecasts rate of 15.5 percent for the year (Table 10). This remain broadly similar. However, the revised will limit the pace of monetary easing in 2015. growth projection reflects the deeper impact Devaluation concerns are projected to wane in that a depreciating ruble and an accelerating 2016 as oil prices stabilize, and low consumer inflation rate are expected to have on household demand is expected to slow the inflation rate to incomes and consumption in 2015. The new an average of 7.5 percent. In 2017, the inflation baseline scenario also assumes that net exports rate is expected to drop to 5 percent, in line will make a stronger contribution to growth, with the central bank’s medium-term target. since imports are expected to drop further than Russia’s consolidated fiscal balance is projected Table 10: Economic indicators, baseline scenario 2012 2013 2014 2015 2016 2017 Oil price (US$ per barrel, WB average) 105.0 104.0 97.6 53.0 53.0 55.0 GDP growth, percent 3.4 1.3 0.6 -3.8 -0.6 1.5 Consumption growth, percent 6.4 3.9 1.5 -7.5 -1.7 1.0 Gross capital formation growth, percent 3.0 -6.6 -5.7 -15.5 -2.0 6.8 General government balance, percent of GDP 0.4 -1.3 -1.2 -4.3 -2.1 -1.7 Current account (US$ billions) 71.3 34.8 58.4 97.3 90.3 76.5 Current account, percent of GDP 3.6 1.6 3.2 8.1 6.9 5.3 Capital and financial account (US$ billions) -30.9 -45.4 -146.6 -113.0 -82.4 -67.0 Capital and financial account, percent of GDP -1.5 -2.2 -7.8 -9.5 -6.3 -4.6 CPI inflation (average) 5.1 6.8 7.8 15.5 7.5 5.0 Exchange rate, annual average (RUB/US$) 31.1 31.8 38.0 62.3 61.0 58.2 Source: Rosstat, Ministry of Finance, CBR, and World Bank staff estimates. 32 Russia Economic Report | Edition No. 34 II. Economic Outlook to deteriorate from 1.3 percent of GDP in 2014 and 2 percent in 2016, partly driven by inventory to 4.3 percent in 2015. Because the projected destocking (Table 10). reduction in expenditures in 2015 would not compensate for the concurrent decline in Nevertheless, the relative price adjustment could revenues, the government is expected to draw support increased investment in manufacturing down the Reserve Fund substantially. The overall industries that are already competitive in government deficit is projected to decrease in international markets. International sanctions 2016 and 2017 due to an expected significant could also boost domestic production in selected fiscal consolidation. sectors, though increased production at existing capacity levels is most likely over the short-to- Consumption is projected to contract for two medium term. Over the medium term, some consecutive years, dropping by 7.5 percent in productive factors may be reallocated to new 2015 and 1.6 percent in 2016 as real household sectors, assuming that capital costs fall and new incomes decline. While the Russian labor market comparative advantages prove durable. is expected to adjust to lower labor demand predominantly through real wage cuts, double- Low international commodity prices and the digit inflation will reduce household income in impact of sanctions will continue to affect the second half of 2015. Together with a drop Russia’s external accounts. Adjustments in the in real public transfers this is expected to cause current account will continue during the second private consumption to contract by 9 percent in half of 2015. Despite the declining value of 2015. The lingering effects of the sharp decline merchandise exports (due to low commodity in economic activity in 2015 followed by prices) the trade balance is likely to increase stagnating real wages and public transfers as imports continue to fall. The CA will also be in 2016 is expected to further erode real supported by a further improvements in the income, leading to a 1.5 percent contraction investment income and service accounts. As in private consumption. Only in 2017, when a result, the baseline scenario projects that inflation is projected to fall to an average the current account will strengthen in 2015 to of 5 percent, are real incomes expected to US$97.3 billion (8.1 percent of GDP), up from increase modestly, supporting a recovery in US$58.4 billion (3.2 percent of GDP) in 2014. In private consumption and helping to build 2016, a modest acceleration in import growth growth momentum in the economy. in a context of stable exports will cause the current account to deteriorate to US$90.3 billion Investment is projected to continue declining (6.9 percent of GDP). Economic sanctions are throughout 2015 and 2016 due to weak expected to limit roll-over capacity and access consumer demand and policy uncertainty. to external financing among Russia’s major Economic sanctions are expected to further banks and corporations. However, pressure on restrict access to longer-term external capital the capital account should gradually subside as for major Russian investors, especially in the the debt-service profile improves in 2015-2017 resource-sector. Meanwhile, the moderate following the already significant deleveraging of anticipated pace of monetary easing would keep external obligations by the private sector. The the cost of domestic credit high in 2015-1016. expected exchange-rate stabilization would help Tight government budgets and high import prices to curb capital flight and slow the acquisition for investment goods and construction materials of foreign exchange by the general public, suggest that large public infrastructure projects moderating net capital outflows. The capital- may be delayed or scaled down. As a result, the account deficit is projected to decrease from baseline scenario estimates a contraction in US$113 billion in 2015 to US$82.4 billion in 2016 gross capital formation of 15.5 percent in 2015 and US$67 billion in 2017. Russia Economic Report | Edition No. 34 33 II. Economic Outlook The Lower-Bound Scenario The lower-bound scenario projects a more T severe deterioration in the fiscal position he lower-bound scenario, in which oil prices than in the baseline but also a more stable fall well below the baseline projection, current account. The loss of export revenue estimates that GDP could contract by as much as would be offset by a steep drop in imports as 4.3 percent in 2015 and by another 2.8 percent the ruble continued to depreciate. This would in 2016. This scenario assumes that oil prices strengthen the current account slightly relative will continue to drop in the second half of 2015, to the baseline. No significant changes in averaging US$43 in the latter six months. This capital outflows are expected in 2015 due to would yield an overall average of US$50 per barrel the same underlying assumptions of continued in 2015, which would slide further to an average international sanctions and weak private-sector of US$40 per barrel in 2016 and 2017. Falling oil confidence. In 2016 the continued decline in oil prices would cause a sharper contraction in both prices and a sharper economic contraction would consumption and investment than predicted keep the cost of external financing elevated in the baseline, resulting in significantly worse and further limit the debt-rollover capacity growth outcomes in 2015 and 2016. The ruble of the private sector. This would result in a would continue to depreciate moderately in somewhat higher capital-account deficit than in response to lower oil prices. Elevated inflationary the baseline. On the fiscal side, the continuing expectations would accelerate the erosion of real depreciating of the ruble would only partially incomes and increase interest rates on consumer compensate for the loss of oil revenue and the and commercial credit. As a result consumption fiscal impact of slowing economic activity. No would contract by 8.4 percent in 2015 and major changes in the level or composition of by 3.8 percent in 2016 (Table 11). In 2015 and public spending are expected in the lower-bound 2016 both private and public investment would scenario, because the government is assumed to contract more sharply than in the baseline due keep real spending close to the baseline level. As to more expensive imported investment goods, a result, the general government deficit would higher credit costs and lower consumer demand. amount to 4.3 percent of GDP in 2015 and 3.2 percent in 2016. Larger deficits are expected to be financed by a more rapid drawdown of the Reserve Fund combined with an increase in external borrowing. Table 11: Economic indicators, lower-bound scenario 2012 2013 2014 2015 2016 2017 Oil price (US$ per barrel, WB average) 105.0 104.0 97.6 50.0 40.0 40.0 GDP growth, percent 3.4 1.3 0.6 -4.3 -2.8 0.0 Consumption growth, percent 6.4 3.9 1.5 -8.4 -3.8 -1.8 Gross capital formation growth, percent 3.0 -6.6 -5.7 -20.6 -5.1 3.2 General government balance, percent of GDP 0.4 -1.3 -1.2 -4.6 -4.0 -2.9 Current account (US$ billions) 71.3 34.8 58.4 97.8 97.7 90.3 Current account, percent of GDP 3.6 1.6 3.2 8.3 8.5 7.1 Capital and financial accounts (US$ billions) -30.9 -45.4 -146.6 -112.9 -99.4 -92.1 Capital and financial accounts, percent of GDP -1.5 -2.2 -7.8 -9.6 -8.6 -7.2 CPI inflation (average) 5.1 6.8 7.8 15.8 8.0 5.0 Exchange rate, annual average (RUB/US$) 31.1 31.8 38.0 63.0 67.1 63.8 Source: Rosstat, MoF, CBR and World Bank staff estimates. 