86640 The World Bank in the Russian Federation RUSSIA ECONOMIC REPORT N .31 | March 2014 Confidence Crisis Exposes Economic Weakness Russia Economic Report Confidence Crisis Exposes Economic Weakness I. Recent Economic Developments II. Economic Outlook III. In Focus: Economic Mobility and Middle Class Formation This report is produced twice a year by World Bank economists of the Europe and Central Asia Region Poverty Reduction and Economic Management Department. The team was led by Birgit Hansl (Lead Economist and Sector Leader for Economic Policy in Russia, bhansl@worldbank.org) and consisted of the following members: Sergei Ulatov (Senior Economist), Stepan Titov (Senior Economist), Olga Emelyanova (Research Analyst), Mikhail Matytsin (Consultant), John Pollner (Lead Financial Officer), Lawrence Kay (Сonsultant), Mizuho Kida (Economist), Damir Cosic (Economist), Ekaterine Vashkmadze (Senior Economist), John Baffes (Senior Economist) and Irina Rostovtseva (Team Assistant). Moritz Meyer (Consultant), Carolina Sanchez-Paramo (Sector Manager for Russia, Ukraine, Belarus, and Moldova) authored the focus note on economic mobility and emergence of the middle class in Russia. Peer reviewers were Wolfgang Fengler (Lead Economist), Raju Singh (Lead Economist) and Denis Medvedev (Senior Economist). The report was edited by Christopher Pala (Сonsultant), and the graphic design was provided by Robert Waiharo (Сonsultant). We are grateful for advice from discussions with Michal Rutkowski (Country Director for Russia), Roumeen Islam (Acting Director for Poverty Reduction and Economic Management in the Europe and Central Asia Region), Lada Strelkova (Country Program Coordinator for Russia), Zeljko Bogetic (Lead Economist in the Europe and Central Asia Region), Kaspar Richter from ECFIN and the IMF team for Russia, led by mission chief Antonio Spilimbergo. TABLE OF CONTENT Abbreviations and Acronyms .............................................................................................. i Executive Summary ................................................................................................................. iii I. Recent Economic Developments ....................................................................................... 1 1.1 Global Trends 2013 – Growth recovers despite tighter financial conditions ............................... 2 1.2 Growth 2013 — Loss of confidence leads to unfulfilled expectations ......................................... 4 1.3 Labor Market 2013 – Demand and income growth stabilize ....................................................... 7 1.4 Balance of Payments 2013 — A weakening current account and increased vulnerability .......... 10 1.5 Monetary Policy and Financial Sector 2013 — Currency volatility and elevated credit risk ........ 13 1.6. Government Budget 2013 – Balances under pressure ................................................................ 15 II. Economic Outlook .................................................................................................................... 19 2.1 Global Outlook - Improving growth prospects with higher market volatility ............................... 20 2.2 Growth Outlook for Russia – A question of confidence and geopolitical risk ............................... 22 External Balances – Deteriorating CA and volatile capital flows .................................................. 26 Inflation and credits – High devaluation and credit default risks ................................................. 27 Fiscal Balances – Is consolidation achievable? ............................................................................. 27 2.3 Other Risks .................................................................................................................................... 29 III. Economic Mobility and Middle-Class Formation in Russia .................................... 31 3.1. Introduction ................................................................................................................................. 32 3.2 Russia in the global context ......................................................................................................... 33 3.3 Aggregate trends and developments: A bird’s eye view .............................................................. 35 3.4 The role of assets, markets and the state in the middle-class formation .................................... 38 Profile of the middle class in Russia ............................................................................................. 38 3.5 Demographic and economic drivers of middle-class emergence ................................................. 41 Middle class entry: A first look ..................................................................................................... 42 Middle class entry: A deeper look ................................................................................................ 43 3.6 Conclusions ........................................................................................................................ 44 3.7 References ........................................................................................................................... 45 Annex: Main indicators ......................................................................................................... 47 List of Figures Figure 1: Global industrial production and trade growth .................................................................... 2 Figure 2: Fed tapering effect on emerging markets ............................................................................. 2 Figure 3: Oil prices and OECD inventories ............................................................................................ 3 Figure 4: World GDP growth, y-o-y, percent ........................................................................................ 4 Figure 5: Year-on-year growth composition, percent .......................................................................... 4 Figure 6: Capacity utilization in industry, percent, 3-month moving average ...................................... 6 Figure 7: Tradable sector growth, percent, y-o-y ................................................................................. 6 Figure 8: Non-tradable sector growth, percent, y-o-y ......................................................................... 6 Figure 9: Number of employed and economically active population, million people ......................... 7 Figure 10: Beveridge curve, percent ...................................................................................................... 7 Figure 11: Contribution to income growth, percentage points, y-o-y ................................................... 8 Figure 12: Households’ real wages dynamics, y-o-y growth .................................................................. 8 Figure 13: Poverty rates in 2012, percent .............................................................................................. 9 Figure 14: Gap between real wages and productivity growth by sectors, y-o-y growth ....................... 10 Figure 15: Trade and services balances and oil prices ........................................................................... 11 Figure 16: Current account balance, percent of GDP ............................................................................ 11 Figure 17: Exchange rate and its bilateral band ..................................................................................... 13 Figure 18: CPI inflation by component, percent, y-o-y .......................................................................... 13 Figure 19: Credit growth, percent, y-o-y ................................................................................................ 14 Figure 20: Nonperforming loans and loan loss provisions, percent of total loans ................................ 14 Figure 21: Gross capital flows to developing countries ......................................................................... 21 Figure 22: Growth of global oil demand by quarter, 2001-2014, percent change, y-o-y ....................... 22 Figure 23: Manufacturing and business surveys .................................................................................... 23 Figure 24: Consumption and consumer confidence .............................................................................. 23 Figure 25: Exchange rate dynamics, Euro-Dollar basket ........................................................................ 24 Figure 26: Stock market reactions ......................................................................................................... 24 Figure 27: Government Projections for the Reserve Fund and National Welfare Fund, ........................ 27 percent of GDP, e-o-p Figure 28: A panorama of the middle class in the emerging world ....................................................... 33 Figure 29: The Russian middle class is the largest in the Europe and Central Asia region .................... 34 Figure 30: Share of total population whose per capita consumption is equal or higher ....................... 35 than US$10/day (2005 PPP) Figure 31: The middle class controls a large share of total income… .................................................... 35 Figure 32: The distribution of income shifted to the right and widened during 2001-2010 ................. 37 Figure 33: The ratio of older (65+) and younger (<18 years) household members ............................... 39 to working-age adults is smallest among middle income households Figure 34: A third of working-age adults in middle income households had completed ...................... 39 tertiary education in 2010 Figure 35: Labor earnings are relatively more important for middle-income households, while ......... 40 public transfers are relatively more important for poor and vulnerable households Figure 36: Wage and pension growth were the two main drivers of middle class growth in 2001-2010 .... 42 List of Tables Table 1: Contribution to growth by demand components, percentage points ................................... 5 Table 2: Contribution to growth by sectors, percentage points .......................................................... 6 Table 3: Poverty rates in Russia, percent ............................................................................................ 10 Table 4: Balance of payments, 2007–2013, US$ billions ..................................................................... 12 Table 5: Net capital flows, 2007–2013, US$ billions ........................................................................... 