34 Russia Economic Report | Edition No. 34 II. Economic Outlook The Upper-Bound Scenario In the upper-bound scenario, Russia’s fiscal I position will strengthen, and its external n the upper-bound scenario, real GDP would balances will slightly improve. The positive fiscal contract by 3.1 percent in 2015, followed by impact of higher oil prices would be augmented 1.3 percent growth in 2016 and 1.7 percent by rising nonoil tax revenue as the economic growth in 2017. As in the lower-bound scenario, recovery accelerated. No major changes in these growth projections are primarily driven by spending are expected in 2015, as oil prices would oil prices, which in this case are expected to rise be only modestly above the budget’s current to US$58 per barrel in 2015, US$63 per barrel reference price, and a fiscal consolidation effort in 2016 and US$67 per barrel in 2017. Higher oil would still be required. Thus the same 5 percent prices are expected to have a positive spillover cut in real expenditures is assumed in 2015. effect on economic activity. As oil prices rise However, in 2016-2017, higher revenue than in from the second half of 2015 through 2017 the the baseline and the upcoming parliamentary ruble is expected to strengthen, which would election could motivate the government ease inflationary expectations. Inflation would to lessen consolidation efforts and support average 7.0 percent in 2016 before falling to economic recovery both in 2016 and 2017. As the central bank target of 5 percent in 2017. borrowing costs would decline in this scenario, This would improve real wage and income large public infrastructure projects would be dynamics and allow the central bank to cut the expected to accelerate relative to the baseline policy rate more aggressively to support credit and the cut in real expenditures may be less than growth. Continued improvements in terms-of- in the baseline. As a result, the projected deficit trade would also increase the purchasing power will be 3.2 percent in 2016 and 2.9 percent in of households. In the upper-bound scenario, 2017, about one percentage points higher than consumption would contract by only 7.0 percent in the baseline for both years. The current in 2015 and then become positive in 2016 and account would be somewhat weaker than in 2017 (Table 12). In 2015, gross capital formation the baseline scenario, both in 2015 and 2016, would contract by 14.7 percent, compared with as rising imports would more than offset the 15.5 percent in the baseline. In 2016 investment positive impact of higher oil prices on the trade demand would grow for the first time since 2012 balance. With flexible exchange system in place, supported by lower interest rates and higher oil flows on capital account are expected to largely prices. Nevertheless, investment would recover mirror the current account changes. Despite the slowly in 2016 due to continued sanctions. The continued imposition of international sanctions fiscal position would improve with higher oil higher oil prices would moderately improve prices and the government is likely to slightly bank and corporate debt roll-over capacity. The support an investment recovery through public capital-account deficit would narrow slightly infrastructure projects towards the end of 2016 compared to the baseline, with net capital and in 2017. outflows falling to 2013 levels by 2017. Russia Economic Report | Edition No. 34 35 II. Economic Outlook Table 12: Economic indicators, upper-bound oil scenario 2012 2013 2014 2015 2016 2017 Oil price (US$ per barrel, WB average) 105.0 104.0 97.6 58.0 63.6 67.1 GDP growth, percent 3.4 1.3 0.6 -3.2 1.3 1.7 Consumption growth, percent 6.4 3.9 1.5 -7.0 2.1 2.8 Gross capital formation growth, percent 3.0 -6.6 -5.7 -14.7 3.5 5.6 General government balance, percent of GDP 0.4 -1.3 -1.2 -4.5 -3.2 -2.9 Current account (US$ billions) 71.3 34.8 58.4 81.9 68.9 50.8 Current account, percent of GDP 3.6 1.6 3.2 6.3 4.4 2.8 Capital and financial account (US$ billions) -30.9 -45.4 -146.6 -92.5 -72.5 -42.5 Capital and financial account, percent of GDP -1.5 -2.2 -7.8 -7.1 -4.7 -2.3 CPI inflation (average) 5.1 6.8 7.8 15.2 7.0 5.0 Exchange rate, annual average (RUB/US$) 31.1 31.8 38.0 58.0 63.6 67.1 Source: Rosstat, MinFin, CBR and World Bank staff estimates. 2.2 Risks and Policy Challenges Russia faces significant external macroeconomic risks, including an uncertain global growth outlook and volatile oil prices. Russia’s medium-term growth trajectory will hinge on its successful adjustment to this new economic environment and the resolution of lingering risks to financial stability and fiscal sustainability. O verall risks to the global outlook remain tilted to the downside. Some previous concerns, such as the threat of deflation in the Emerging economies, including Russia, continue to endure significant financial and exchange- rate pressures. Recent stock market adjustments euro zone, have abated, yet new financial stability and currency depreciation, combined with and growth risks have emerged. Deteriorating the renewed strength of the US dollar and the economic prospects in some developing persistent weakness of commodity prices, economies, especially commodity exporters, have sparked a sharp selloff in emerging- are eroding their resilience. Uncertainty in market currencies and equities and put upward developing countries and a slowdown in major pressure on borrowing costs. Although recent emerging markets is increasing global financial disruptions were mostly concentrated in equity pressures, which are already elevated due to the and currency markets, borrowing costs also rose anticipated normalization of US monetary policy. in emerging economies due to a general increase In addition, the broad-based appreciation of the in risk aversion, with the Emerging Market Bond US dollar could slow the US economic recovery Index spread rising by 50 basis points since end- to a greater extent than currently expected. July. Significant outflows from emerging-market Further volatility in global commodity prices equity funds continued through August, though accompanied by a slowing US economy could bond outflows were more measured. severely disrupt international financial markets and derail growth in developing countries and A high degree of oil-price volatility significantly emerging economies. However, the growth increases the uncertainty of global energy benefits generated by lower oil and nonoil market forecasts. In addition to the standard commodity prices could also prove stronger than array of supply- and demand-side variables, OPEC current projections indicate. policies represent a major source of exogenous 36 Russia Economic Report | Edition No. 34 II. Economic Outlook risk. Persistently low global oil prices have been liabilities continue to rise relative to both the stock driven in part by OPEC’s November 2014 decision of liquid assets and the real earnings potential not to engage in supply management. Since of those assets. Deteriorating asset values make then, OPEC officials have repeatedly stated that banks more vulnerable to funding shortfalls, the cartel will maintain this policy even if prices especially smaller banks. Liquidity support from fall to US$20 per barrel. The next OPEC meeting the central bank and the collateral requirements will take place on December 4. for central bank loans could expose the declining market value of assets on bank balance sheets. In an uncertain global economic context, Russia’s banking sector remains overcrowded, Russia must maintain policy flexibility while with around 730 registered banks, and it is likely continuing to pursue policies that will facilitate that some smaller institutions may need to be its macroeconomic adjustment to a new removed from the market. The central bank’s external environment. Financial sector stability current liquidity-support measures have avoided and fiscal sustainability risks remain especially a banking crisis, but solvency margins are prominent. Adhering to inflation targeting within thinning and banks are becoming unprofitable. a flexible exchange-rate regime will continue to To maintain the viability of the sector liquidity allow for timely monetary adjustments to shore measures should be accompanied by a medium- up external balances and maintain adequate to-long-term sector restructuring plan designed international reserves. to ensure that banks successfully rebuild their capital assets (Box 14). Russia’s financial sector remains in a state of heightened vulnerability, which is negatively Risks to fiscal sustainability are rising as existing impacting investment. Financial sector buffers deteriorate and oil-price projections authorities will need to continue earmarking remain low. This