12 Table 6: Russia’s external debt, US$ billions ....................................................................................... 12 Table 7: Federal budget 2011-2013, percent of GDP .......................................................................... 15 Table 8: Consolidated budget and consolidated subnational budget in 2011-2013, percent of GDP ........ 16 Table 9: Global real GDP growth, percent ........................................................................................... 20 Table 10: Main economic indicators: low-risk scenario ........................................................................ 25 Table 11: Main economic indicators: high-risk scenario ....................................................................... 26 Table 12: Medium-term government budget projections for 2014-2016, percent of GDP .................. 28 Table 13: The emergence of the middle class is part of a broader pattern of strong upwards mobility ...... 36 List of Boxes Box 1: 2013 GDP production structure .................................................................................................. 6 Box 2: The gap between productivity and wages is highly unequal levels across sectors ..................... 10 Box 3: Sanitizing the banking system in Russia ...................................................................................... 15 Box 4: Market response to the Crimea events ...................................................................................... 24 Box 5: Government’s medium-term budget framework for 2014-2016 ................................................ 28 Box 6: Mobility and the middle class – Definition and measurement ................................................... 32 ABBREVIATIONS AND ACRONYMS APEC Asia-Pacific Economic Cooperation BoP Balance of Payments CA Current Account CBR Central Bank of Russia CPI Consumer Price Index ECA Europe and Central Asia EU European Union FDI Foreign Direct Investment GDP Gross Domestic Product IEA Institute for Economic Analysis LAC Latin America and the Caribbean NPL Non-Performing Loan NWF National Welfare Fund OECD Organization for Economic Cooperation and Development OPEC Organization of the Petroleum Exporting Countries PMI Purchasing Managers Index PPP Purchasing Power Parity QE Quantitative Easing RLMS - HSE Russian Longitudinal Monitoring Survey – Higher School of Economics US United States WTI West Texas Intermediate Russia Economic Report | Edition No. 31 i EXECUTIVE SUMMARY R ussia’s economy is navigating an economic downturn. Real GDP growth slowed to an estimated 1.3 percent in 2013 from 3.4 2013 and exports grew robustly. However, global markets appear to normalize to a higher level of volatility and their reactions to the gradual percent of 2012. In January 2013, we projected withdrawal of the U.S. monetary stimulus 3.6 percent growth for 2013, but while the remain erratic. The Ruble came under increasing global economy has continued to improve at a pressure, triggered by the ongoing deterioration moderate pace, Russia’s is struggling to find its of the current account and by higher volatility footing. The first part of this report explores the in capital outflows. This was in part related to recent economic developments that underlie this uncertainties around the quantitative easing slowdown. To emerge from the downturn with policies by the U.S. Fed, but unrealized growth improved long-term prospects Russia will need expectations and large foreign debt payments by a combination of cyclical and structural policy the corporate sector played a more prominent measures. As the relative weight of the reasons role in Russia. In 2014 so far, global markets have for Russia’s downturn is tilted toward structural seen little disruption from the growing tension factors, structural measures will need to lead between Ukraine and Russia, and oil markets the rebound. The lack of more comprehensive remained stable. But such geopolitical and structural reforms in the past has led to a gradual commodity risks could actually play out to the erosion of investor confidence. This was masked benefit of Russia by pushing oil and gas prices by a growth model based on large investment temporarily up. Most of all, confidence in a projects, continued increases in public wages, broad-based global recovery is still wavering and transfers—all fueled by sizeable oil and becoming increasingly driven by a higher revenues. Recent events around the Crimea differentiation into regional and country- have compounded the lingering confidence specific sentiments. problem into a crisis of confidence and more clearly exposed the economic weakness of this Business and consumer sentiment in Russia growth model. Investor pessimism became remain weak. In 2013, frail domestic demand the decisive factor affecting Russia’s economic dragged the Russian economy close to outlook, presented in part two of the report. The stagnation. When major infrastructure projects special focus note in part three discusses the came to an end in early 2013, the spare capacity link between Russia’s growth in the past decade was immediately felt in the economy. Then the and how it fueled an unprecedented growth in anticipation that private investors would start household welfare. investing more during the second half of 2013 did not materialize. The lack of growth-supporting