issue has already become resources to support Russia’s systemically apparent in the current budget cycle, and the important banks. While many of Russia’s largest government has adjusted its proposed 2016 banks are state-owned or state-controlled, budget to reflect lower anticipated oil prices. sectoral support must be impartially selective, The revenue uncertainty resulting from volatile as the government’s resources would not be oil prices makes medium-term budget planning sufficient to support the entire financial system difficult, and policymakers are currently in the event of a major disruption. The central attempting to shorten the budget horizon to one bank’s efforts notwithstanding, high interest year. Improvements in expenditure efficiency rates continue to exert upward pressure on could help the government maximize the value of funding costs, while credit levels are decline and its existing resources, but such gains may not be defaults are increasing. This threatens to create enough to compensate for increasing structural a vicious cycle in which a shortage of investment imbalances. Going forward the government will credit increases lending rates, which in turn need to develop a policy framework for long- tighten credit constraints and further discourage term expenditure management, complete with a investment. corresponding financing strategy. Government and central bank policies Rising fiscal pressures warrant a comprehensive implemented as part of the anti-crisis plan review of expenditure priorities—including are providing short-term relief to banks, yet major expenditure items such as national these measures are also keeping systemic defense, economic subsidies, and social risks elevated, and additional financial-market programs and pensions—as well as a renewed restructuring measures are warranted. Bank discussion of external borrowing limits. The Russia Economic Report | Edition No. 34 37 II. Economic Outlook Box 14 Financial market restructuring options Certain recent banking crises have been marked by liquidity shortages that eventually caused bank failures even while underlying solvency positions remained satisfactory; the Russian situation, however, is essentially the reverse. The central bank and the government are providing ample liquidity support (while closing small unviable banks) and allowing banks to trade foreign exchange at favorable ruble rates. Russia has also set up its own internal version of the international SWIFT payment system. While these are important short-term stabilization measures they do not address underlying solvency issues, since the deterioration of asset values (due to lower lending rates, rising NPLs and diminished collateral value such as for real estate) will eventually erode statutory solvency margins. The central bank is currently exercising regulatory forbearance by not requiring that banks immediately recognize asset losses and the consequent decline in their solvency margins. However, without assets-generating returns bank profitability will eventually become negative, as indeed has already happened in some banks, as a rising stock of nonperforming assets will drain bank resources. Three policy options can help to address this problem and restore the long-term health of the banking sector. These can be implemented individually or jointly by the central bank and the government: (i) Launch a bank-strengthening program under which a portion of the income earned by banks is allocated to loan- loss reserves for the next five years; this will prepare banks to write-off fully nonperforming assets and maintain sound balance sheets. (ii) Contract asset-management companies to transfer and manage bad loans from the sector, enabling them to earn fees for collecting on bad loans, which could be temporarily replaced on bank balance sheets with long term bonds. Such a scheme would need to be designed based on the probable receipt of sufficient returns on bad assets to pay for asset-management fees and cover at least some of the interest payable on the bonds, which can initially be low-yield and with advances provided by the government. (iii) Based their progress under the above programs during a period of at least two years the central bank should begin closing banks that are still considered unviable and insolvent, though creditors would suffer losses during liquidation. fiscal rule should be refined to enable more term, facilitating structural change will be rapid adjustments in the face of changing oil especially critical as Russia will strive to cope prices. Prudent management of fiscal buffers with a simultaneous demographic and economic will absolutely essential, including measures to transformation driven by a rapidly aging and increase transparency in investment decisions. shrinking population and by the diminishing Strengthening public investment management relative importance of the natural resource would help to ensure that scarce capital sector (see Part III). Successfully addressing these resources generate adequate long-run returns. challenges will require a combination of fiscal discipline, regulatory restraint and institutional The transformation process that began with the capacity building while resisting pressure to recent macroeconomic adjustment presents a adopt policies that may temporarily mitigate set of risks, and managing them will pose a key the disruptive effects of the adjustment at the policy challenge over the medium term. Russian expense of the country’s long-term growth. policymakers are confronted with complex Consequently, political-economy risks present a challenges posed by the short-term economic serious threat to Russia’s economic outlook. adjustment to external changes coupled with major internal long-term shifts in its society and In the short-term, reforms that promote the economy. In the short-to-medium term, Russia’s reallocation of productive factors would enable changing external environment will continue the private sector to take full advantage of to alter the internal structure of its economy, the opportunities generated by the recent and while adapting to relative price changes change in relative prices, potentially leading to and the reallocation of productive factors to a broad improvement in Russia’s international new sectors is a difficult process, policies that competitiveness. Achieving this goal will require facilitate Russia’s economic transformation a further retrenchment of the public sector’s could have lasting positive effects. In the long- economic role and a shift in focus toward 38 Russia Economic Report | Edition No. 34 II. Economic Outlook providing highly effective regulatory institutions number of serious short-term challenges, given that foster robust competition. Strong signals an appropriately supportive policy environment indicating the government’s commitment to Russia’s current macroeconomic transformation regulatory discipline and to policies that facilitate could substantially enhance its medium-term the process of macroeconomic adjustment growth potential. However, without deep and would speed the recovery of private-sector sustained structural reforms Russia will remain confidence and promote investment despite at serious risk of falling into a medium-term tight financial conditions. Though it poses a low-growth trap. Russia Economic Report | Edition No. 34 39 PART III Russia’s Dual Transformation: The Fiscal Implications of an Aging Population and the Diminishing Economic Role of the Natural Resource Sector 14 T he Russian Federation is undergoing a major demographic and economic transformation driven by a rapidly aging population and by the diminishing economic importance of the natural resource sector. Russia’s total population will shrink by an estimated 2 million people by 2050. At the same time, the old-age dependency ratio will increase by more than 50 percent, from 0.4 retirees per active worker to about 0.64. Meanwhile, the total output of the oil and gas sectors will remain broadly stable, and as productivity in other economic sectors continues to grow, the role of natural resources will diminish significantly in the decades to come. These trends will have important macroeconomic and fiscal implications, as the changing size and composition of both the population and the real economy will directly and indirectly impact the public finances. A narrowing base for income tax collection and pension contributions will limit revenue inflows, while the government’s social-policy commitments will intensify expenditure pressures. An aging population can shift the demand for the provision of public services in healthcare, long term care, and education, as well as changing the size of transfers through the pension system. 