Russia’s external environment remains volatile. structural reforms and decreasing profit margins The recovery in high-income countries is robust, weighed heavily on business sentiment and yet settling at growth rates much lower than pushed down industrial activity and investment. before the 2008 global economic and financial The contribution of fixed investment to GDP crisis. Russia’s external demand recovered in growth turned negative in 2013, compared to line with expectations during the second half of 1.4 percent in 2012. Companies also continued Russia Economic Report | Edition No. 31 iii Executive Summary drawing down inventories. Consumption consumption growth. In the medium to longterm remained the main growth driver, supported labor market demand relaxation will be partly by fast credit and wage growth, yet its pace of compensated by a shrinking of the labor force expansion more than halved compared to 2012. due to demographic factors, such as population aging, but in the short-term upward economic The World Bank outlook for Russia comes with mobility is likely to slow down. Our special focus two growth scenarios―both project lower note shows that most of poverty-reduction growth than our forecast in November. The and middle-class growth was explained by high scenarios reflect the increased market volatility growth in average incomes and consumption created by the Crimean crisis in early March 2014. during 2000-2010. We assume that political risks will be prominent in the short-term. If the Russia-Ukraine conflict Crisis management response could replace escalates, uncertainty could rise around sanctions efforts to advance the structural reform agenda. from the West and Russia’s response to them. Russia’s long-term outlook will depend on a This could further worsen business and consumer sustained positive shift in investor and consumer confidence and raise market volatility, dimming confidence. To overcome the current confidence prospects for domestic demand and growth. The crisis and achieve sustained long-term growth, World Bank’s low-risk scenario assumes a limited structural reforms would need to resume in the and short-lived impact of the Crimea crisis and coming years. The dearth of such reform efforts projects growth to slow to 1.1 percent in 2014 is darkening Russia’s growth outlook. Attracting before a slight increase to 1.3 percent in 2015. larger private investment in a sustained manner The World Bank’s high-risk scenario assumes a and on a larger scale―through innovative firms more severe shock to economic and investment of all sizes―would require that inefficiencies activities from the Crimean crisis and projects a in factor allocation across the economy be contraction in output of 1.8 percent for 2014. addressed. It would also require creating a level playing field for such businesses by improving Economic mobility could be on hold. Weaker the quality of regulatory and market institutions, growth prospects and stabilizing consumption at so that rules are implemented evenly. No a lower rate would dim the outlook for economic matter how the Crimean crisis plays out, mobility and continued middle-class formation there is the risk that the Russian government in Russia. We project in our low-risk scenario will be put back into a crisis mode to uphold that consumption growth will decrease to about macroeconomic stability, depending on the 2 percent in 2014-2015, compared to 3.4 percent evolving scenario. It is likely that policy choices in 2013 and 6.9 percent in 2012. We expect some will be about managing short-term issues, and already announced labor shedding which will be the medium-term agenda of structural reforms realized throughout the year. This will dampen will continue to take a back seat. households’ income prospects and as a result iv Russia Economic Report | Edition No. 31 PART I Recent Economic Developments T he continued growth recovery in high-income economies provided support to economic activity in developing and emerging countries. Financial markets in both developing and high-income countries underwent a significant transition as strengthening growth in high-income countries prompted a normalization of the extraordinary measures taken in the wake of the 2008-2009 crisis. Russia’s 2013 growth outturn surprised on the downside, tumbling from 3.4 percent in 2012 and a projected 3.6 percent for 2013 to just 1.3 percent that year. Frail domestic demand with zero investment growth dragged the Russian economy close to stagnation. Consumption drove what little growth there was, supported by fast growth in credit and wages, yet its pace of expansion in 2013 was barely more than a third of what it was in 2012. Key labor market indicators reflected the stagnation in the real sector. As a result, income growth stabilized at a new, much lower level and led to a slight moderation in the growth of the productivity gap. The slowdown in real-sector growth translated into a slight increase in the poverty rate for 2013. Russia’s balance of payments position weakened in 2013 while the current account surplus shrank to less than half of its 2012 level. During the second half of the year, capital outflows from the private sector picked up as a result of the scaling back of the US monetary stimulus and large external debt payments. The Ruble came under increased pressure as the current account deteriorated and investors became more risk-averse in anticipation of the impact of the scaling-down of the US monetary stimulus. Perceived credit risks rose as firms and households found it increasingly difficult to service their debts. Inflation pressure remained high in 2013, driven by food and service prices. The overall fiscal balance worsened slightly on a year-to-year basis and the non-oil deficit continues to exceed 10 percent of GDP. The consolidated budget ended in a deficit for the first time since the crisis period as sub-national public finances weakened. The funds that serve as Russia’s fiscal buffers increased moderately, but their investment decisions became more subject to political pressures. I. Recent Economic Developments 1.1 Global Trends 2013 – Growth recovers despite tighter financial conditions The continued growth recovery in high-income economies provided support to economic activity in developing and emerging countries. Financial markets in both developing and high-income countries underwent a significant transition as strengthening growth in high-income countries prompted a normalization of the extraordinary measures taken in the wake of the 2008-2009 crisis. D uring 2013, the global economy continued to improve at a moderate pace, led by a recovery in high-income countries (Figure 1). But tighter international financial conditions from mid-2013 created headwinds for developing and emerging countries. Financial Following a robust expansion of GDP in the conditions in developing countries were third quarter (Q3) of 2013 by 4.1 percent in the unsettled in mid-2013 by a portfolio adjustment quarter-on-quarter seasonally adjusted annual that was triggered by speculation over the timing rate (q/q saar), the US economy continued to of eventual tapering of the US Federal Reserve’s grow at 3.2 percent in Q4, supported by strong quantitative easing (QE) policies. This portfolio consumer spending and rising exports that adjustment caused a temporary but significant offset a significant drag from lower government reversal in capital flows from developing and spending. In Japan, the monetary and fiscal emerging countries, leading to the withdrawal stimuli boosted the Tankan business confidence of a net total of US$64 billion from their mutual index to a six-year high, but they also pushed funds between June and August. Those losses up core inflation to 1.3 percent in December. during the summer of 2013 were partially Japan’s GDP continued to expand by 1.0 recouped later in the year as the initial portfolio percent (q/q saar) in Q4 while growth in private rebalancing came to an end and with the Federal consumption and investment remained strong, Reserve’s decision in September to postpone the suggesting that the domestic economic recovery tapering of QE. Credit-default swap spreads and remains intact. The Euro Area has managed to borrowing costs for developing and emerging expand for three consecutive quarters with GDP countries declined from their June peaks and growth accelerating to 1.2 percent (q/q saar) in stock markets regained some of the lost ground Q4, double the pace of Q3. The recovery was (Figure 2). Nevertheless, none of the indicators broad-based, with France growing in Q4 at 1.3 fully recovered their pre-summer levels. Overall, percent and Italy becoming the fourth periphery developing and emerging country stock market economy to exit recession. volatility was lower in 2013 than in any other Figure 1: Global industrial production and trade growth Figure 2: Fed tapering effect on emerging markets % 3m/3m Index, reabsed April 1, 2013 =100 25 105 Fed "no tapering" announcement Fed "tapering" announcement 20 103 15 101 10 99 5 97 0 95 93 5 91 -10 89 -15 87 2010 2011 2012 2013 Q4 85 2013 Developing and emerging Developing and emerging Apr-13 Jun-13 Aug-13 Oct-13 Dec-13 Feb-14 Industrial Production Country Exports High Income Imports High Income Industrial Production MSCI EM stock index EMBIG bond index EM currency*(right axis) Source: Datastream and World Bank prospects Source: Bloomberg* Nominal Effective Exchange Rate 2 Russia Economic Report | Edition No. 31 I. Recent Economic Developments post-crisis year, following a decline in market Oil prices averaged US$104/barrel in 2013, uncertainty and financial stability concerns in down slightly from US$105/barrel in 2012. high-income countries. The three years from 2011 to 2013 have been among the least volatile for the oil market in Despite financial market tensions, growth in recent history. Crude oil prices1 fluctuated within developing and emerging countries began to a remarkably tight band around OPEC’s “desired strengthen. Steady demand for imports from range” of US$105/barrel (bbl) after reaching high-income economies and China, combined US$100/bbl in early 2011 for the first time with depreciated local currencies, contributed since the 2008 financial crisis (Figure 3). During to a continued expansion of developing-country 2013, fluctuations in oil prices were driven on exports (Figure 1). The recovery in the Euro the supply side by geopolitical concerns over Zone has boosted export growth in the Europe Egypt and Syria and output disruptions in Iraq and Central Asia region, following an earlier and Libya, and on the demand side by concerns period of contraction. While Q4 GDP figures around