14 This note was prepared by Birgit Hansl based on a report by Harun Onder and Fernando Hernandez titled “Fiscal Implications of Aging and Natural Resource Dynamics.” The original report was part of a suite of papers prepared for the World Bank’s Aging Research Project for the Russian Federation under the guidance of Birgit Hansl. The team would like to thank Lalita Moorty, Philip O’Keefe, Emilia Skrok, Sonia Plaza, Harun Dogo, Maurizio Bussolo, Sergei Ulatov, Mikhail Matystin, Victoria Levin, Oleksiy Sluchinskyy, and all those who participated at the Higher School of Economics Conference, which yielded useful comments and discussions. The team would also like to thank Olga Emelyanova, Alexiy Balaev, and Maria Kazakova for providing data used in this analysis. Russia Economic Report | Edition No. 34 41 III. Russia’s Dual Transformation 3.1 The Demographic Challenge D emographic changes are transforming the Russian Federation. Russia’s population peaked at about 149 million people in 1990, A simultaneously shrinking and aging population can depress economic growth by reducing the size of the labor force. Meanwhile, the just prior to the dissolution of the Soviet Union, evolution of the capital stock would depend but by 2008 it had shrunk to about 142 million. on country-specific factors that affect savings In 2010, the population stabilized and slightly decisions.15 The net effect on production would rebounded, reaching an estimated 143.5 million be determined by the magnitude of these two in 2013 (Figure 49A). However, this trend is changes. Demographic trends will also affect not expected to continue over the long term. the public finances, both directly and through According to the baseline projections of the their influence on the real economy. On the Russian Statistical Office (Rosstat), the country’s revenue side, a smaller, older population will total population will gradually decrease by about narrow the base for tax collection and social 2 million, reaching 141 million by 2050. Rosstat’s security contributions. On the expenditure alternative scenarios anticipate that by 2050 the side, the policy commitments involved in caring total population could be as low as 116 million or for Russia’s aging population, as well as the as high as 165 million. The United Nations (UN) shifting demands of the population itself, will Population Division projects a more conservative intensify spending pressures in the health and baseline scenario, roughly corresponding to the education sectors, while profoundly altering the low-end Rosstat forecast, and the UN’s high- composition of social security transfers. end scenario is similar to Rosstat’s baseline. Moreover, the decline in the total population As Russia’s demographics continue to evolve, is expected to be accompanied by a substantial ensuring the sustainability of the fiscal balances increase in the relative share of the elderly will become an increasingly complex yet crucial population (Figure 49B). task. The Russian government’s ability to manage long-term structural changes in revenue These projected changes in the size and and expenditure dynamics will determine the composition of the Russian population have extent to which it can provide the public goods potentially serious economic implications. and services required by an aging society. Figure 49: Population dynamics in the Russian Federation, 1970–2050 A. Total Population B. Age Composition (Baseline) Millions Percent 170 100 90 160 80 150 70 140 60 50 130 40 120 30 20 110 10 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 0 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Population Low Variant High Variant Young Age Working Age Old Age Source: UN Population Division (historical) and Rosstat (projections). 15 Dedry, Onder and Pestieau (2014). 42 Russia Economic Report | Edition No. 34 III. Russia’s Dual Transformation Anticipating the impact of demographic trends scenario in which the government implements on the fiscal balances can inform timely policy measures to boost labor-force participation. decisions and help avoid potential solvency problems. In this context the following section The analysis devotes special attention to presents a projection model designed to quantify the natural resource sector, which is always the macro-fiscal impact of Russia’s changing a major factor in macroeconomic and fiscal demographics over the next four decades. The projections for Russia. While the resource analysis combines projected trends in: (i) the sector’s output is expected to remain broadly population and the labor force, (ii) the real stable over the medium term, the sector’s economy, including the natural resource sector, share of GDP is expected to shrink over time (iii) fiscal revenues, with specific attention to due to productivity growth in the non-resource the fiscal rule governing resource revenues, and economy. This trend could magnify the fiscal (iv) public spending, particularly age-related implications of demographic change. Other expenditures such as education, healthcare and resource-rich countries have successfully social security. As many underlying factors are leveraged their resource sectors to finance the difficult to project with precision, the analysis liabilities generated by an aging population (see employs a scenario approach that reflects a Box 15). However, while Russia’s resource sector wide range of possibilities for multiple drivers is expected to help ease fiscal pressures early in of macroeconomic and fiscal outcomes. These the projection period, its diminishing economic include lower-, middle- and upper-bound importance and the increasing costs of an scenarios for demographic trends, oil prices and aging population limit its ability to sustain fiscal labor-productivity growth, as well as a policy equilibrium through the projection horizon. 3.2 The Growth Implications of Demographic Trends A n aging population has an ambiguous effect on per capita output, which complicates economic forecasting in Russia.16 The three expected to decline from about 75 million in 2014 to about 64 million by 2050 (Figure 50A). In the low-end population scenario, the labor most important and uncertain components of force plummets to 55 million, whereas in the Russia’s GDP are (i) the size of the labor force, high-end scenario it diminishes modestly to 72 (ii) the marginal productivity of labor, and (iii) million.18 Other simulations explore the potential natural resource prices, in particular oil prices. impact of government policies designed to The simulations presented below draw on increase labor-force participation (LFP).19 In labor-force estimates by Balaev et al.17 In the the baseline scenario, these policies add about baseline forecast, the size of the labor force is 4 million participants to the labor force by 16 A decline in fertility reduces the number of workers and increases the inactive population relative to the workers (the dependency rate). Other things being equal, this could reduce per capita output. However, since a decline in fertility does not immediately affect worker’s incentives to save (unless institutional factors like a specific type of Pay-As-You-Go (PAYG) social security system create such incentives), there are fewer workers, and each worker has access to more capital, so that labor productivity, and perhaps per capita output, rises. Similarly, an increase in longevity increases the number of inactive people, which alone would reduce per capita output. However, those who expect to live longer are likely to increase their savings to support consumption over a longer lifetime. These adjustments will increase the capital stock, thus increasing labor productivity, and moderate the decline in the number of workers, seeing the output per capita increase. Institutional factors will determine how aging affects the real economy in net terms. For example, a defined contribution pension system heightens incentives to save, which may increase capital per worker and therefore per capita output, while a defined benefit system would achieve the opposite, see Dedry, Onder, and Pestieau (2014) for a formal discussion on this. 17 Balaev, A.; Ivanova, M.; Prilepskiy, I. and Ulatov S. (2015). “The Demographic Transition and Long-Term Growth.” World Bank Aging Research Project for the Russian Federation. Washington DC: The World Bank. 18 This employment forecast assumes that the 5 percent unemployment rate observed in 2013 reflected an economy at full capacity (IMF 2013), so in this scenario that rate is extended through the projection horizon. 19 These include supporting youth employment through internships and vocational training, strengthening regulations regarding the employment of disabled persons, and stepping-up measures to encourage female participation in the labor force by expanding access to childcare and elder care (Balaev et.al. 2015). Russia Economic Report | Edition No. 34 43 III. Russia’s Dual Transformation 2050 (Figure 50B). Uncertainty is also a major • The optimistic scenario uses upper-bound factor in labor-productivity growth projections, forecasts for demographic variables, the and three scenarios based on the data series size of the labor force, labor productivity, developed by Balaev et al. simulate changes in and oil and gas prices; government policies output per worker in the non-resource sector successfully boost LFP. (Figure 50C). Finally, a set of simulations explores • The pessimistic scenario uses lower-bound the potential impact of developments in the forecasts for demographic variables, the size natural resource sector. Projecting oil and gas of the labor force, labor productivity, and prices is notoriously difficult, as they reflect oil and gas prices; no government policies a constellation of unpredictable supply- and boost LFP.21 demand-side variables. However, the resource sector is largely unaffected by aging, as it is These simulations indicate that GDP growth extremely capital intensive and employs only a will slow gradually over time, and that changes small share of the labor force. The projections in labor productivity and labor-market policies presented below assume that oil production will may have a greater impact on GDP growth than gradually decrease from 520 million tons in 2014 oil prices. In the baseline scenario the annual to 436 million tons in 2050 (Figure 50D). In the nonoil GDP growth rate rises to 2.3 percent in baseline scenario, oil prices stabilize at around 2018 and then moderates to 1.6 percent over the US$100 per barrel (in constant 2014 US$), while long term, as a slight increase in labor productivity in the low-end scenario they fall to US$69 per fails to offset a substantial decline in the size of barrel (Figure 50E).20 the labor force (Figure 50).22 In the optimistic scenario long-term annual GDP growth averages Overall projections for Russia’s GDP are based about 2.7 percent, while in the pessimistic on three aggregate scenarios. The analysis scenario growth averages just 0.4 percent. includes three scenarios for demographic trends, Using the baseline scenario as the reference three scenarios for labor productivity, three point enables an assessment of each variable’s commodity-price projections, and two labor- individual impact on GDP.23 The differences policy scenarios. All together, these variables between high-end, low-end, and baseline yield a total of 54 alternative GDP forecasts. assumptions for the growth of labor productivity Since it is not feasible to discuss all 54 potential and the size of the labor force widen over time, outcomes individually, and in order to avoid and their impact on GDP is more pronounced in arbitrary mapping between different variables, the later years of the simulation period (Table the analysis consolidates these alternatives into 13). By contrast, the effects of oil and gas prices an aggregate baseline scenario, an optimistic on GDP diminish over time, because the relative scenario and a pessimistic scenario. These are economic size of the resource sector gradually defined as follows: shrinks as the non-resource sectors grow. Finally, • The baseline scenario uses median forecasts policies that encourage greater LFP are effective for demographic variables, the size of the at boosting GDP. By 2050 the projected increase labor force, labor productivity, and oil and gas in the labor force increases GDP by about 6 prices; no government policies increase LFP. percentage points over the baseline scenario, exceeding the positive effect of higher oil prices. 20 The short-term projections for oil prices and other variables are different in this part from the rest of the document report as the underlying research was finalized in 2014. 21 It should be noted that a low-end demographic scenario could increase per capita income, since the old-age dependency ratio is greatest in the high-end demography scenario. 22 A recent study by the Gaidar Institute (Goryunov et al. 2013) presents a similar projection. 23 For example, starting from the baseline it is possible to make projections using the high-end labor productivity scenario while keeping all others variables at their baseline levels. The resulting GDP projections can then be compared to the baseline scenario in terms of values and percentage deviations. 44 Russia Economic Report | Edition No. 34 III. Russia’s Dual Transformation Table 13: Marginal effects of labor productivity, oil prices, and labor policies on baseline GDP Labor Productivity Effects Oil Price Effects Labor Policy Effects High End Low End High End Low End Medium Policy (USD, billions) 2020 45.9 -58.8 43.1 -40.6 39.3 2030 132.4 -132.5 32.0 -64.6 103.7 2040 281.5 -262.1 34.4 -69.4 148.3 2050 481.2 -445.5 33.7 -68.1 216.7 (Percent of current GDP) 2020 2.1 -2.6 1.9 -1.8 1.8 2030 5.0 -5.0 1.2 -2.4 3.9 2040 9.0 -8.4 1.1 -2.2 4.7 2050 13.3 -12.3 0.9 -1.9 6.0 Source: World Bank staff calculations. Figure 50: Baseline trajectories and projection boundaries A. Labor Force B. Labor Force with Labor Policy 80 85 75 80 70 75 Millions Millions 65 70 60 65 55 60 50 55 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Population Low Variant High Variant Baseline Population Low Variant High Variant C. Labor Productivity Growth in Non-Resource Sectors D. Hydrocarbon Production 4.0 900 Mln Tonnes (Oil), or Bln Cubic Meters (Gas) 3.5 800 3.0 700 2.5 Percent 2.0 600 1.5 500 1.0 400 0.5 300 0 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 2044 2046 2048 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Growth Low Variant High Variant Gas Oil E. Oil Prices F. Non-Oil GDP Growth 140 4.0 130 120 3.0 110 Percent 100 2.0 USD 90 80 1.0 70 60 0 50 40 -1.0 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Price Optimistic Price Pessimistic Price Baseline Pessimistic Boundary Optimistic Boundary Sources: Rosstat, IMF and World Bank staff calculations. Russia Economic Report | Edition No. 34 45 III. Russia’s Dual Transformation 3.3 The Fiscal Implications of Russia’s Aging Population A n aging population can profoundly affect the size and composition of both revenues and expenditures. Aging directly alters the demand windfall gains to the government and have little direct impact on private disposable income if not injected back into the economy through fiscal for public goods and services by increasing the programs. By contrast, rising wages driven by total number of beneficiaries and by shifting increasing labor productivity boost both public the focus of service provision. For example, a revenues and private income, and as noted above, rising number of elderly people will, ceteris private income growth will intensify demand for paribus, lead to both a general increase in public public goods and services. Finally, because they spending and a specific increase in demand for directly affect only a small subset of economic healthcare and pensions. Conversely, a decline activities, resource-related taxes and royalties in the share of young people will prompt a have a limited impact on demand for public relative decrease in education spending. Public services. Over time, the growing fiscal importance spending responds to age-related changes in of taxes on the non-resource economy may demand because governments have explicit further increase expenditure pressures. and implicit commitments to provide public education, pensions, healthcare and other social Revenue Projections F services. Aging also affects revenues. Taxes and iscal revenues from the non-resource social security contributions are largely tied to sectors are expected to rise over time. The individual income, and changing demographics simulations presented here assume that non- can influence the size of the revenue base and resource revenues will increase more rapidly than alter the sources of tax revenue. For example, non-resource GDP, i.e. that the income elasticity an increase in the share of retirees may reduce of revenues is greater than 1. This assumption income tax revenue relative to VAT, capital gains, is based on several observations. First, in a inheritance or other taxes. Aging also affects progressive tax system rising incomes typically the nature of the real economy, with indirect generate an especially large increase in revenue implications for revenues and expenditures. from higher marginal tax brackets. Second, rising For example, if an upward shift in the median income levels prompt consumers to spend more age is associated the sustained growth of per capita GDP (as in the familiar “demographic on normal and superior goods, which are usually transition” phenomenon), rising income levels subject to higher tax rates than inferior goods. will compound the increase in demand for Third, more effective tax-collection mechanisms healthcare services generated by the aging of and policies to curb informality, both of which the population. Similarly, rising real wages can are associated with higher per capita income indirectly increase social security spending by levels, will further boost tax revenues. Fourth, raising expectations for retirement income. individual social security contributions grow proportionately with per capita income, though An analysis of Russia’s long-term fiscal in the aggregate they are also affected by the prospects must also consider the evolution of number of workers. Due to these factors, in the natural resource revenues. Natural resources baseline scenario non-resource fiscal revenues accounted for one-third of total public revenues increase from about 28 percent of non-resource in 2014. However, this share is likely to fall over GDP in 2014 to 32 percent by 2050. Fiscal time, as resource output is expected to remain revenues reach 30 percent of non-resource GDP stable while productivity steadily rises in the in the pessimistic scenario and 36 percent in the non-resource economy. Resource revenues are optimistic one (Figure 51A). 