developing-country growth prospects. are still unavailable for developing-country and However, fears that the Syrian conflict might regional aggregates, more timely manufacturing spread to the Gulf and cause a major disruption Purchasing Managers’ Index (PMI) data for in oil supplies have been replaced by cautious developing and emerging countries moved into optimism. For Iran, the interim arrangement the above 50-zone in August and continued to between the country and Western powers show sustained expansion in four out of five eased some sanctions, including lifting the ban regions with data. on insuring oil shippers, but the ban on crude exports remained in place. Figure 3: Oil prices and OECD inventories $US per bbl Million 160 2850 140 2800 2750 120 2700 100 2650 80 2600 60 2550 40 2500 20 2450 0 2400 2007 2008 2009 2010 2011 2012 2013 Feb-2014 Oil Price, World Bank average (left axis) OECD oil inventories (right) Source: Datastream and World Bank Prospects 1 World Bank average. Russia Economic Report | Edition No. 31 3 I. Recent Economic Developments 1.2 Growth 2013 — Loss of confidence leads to unfulfilled expectations Russia’s 2013 growth outturn surprised on the downside, tumbling from 3.4 percent in 2012 and a projected 3.6 percent for 2013 to just 1.3 percent. Frail domestic demand with zero investment growth dragged the Russian economy close to stagnation. Consumption remained the main growth driver, supported by fast credit and wage growth, yet its pace of expansion more than halved in 2013 compared to 2012. I n 2013, Russia’s economic growth dipped under that of other high-income economies and remained only slightly above that of EU with zero investment growth and consumption expanding at a slower pace. emerging countries (Figure 4). Growth in high- Hopes for acceleration in domestic demand income economies and EU emerging ones picked during the second half of 2013 did not up substantially in Q3 and especially in Q4, while materialize and were the main reason behind the expected acceleration of growth in the Russia’s lower-than-projected growth outturn second half of 2013 for Russia did not materialize. of an estimated 1.3 percent for 2013. This is Russia’s 2013 third-quarter growth slowed to 1.2 only slightly more than a third of the growth percent from 3.0 percent in the same period a we projected for the year in January 2013 and year ago. In Q4 2013, growth was estimated at well below the 3.4 percent growth in 2012 1.4 percent, compared to 2.1 percent in 2012. (Table 1). In fact, the continued slowdown of The gap between Russia’s growth rate and that domestic demand during the second half of of non-EU emerging economies dramatically 2013 forced Government and analysts, including increased in the second half of 2012 and us, to drastically revise downward the short- persisted in 2013. Russia’s external demand, term outlooks. The lack of growth-supporting reflected in robust export growth, recovered structural reforms and decreasing profit margins in line with expectations during the second weighed heavily on business sentiments and saw half of 2013. However, weak domestic demand industrial and investment activities stalling. persisted throughout the second half of 2013, Figure 4: World GDP growth, y-o-y, percent Figure 5: Year-on-year growth composition, percent 12 15 8 10 4 5 0 0 -4 -5 -8 -10 -12 -15 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Q1 Q4 Q4 Q4 Q4 Q4 Q4 Q4 07 07 08 09 10 11 12 13 Consumption GFCF Import GDP growth Russia OECD HI EU Emerging Other Emerging Change in inventories Export Stat error Source: OECD Source: Rosstat and World Bank staff estimates Note: Emerging EU economies include the six central European countries that are member both of 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 4 Russia Economic Report | Edition No. 31 I. Recent Economic Developments Table 1: Contribution to growth by demand components, percentage points 2008 2009 2010 2011 2012 2013 GDP growth, percent 5.2 -7.8 4.5 4.3 3.4 1.3 Consumption 5.5 -2.6 2.5 3.6 4.8 2.4 Households 4.9 -2.5 2.8 3.4 4.1 2.5 Government 0.6 -0.1 -0.3 0.3 0.7 0.0 Gross capital formation 2.5 -10.5 4.7 4.2 0.3 -0.8 Fixed Investment 2.3 -3.2 1.2 1.9 1.4 -0.1 Change in stocks 0.3 -7.3 3.4 2.3 -1.1 -0.7 Export 0.2 -1.5 2.3 0.1 0.4 1.2 Import -3.0 6.7 -4.3 -4.1 -2.0 -1.4 Source: Rosstat and World Bank staff estimates Investment activities came to a halt with the confidence crisis that swept through the Russian tapering of large infrastructure projects and economy during 2013. Consumption remained a deterioration of business confidence in the the main growth driver, but both household economy in the second half of 2013. When the and government consumption contributed two major projects (the Nord Stream Pipeline significantly less to aggregate growth than in and the Sochi Winter Olympics2) came to an end 2012 (Table 1). Consumption’s contribution to in in late 2012 and early 2013, the base effect GDP growth halved to 2.4 percent compared of this on aggregate investment demand was to 4.8 percent in 2012. Along with weakening immediately felt in the economy. As business household consumption, imports slowed, sentiments failed to improve, the anticipation lessening the negative contribution of net export that private investors would kick in and start to growth to 0.2 percent, compared to 1.6 investing more in the second half of 2013 did not percent in 2012. Decelerating real income growth materialize. This clearly reflected a confidence and increased household indebtedness levels crisis of investors in the domestic economy. At the negatively affected consumers’ sentiments. same time, the external environment improved, It appears that the observed adjustment in translating into better demand for Russia’s consumption growth last year to a significantly exports, which increased their contribution to lower growth trajectory will be a medium-term growth to 1.2 percent last year from 0.4 percent event. This also means that the expansion of in 2012. Despite this increase in external demand, major non-tradable sectors, the main engine the contribution of fixed investment turned of growth during last two years, will also slow, negative (-0.1 percent) in 2013 compared to dimming medium-term growth prospects (Box1). 1.4 percent in 2012 while companies continued inventory destocking (Table 1). This resulted in The rate of capacity utilization fell towards the the contribution of gross capital formation to end of 2013 along with deteriorating business growth also turning negative (0.8 percent) in confidence. After having been rather sticky during 2013 compared to 0.3 percent in 2012 and 4.2 2012, the level of capacity utilization remained percent in 2011 (Figure 5). in the first half of 2013 near the upper historical limits of 80 percent, but it started falling during Added to the zero investment growth, the H2 2013. The adjustment in capacity utilization consumption slowdown confirmed the can be explained with the observed pessimistic 2 The cost of the Sochi Winter Olympics was estimated at RUB 1.53 trillion, or US$ 50 billion. Russia Economic Report | Edition No. 31 5 I. Recent Economic Developments sentiments on part of the producers. The Figure 6: Capacity utilization in industry, percent, 3-month moving average seasonally adjusted HSBC Russia Manufacturing PMI remained below 50 during Q4 2013 and in 10 60 January 2014, indicating a decline in economic 9 65 activities in the manufacturing industries. 8 70 Despite the somewhat lower capacity utilization, in our view the economy still faces structural 7 75 supply constraints. These have implications for 6 80 growth-supporting policies. Investment activities remained subdued for more than a year, with 5 85 companies continuing inventory destocking and 4 90 the labor market relaxed only marginally, relative 2001 2003 2005 2007 2009 2011 2013 to 2012 conditions. Unemployment rate Capacity, 3 mma (right axis, reverse order) Source: Haver Analytics Box 1 2013 GDP production structure Non-tradable sectors prevailed as the main growth engine, yet their aggregate contribution to growth dropped to only 1.0 percent in 2013 from 3.0 percent in 2012 (Figure 7). It appears that the non-tradable sectors were also the main victims of slowing domestic demand and deteriorating consumer confidence in 2013. Major service sectors considerably slowed: retail and wholesale trade to 1.1 percent growth in 2013 compared to 3.8 percent in 2012, transportation and communication services to 0.9 percent growth in 2013 compared to 3.8 percent in 2012 and real estate operations to 1.6 percent growth compared to 6.4 percent. The financial services sector was the only bright spot, with growth registering a solid 12.0 percent, but still less than the 19.6 percent in 2012. Despite strong growth in agriculture and fisheries, the aggregate contribution to growth from tradable sectors fell to 0.4 percent in 2013 compared to 0.5 percent in 2012 and 2.0 percent in 2011 (Table 2). Major industrial sectors, such as extracting industries and the production and distribution of electricity, gas and water, lost growth momentum during 2013. Industrial performance was especially shaky, with manufacturing growth dropping to 0.8 percent in 2013 compared to 2.7 percent in 2012 (Figure 8). Figure 7: Tradable sector growth, percent, y-o-y Figure 8: Non-tradable sector growth, percent, y-o-y 20 14 12 15 10 8 10 6 4 5 2 0 0 -2 -4 -5 2011 2012 2013 2011 2012 2013 Electricity, Gas, and Water Construction Retail Trade Agriculture and Forestry Mineral Extraction Manufacturing Transport Financial Services Real Estate Source: Rosstat and World Bank staff estimates Source: Rosstat and World Bank staff estimates 6 Russia Economic Report | Edition No. 31 I. Recent Economic Developments Box 1 2013 GDP production structure (cont) Table 2: Contribution to growth by sectors, percentage points 2011 2012 2013 Tradable sectors 2.0 0.5 0.4 Non-tradable sectors 2.1 3.0 1.0 Public sector -0.2 0.1 0.1 Discrepancy -0.2 -0.2 -0.1 Source: Rosstat and World Bank staff estimates 1.3 Labor Market 2013 – Demand and income growth stabilize Key labor market indicators reflected the stagnation in the real sector. As a result, income growth stabilized at a new lower level and led to a slight moderation in the growth of the productivity gap. The slowdown in real-sector growth translated into a slight increase in the poverty rate for 2013. T he demand for labor as measured by the vacancy rate did not change significantly during 2013 (Figure 10). Total employment across regions. The regions with the lowest unemployment in Q4 2013 were the largest Russian metropolitan areas: Moscow and St. declined sharply in the first half (H1) of 