46 Russia Economic Report | Edition No. 34 III. Russia’s Dual Transformation Figure 51: Baseline revenue trajectories and projection boundaries A. Non-Resource Revenues B. Decomposition of Tax revenues Revenues/GDP (%) Percent of GDP 37 100 90 35 80 70 33 60 50 40 31 30 20 29 10 0 27 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Pessimistic Boundary Optimistic Boundary Direct Taxes Indirect Taxes Non-Tax Revenues Oil Revenue Transfers Grants Sources: Rosstat, IMF and World Bank staff calculations. The share of natural resource revenues in increase in non-resource GDP.24 Overall, primary total fiscal revenues is projected to decline. In expenditures in all categories are expected to the baseline scenario natural resource output rise. By 2050, noninterest government spending rises only slightly, as an expected increase in increases from 36.7 percent of GDP in 2014 to natural gas production is offset by a drop in oil 37.8 percent in the baseline scenario, or to 42.3 production and the stabilization of oil prices. percent in the pessimistic scenario, though it As a result, the net increase in natural resource drops to 32.8 percent in the optimistic scenario revenues fails to keep pace with the growth (Figure 52E). Age-related spending rises in the of non-resource revenues, and the share of baseline scenario from about 32 percent of resource revenues in total fiscal revenues total expenditures in 2014 to 49 percent in 2050 decreases from about 30 percent in 2014 to 14 (Figure 52). Education remains stable as a share percent by 2050 (Figure 51B). of total spending, but the shares of healthcare spending and social security transfers rise by 3 Expenditure Projections and 14 percentage points, respectively. A combination of rising non-resource GDP and an aging population will significantly alter expenditure patterns over time. In the baseline Public spending on education is projected to increase modestly in absolute terms, while scenario, spending on categories that are not healthcare spending would rise more rapidly. affected by demographics is expected to decline The projected increase in GDP is expected to from 24.6 percent of GDP in 2014 to 19.5 percent boost education expenditures (as richer citizens by 2050 (Figure 52A). This pattern is based on typically demand better education quality), the assumption that while public investments though the number of young people would often entail large initial costs, these costs do remain stable at around 23-26 million.25 In the not necessarily grow in line with GDP. Age- baseline scenario, public education spending related spending categories such as education, increases from about 4.1 percent of GDP in 2014 healthcare and social security are affected both by to 4.3 percent in 2050 (Figure 52B). Education the aging of the population and by the projected expenditures in the optimistic scenario begin 24 There is no empirical consensus regarding the size of income elasticities of demand for public services. Cross-country evidence usually suggests income elasticities above 1 for health care spending: Newhouse (1977) found an elasticity of 1.35 for 30 OECD countries and Leu (1986) found 1.2 for 19 OECD countries. A study by the European Commission (2012) used 1.3 to project healthcare expenditures. The simulations in this chapter use 1.2. 25 The number of young people does not decline significantly because the baseline scenario assumes that the fertility rate rebounds from 1.6 percent in 2020 to 1.9 in 2050. Education spending may also rise in response to changing policy priorities. Russia Economic Report | Edition No. 34 47 III. Russia’s Dual Transformation to exceed those in the pessimistic scenario in Financing the pension system’s increasing 2026, and the gap continues to rise through deficit is expected to drive a large expansion the end of the forecast period.26 Population in age-related public spending.28 All three aging is expected to increase the share of health scenarios predict that by 2050 the pension expenditures in total spending, as older people fund’s deficit will double, rising from about 4 typically require more healthcare, including percent to 8 percent of GDP or more (Figure more expensive forms of long-term care.27 52D).29 The different deficit trajectories reflect Meanwhile, rising per capita income levels are the interaction between GDP growth and old- expected to compound the increasing demand age dependency ratios. The optimistic scenario for healthcare generated by an aging population. incorporates both the highest GDP growth rate As a result, public healthcare spending climbs and the highest old-age dependency ratio. In from about 3.9 percent of GDP in 2014 to about 5 the 2030s, these two factors expand the deficit percent by 2050 in the baseline scenario (Figure to a much greater extent than in the pessimistic 52C). Health spending reaches similar levels in scenario. By 2050, however, the impact of GDP the pessimistic (5.3 percent) and optimistic (4.7 growth dominates, and the optimistic scenario percent) scenarios. projects the lowest pension fund deficit as a share of GDP. Figure 52: Baseline trajectories and projection boundaries: primary expenditure A. Non-Age related Expenditures B. Public Education Expenditures 27 4.8 24 Percent of GDP Percent of GDP 4.4 21 4.0 18 15 3.6 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Pessimistic Boundary Baseline Pessimistic Boundary Optimistic Boundary C. Public Healthcare Expenditures D. Transfers to Pension Fund 5.4 10.0 9.0 5.0 8.0 Percent of GDP Percent of GDP 7.0 4.6 6.0 5.0 4.2 4.0 3.8 3.0 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Pessimistic Boundary Optimistic Boundary Baseline Pessimistic Boundary Sources: Rosstat, IMF and World Bank staff calculations. 26 Over the first decade of the forecast period, the non-resource sector’s share of GDP is greater in the pessimistic scenario, and education spending is also higher. Over time, the higher fertility rates in the optimistic scenario increase the number of young people, which boosts education spending. 27 The projected fiscal burden can vary significantly depending on the methodology used. The demographic approach assumes costs to track only changes in income and the number of people in different cohorts, while other studies indicate that healthcare costs mainly reflect proximity to death rather than nominal age. Therefore, increasing longevity may not necessarily drive up health care costs. Healthcare costs may also be affected by advances in medical technology. New treatment options could boost per capita health expenditures faster than income growth. 28 Russia has recently reformed its social security system, and these projections may vary if the new system parameters are used. 29 This demography approach holds worker contributions and recipient benefits constant as a share of per capita income. Different assumptions for economic growth and social security system characteristics can alter the simulations. For instance, a 2013 World Bank study using a more optimistic growth outlook found that Russia’s social security deficits could be held to low single digits if the average benefit of all current recipients were capped at half the average wage by 2050. 48 Russia Economic Report | Edition No. 34 III. Russia’s Dual Transformation Figure 52: Baseline trajectories and projection boundaries: primary expenditure (continued) E. Primary Expenditures F. Primary Expenditure Decomposition 44 100 (Baseline) 90 Percent of Primary Expenditures 42 80 70 Percent of GDP 40 60 38 50 40 36 30 20 34 10 32 0 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Other Expenditures Health Care Expenditures Baseline Pessimistic Boundary Optimistic Boundary Education Expenditures Transfers to the Pension Fund Sources: Rosstat, IMF and World Bank staff calculations. Fiscal Sustainability of various assumptions on the debt-to-GDP ratio E conomic and demographic changes are is measured using the baseline scenario as the projected to generate protracted fiscal reference point and changing the assumptions deficits over the coming decades. In the baseline for labor productivity, labor market policies and simulations the primary deficit widens to 3 oil prices. Switching from the baseline projection percent of GDP (Figure 53A). In the optimistic to the high-end projection for labor productivity scenario the deficit climbs to 1.1 percent of would reduce the debt-to-GDP ratio by 16.8 GDP in the medium-term but then gradually percentage points. Using the high-end projection narrows, ultimately becoming a surplus in the for labor-market policies would reduce the second half of the projection period. By contrast, ratio by 24.9 percentage points, and using the in the pessimistic scenario the primary deficit high-end projection for oil prices would cut rapidly widens to 6 percent of GDP and reaches the debt-to-GDP ratio by a full 43.3 percentage 9 percent by 2050. The overall fiscal balance, points (Table 14). There are two reasons for the which includes interest payments on public debt, outsized impact of oil prices on the debt-to- is projected to hold at about 4 percent of GDP GDP ratio. First, greater economic productivity throughout the baseline forecast (Figure 53C), and successful labor market policies would as the interest rate on Russia’s debt is assumed increase non-resource GDP, but they would also to remain well below its projected rate of GDP boost public spending by raising demand for growth.30 Nevertheless, persistent deficits push education, healthcare, pensions, and non-age- the public debt-to-GDP ratio from less than 20 percent in 2014 to 116 percent by 2050. The total related spending. Second, oil prices have a direct public debt falls to just 0.3 percent of GDP in the effect on revenues, and the declining share optimistic scenario but rises to a staggering 272 of oil revenues is largely responsible for the percent in the pessimistic scenario. expanding primary deficit. Yet, the oil sector’s impact on spending is smaller than that of the Changes in oil-price projections have the largest other two variables, and consequently the net impact on the debt-to-GDP ratio. The influence improvement in fiscal balances is greater. 30 These simulations assume a 1 percent real interest rate on domestic debt and a 1.2 percent rate on external debt; in the baseline scenario GDP would grow by 2.5 percent annually. The debt-burden assumptions should therefore be regarded as conservative. Russia Economic Report | Edition No. 34 49 III. Russia’s Dual Transformation Figure 53: Fiscal sustainability indicators A. Primary Balance B. Interest Payments to Revenue Ratio 9.0 4.0 8.0 2.0 7.0 0 Percent of GDP 6.0 Percent -2.0 5.0 -4.0 4.0 3.0 -6.0 2.0 -8.0 1.0 -10.0 0 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Medium Demography Pessimistic Boundary Baseline Pessimistic Boundary Optimistic Boundary C. Overall Balance D. Debt Stock 300 4 2 250 0 Percent of GDP Percent of GDP 200 -2 -4 150 -6 100 -8 -10 50 -12 -14 0 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Pessimistic Boundary Optimistic Boundary Baseline Pessimistic Boundary Optimistic Boundary Sources: Rosstat, IMF and World Bank staff calculations. Table 14: Marginal impacts of alternative scenarios on the baseline Debt-to-GDP ratio, percentage point deviation Labor Productivity Effect Oil Price Effect Labor Market Policy Effect High Low High Low Moderate Policy 2020 -0.9 1.1 -8.5 7.0 -1.4 2030 -3.9 4.3 -21.8 29.3 -7.4 2040 -9.1 9.7 -33.8 50.8 -14.7 2050 -16.8 18.9 -43.3 70.4 -24.9 Source: World Bank staff calculations. 3.4 Can Russia’s Natural Resource Sector Mitigate the Fiscal Implications of an Aging Population? R ussia’s aging population threatens its fiscal sustainability but the government has instruments at its disposal that could mitigate The two-tiered structure of Russia’s sovereign wealth fund provides a set of policy options that could help manage demographic risks. the fiscal impact of demographic change. A The sovereign wealth fund comprises two rising old-age dependency ratio is expected to fiscal mechanisms, the Reserve Fund and the put significant pressure on the fiscal balances, National Welfare Fund. Savings that accrue in which will be magnified by the relative decline the Reserve Fund are used for fiscal stabilization. in natural resource revenues. In the baseline When combined with the current fiscal rule the scenario, the debt-to-GDP ratio climbs to about Reserve Fund can protect the economy from 116 percent by 2050, and if productivity growth moderate fluctuations in oil and gas prices, stalls, oil prices drop, or the population ages by especially if prices fall for fewer than three more than the baseline assumptions predict, the consecutive years.31 This smoothing effect limits ratio could rise to over 250 percent. the procyclicality of fiscal policies. Meanwhile, 31 Three years of consecutive decreases in oil prices triggers a shorter averaging horizon (3 years), which brings the benchmark price closer to the actual price cycle. 50 Russia Economic Report | Edition No. 34 III. Russia’s Dual Transformation the National Welfare Fund can finance future If utilized strategically, natural resource pension liabilities, and its role is expected to revenues could finance the necessary reforms, become increasingly crucial as the aging of the and a relatively small increase in short- and population intensifies pressure on the fiscal medium-term liabilities may be desirable if balances. However, while savings from the fund it helps avoid a much larger increase over can cover temporary fiscal gaps, the mechanisms the long term.32 Amending the fiscal rule to was not designed to finance the structural guarantee a certain amount of annual savings increase in expenditures generated by an aging would increase the rate at which reserves are population, nor will its resources be sufficient to accumulated. Currently, only residual revenue cover the widening fiscal deficits projected over is transferred to the Welfare Fund, and this the coming decades (Annex 1). happens when oil prices increase and the Reserve Fund is already at its ceiling. If oil prices remain Managing the secular increase in expenditure persistently low, no savings will accrue. Faced pressures caused by an aging population will with similar challenges, a number of countries require significant structural reforms, especially have successfully amended their fiscal rules and of the pension system. Directly addressing used their sovereign wealth funds to manage the the root cause of the deficit—the rising old- impact of an aging population; Box 15, describes age dependency ratio—could prove to be the Chilean experience. While adequate savings an effective strategy. Labor market policies will be necessary to maintain fiscal stability, designed to boost LFP, adjustments to the increased financing alone will not be sufficient to retirement age, changes in contribution rates, address the complex challenges facing Russian or a shift from publicly funded to contribution- policymakers. In order to overcome these funded benefits could have a significant impact challenges the government must draft a strategy on systemic liabilities. The simulations presented and contingency plans for managing its rising here indicate that increasing LFP could reduce fiscal burden and begin building the institutional new debt by about 25 percent. However, capacity and inter-agency coordination necessary achieving long-term sustainability through labor to implement effective structural reforms. market policies may be costly and could add to the short- and medium-term fiscal burden. Box 15 The Chilean experience with fiscal rules and financing social security liabilities Achieving long-term fiscal sustainability in a context of profound demographic shifts may be costly in the short and medium term, but postponing necessary reforms will only exacerbate the future fiscal burden. In 1981, the Chilean government was confronted by a steep increase in the beneficiary-to-contributor ratio and replaced its PAYG pension system by a fully funded one based on individual capital accounts. However, the transition proved costly for the budget in the next few years, because contributions stopped flowing to the public accounts but benefits for those who had already retired under the old system continued to drain public finances. To make the reform feasible, the government also issued recognition bonds to recognize the pension claims of active contributors who were moved to the new funded system and provided guarantees of minimum pensions for those in the new system. Substantial fiscal resources were needed to finance the transition. Ruiz-Tagle and Castro (1997) estimated that in the decade after the reform the additional fiscal burden averaged more than 6 percent of GDP annually, but overall, these policies brought back long-term fiscal solvency. Over time, the pool of old beneficiaries shrank by attrition and the cost of the reform gradually faded, yet the minimum pension guarantees remained a source of considerable fiscal burden. However, postponing the reforms would have only added to this burden, because old-age dependency ratios kept increasing, and thus the pool of retirees entitled to pension benefits would have gone up with each year of postponement. Chile consolidated the reform process in 2006 by passing a Fiscal Responsibility Law that obligates the government to contribute 0.2-0.5 percent of GDP annually to the Pension Reserve Fund, which was created to pay the statutory minimum in social security benefits. A similar approach in Russia would not only facilitate its transition to a more sustainable fiscal path, but would also help shore-up living standards for those who may be negatively affected by the transition. 32 Simulations of alternative price trajectories show that a recovery from the current slump in oil and gas prices could cause a long-term increase in savings accumulated in the wealth funds. Although the Reserve Fund hits its threshold value of 7 percent of GDP in 2035, the Welfare Fund reaches just 5 percent. However, this only occurs in the outer years of the projections, by which time the old-age dependency ratio will be about 50 percent higher than it is now, and as a result reforming the social security system will be more costly and more politically difficult. Russia Economic Report | Edition No. 34 51 REFERENCES ▪ Dedry, A., H. Onder, and P. Pestieau. 2014. “Aging, Social Security Design and Capital Accumulation,” Center for Operations Research and Econometrics (CORE) Discussion Paper Series 023, Université catholique de Louvain. ▪ Engel, E., M. Marcel, and P. Meller. 2007. “Meta de Superávit Estructural: Elementos para su Análisis,” Report prepared for the Ministry of Finance. ▪ Escolano, Julio, 2010. “A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates: Technical Notes and Manuals Series.” IMF Fiscal Affairs Department, International Monetary Fund, Washington, DC. ▪ European Commission. 2012. “The 2012 Ageing Report: Economic and Budgetary Projections for the EU-27 Member States (2010–2060).” European Economy 2, Brussels, Belgium. ▪ Goryunov, Eugene, Maria Kazakova, Laurence J. Kotlikoff, Arseny Mamedov, Kristina Nesterova, Vladimir Nazarov, Elena Grishina, Pavel Trunin, and Alexey Shpenev. 2013. “Russia’s Fiscal Gap.” NBER Working Paper 19608, National Bureau of Economic Research, Inc., Cambridge, MA. ▪ Government of the Russian Federation. 2014. “Employment Plan.” https://g20.org/wp-content/ uploads/2014/12/g20_employment_plan_russian_federation.pdf ▪ IMF. 2013. “Article IV Consultation Staff Report.” International Monetary Fund, Washington, DC. IMF. 2014. ▪ Jabłonowski, J., and C. Müller. 2014. “Sustainability of Fiscal Policy in Poland.” Research Center for Generational Contracts, Freiburg University. ▪ Leu, R. 1986. “The public-private mix and international health care costs,” AJ Culyer, B. Jönsson (Eds.), Public and private health services, Basil Blackwell, Oxford. ▪ Newhouse, J. P. 1977. “Medical care expenditure: A cross-national survey.” Journal of Human Resources 12, 115-125. ▪ Onder, Harun. 2015. “Macroeconomic and Fiscal Implications of Aging in Europe and Central Asia.” background paper for The Golden Age of Aging. World Bank, Washington, DC. ▪ Onder, Harun, Pierre Pestieau, and Eduardo Ley.2014. “Macroeconomic and Fiscal Implications of Population Aging in Bulgaria.” Policy Research Working Paper Series No 6774. World Bank, Washington, DC. ▪ Ruiz-Tagle, J.V., and F. Castro, F. 1997. “The Chilean Pension System.” OECD Working Paper AWP 5.6, Organisation for Economic Co-operation and Development, Paris. 52 Russia Economic Report | Edition No. 34 Annex 1: Russia’s Fiscal Rule and Savings from Natural Resource Revenues O ur projections show that the current fiscal rule, which determines the share of natural resource revenues that is saved, will not balance shrinks from about 4.7 percent of the GDP to 0 percent in the medium term in the baseline and pessimistic price scenarios. As oil accumulate enough savings to cover the rise in prices recover over the long term, savings turn financing that an aging population requires. positive, especially in the high-price scenario As Figure 54A shows, the benchmark price has but also in the baseline (Figure 54E). However, a smoother trajectory than the actual price, our simulations show that in the long run the especially when the benchmark price is the 10- cumulative National Welfare Fund balances year moving average. However, savings from will not be adequate to cover the fiscal deficits. natural resource revenues are only likely when oil Toward the end of the projection horizon deficits prices are going up. Figure 54D shows that in the keep widening, but National Wealth Fund assets beginning of the projections there are no savings remain at about 5 percent of GDP at all times from natural resource revenues in the baseline (Figure 54F). These savings are barely enough to and pessimistic price scenarios. As a result of finance two years of deficits. withdrawals and growing GDP, the Reserve Fund Figure 54: The performance of the fiscal rule in different oil price scenarios A. Reference Prices B. Benchmark Oil Prices 120 130 110 100 USD 90 USD 80 70 60 50 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Benchmark Price 3-Year Moving Average 10-Year Moving Average Actual Price Baseline Price Optimistic Price Pessimistic Price C. Transfers to Budget D. Savings from Natural Resource Revenues 300 40 250 0 Billion USD Billion USD 200 -40 150 -80 100 -120 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Price Optimistic Price Pessimistic Price Baseline Price Optimistic Price Pessimistic Price E. Reserve Fund Balance F. Welfare Fund Balance 8 8 7 6 Percent of GDP Percent of GDP 5 6 4 3 2 4 1 0 -1 2 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 2014 2018 2022 2026 2030 2034 2038 2042 2046 2050 Baseline Price Optimistic Price Pessimistic Price Baseline Price Optimistic Price Pessimistic Price Sources: Rosstat, IMF and World Bank staff calculations. Russia Economic Report | Edition No. 34 53 Annex 2: Main Macroeconomic Indicators 54 2015 Output Indicators 2007 2008 2009 2010 2011 2012 2013 2014 Jan Feb Mar Apr May Jun Jul Aug GDP, % change, y-o-y 8.5 5.2 -7.8 4.5 4.3 3.4 1.3 0.6 - - -2.2 - - -4.6 - - Industrial production, % change, y-o-y 6.8 0.6 -10.7 7.3 5.0 3.4 0.4 1.7 0.9 -1.6 -0.6 -4.5 -5.5 -4.8 -4.7 -4.3 Manufacturing, % change, y-o-y 10.5 0.5 -15.2 10.6 8.0 5.1 0.5 2.1 -0.1 -2.8 -1.9 -7.2 -8.3 -6.6 -7.1 -6.8 Extraction of mineral resources, % change, y-o-y 3.3 0.4 -2.8 3.8 1.8 1.0 1.1 1.4 1.5 0.1 0.4 -0.8 -0.9 -0.9 0.2 0.8 Fixed capital investment, % change, y-o-y 23.8 9.5 -13.5 6.3 10.8 6.8 0.8 -2.7 -3.9 -4.3 -2.7 -4.8 -7.6 -7.1 -8.5 -6.8 Fiscal and Monetary Indicators Federal government balance, % GDP 1/ 5.4 4.5 -5.9 -4.1 0.8 -0.1 -0.5 -0.5 -5.4 -7.4 -4.9 -4.4 -3.7 -2.6 -2.8 - Russia Economic Report | Edition No. 34 2 M2, % change, p-o-p / 51.3 27.2 -3.5 30.6 23.3 17.9 15.4 7.3 -2.1 0.9 -0.3 1.5 0.6 0.6 0.5 - Inflation (CPI), % change, p-o-p 9.0 14.1 11.7 6.9 8.5 5.1 6.8 7.8 3.9 2.2 1.2 0.5 0.4 0.2 0.8 0.4 Producer price index (PPI), % change, p-o-p 25.1 -7.0 13.9 16.7 13.0 6.8 3.4 6.1 1.3 2.1 5.5 2.7 -1.2 0.7 1.5 0.1 Nominal exchange rate, average, Rb/USD 25.6 24.8 31.7 30.4 29.4 31.1 31.8 38.4 61.7 64.6 60.2 52.9 50.6 54.5 57.1 65.2 Reserve Fund, bln USD e-o-p 137.1 60.5 25.4 25.2 62.1 87.4 87.9 85.1 77.1 75.7 76.4 76.3 76.8 72.9 70.7 National Wealth Fund, bln USD, e-o-p 88.0 91.6 88.4 86.8 88.6 88.6 78.0 74.0 74.9 74.4 76.3 75.9 75.7 74.6 73.8 Reserves (including gold) billion $, end-o-p 478 427 439 479 499 538 510 385 376 360 356 356 357 362 358 366 Balance of Payment Indicators Trade Balance, billion $ (monthly) 123.4 177.6 113.2 147.0 196.9 191.7 181.9 188.7 15.3 13.7 15.4 15.0 15.3 13.8 10.7 - Current Account, billion $ 72.2 103.9 50.4 67.5 97.3 71.3 34.1 56.6 - - 28.9 - - 19.2 - - Export of goods, billion $ 346.5 466.3 297.2 392.7 515.4 528.0 523.3 496.7 27.8 29.3 32.7 31.5 30.9 30.3 27.7 - Import of goods, billion $ 223.1 288.7 183.9 245.7 318.6 335.7 343.0 308.0 12.5 15.6 17.3 16.4 15.6 16.5 17.0 - Financial Market Indicators Average weighted lending rate for enterprises, % 3/ 10.8 15.5 13.7 9.1 9.3 9.4 9.4 18.3 19.9 18.1 17.9 17.2 16.0 15.5 14.7 - CBR policy rate, %, end-o-p 10.0 9.5 6.0 5.0 5.3 5.5 5.5 17.0 17.0 15.0 14.0 12.5 12.5 11.5 11.5 11.0 Real average rate for Ruble loans, % (deflated by PPI) -3.4 -6.8 -0.1 -6.5 -3.2 3.9 5.5 11.7 12.1 8.1 4.3 1.9 2.3 2.1 1.4 - Stock market index (RTS, ruble term, eop) 2,291 632 1,445 1,770 1,382 1,527 1,443 791 737 897 880 1,029 969 940 859 834 Income, Poverty and Labor Market Real disposable income, (1999 = 100%) 245.6 251.5 259.3 272.5 274.7 286.2 297.7 294.7 201.3 263.6 254.7 286.6 256.4 279.3 284.8 285.2 Average dollar wage, US $ 532 697 588 698 806 859 942 841 449 511 558 665 649 638 575 479 Share of people living below subsistence, % 1/ 13.3 13.4 13.0 12.5 12.7 10.7 10.8 11.2 - - 15.9 - - 15.1 - - Unemployment (%, ILO definition) 6.1 7.8 8.2 7.2 6.1 5.1 5.6 5.3 5.5 5.8 5.9 5.8 5.6 5.4 5.3 5.3 Source: Rosstat, CBR, EEG, IMF, staff estimates. 1 /Cumulative from the year beginning. 2 / Annual change is calculated for average annual M2. 3 /All terms up to 1 year. 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