2013, Petersburg (2.0 percent, respectively), followed but the seasonally adjusted indicator ended the by Samara oblast (2.7 percent), Moscow oblast year at 71.2 million people compared to 71.8 (2.8 percent) and Magadan oblast (2.9 percent) million people in 2012 (Figure 9). As results, in the Far East. The highest unemployment the unemployment rate remained unchanged rates are traditionally registered in the Northern in H2 2013 at a seasonally adjusted level of 5.5 Caucases federal district of Ingushetia (39.5 percent, suggesting a balanced labor market. percent), Chechnya (25.7 percent) and the On the regional level, against a backdrop of low Kalmyk and Tuva republics (12.6 and 19.6 percent population and labor mobility, unemployment respectively). The latter also represent the two rates remained highly heterogeneous regions with highest poverty rates in Russia Figure 9: Number of employed and economically active population, million people Figure 10: Beveridge curve, percent 77 3.2 4Q 13 76 2Q 13 75 4Q 12 74 2Q 12 2.7 73 Vacancy rate, % 4Q 11 72 71 70 2.2 4Q 09 4Q 10 69 68 67 Dec 1.7 2010 2011 2012 2013 2013 5.0 6.0 7.0 8.0 9.0 Employment Activity Activity, SA Employment, SA Unemployment rate, % Source: Rosstat and World Bank staff estimates Source: Rosstat and World Bank staff estimates Russia Economic Report | Edition No. 31 7 I. Recent Economic Developments (Figure 10). Women’s contribution to the labor 2012.3 Considering continued high interest rates market was reduced throughout 2013, with the of 20-25 percent on a 3-year loan, pressure female unemployment rate increasing and the on consumption has increased as a significant average number of working hours for women percentage of household’s disposable income (of slightly declining. up to 5 percent4) is used for servicing this debt. Real disposable income grew at 3.3 percent Poverty increased slightly during 2013 as a during 2013, compared to 4.6 percent in 2012. result of the observed economic slowdown, Disposable income growth decreased in the which brought with it a deceleration in nominal second half of 2013 to 2.9 percent from 4.2 income growth (Table 1). Food and services- percent in H1. Average income growth for the CPI continued to outpace headline inflation. last five years stood at around 3.4 percent. As a result, the poverty line was increasing The composition of growth remained driven by faster than the nominal income for lowest market wages (labor income) followed by public quintiles. The poverty rate increased slightly in wages and pensions (transfers) (Figure 11). the beginning of the year and remained at this However, real wage growth decelerated in Q4 level of 11.9 percent for the remainder of 2013 2013 as public wage growth slightly diminished. (seasonally adjusted). Regional poverty rates are Although Q4 2013 data is still preliminary, the very unequal (Figure 13). The lowest rates were decline in public wages affected the composition registered in the most developed regions of of income growth. The contribution of public Central Russia (e.g. Moscow region and Kaluga) wages and transfers to income growth was as well as in the resource rich regions (Yamalo- lower than before, compared to other sources, Nenets autonomous okrug and Tatarstan). The such as market wages (Figure 11). Together with highest rates are in the Eastern Siberian regions household credit as a share of GDP (Figure 19), (Altai, Tuva republics), some regions of the Far households’ indebtedness continued to grow East (Kamchatka oblast) and in the South of from to 25.6 percent of disposable income Russia (Kalmykia). Income inequality did not at end-2013 from 21.9 percent in December change during 2013. Figure 11: Contribution to income growth, Figure 12: Households’ real wages dynamics, percentage points, y-o-y y-o-y growth 12 15 10 8 10 6 4 5 2 0 0 -2 -4 -6 -5 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4* -10 2009 2010 2011 2012 2013 Dec 2009 2010 2011 2012 2013 2013 Others Business and Property Total Non-Market Non-Tradables Tradables Total Market Wages Public Wages and Transfers Source: Rosstat and World Bank staff estimates Source: Rosstat and World Bank staff estimates Note: *Data for 4Q 2013 are preliminary 3 As a share of GDP consumer loans increased to 15.0 of GDP at end- 2013, compared to 12.4 percent in December 2012. However, the stock of household debt increased at a slower rate of 28.7 percent in 2013 compared to 39.3 percent in 2013 (y-o-y). 4 World Bank staff estimate. 8 Russia Economic Report | Edition No. 31 Figure 13: Poverty rates in 2012, 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 6.60, 9.50 9.50, 11.20 11.20, 12.60 12.60, 14.70 14.70, 16.80 16.80, 31.40 I. Recent Economic Developments No Data Russia Economic Report | Edition No. 31 Source: Rosstat and World Bank staff estimates 9 I. Recent Economic Developments Table 3: Poverty rates in Russia, percent Period 2010 2011 2012 1Q 2013 2Q 2013 3Q 2013 Poverty rate, percent 12.5 12.7 11.0 13.8 13.0 12.6 Source: Rosstat and World Bank staff estimates Box 2 The gap between productivity and wages is highly unequal levels across sectors The deceleration in GDP growth and shrinking total Figure 14: Gap between real wages and productivity employment led to a moderation in the growth of growth by sectors, y-o-y productivity per worker. As real wages grew more 135 slowly in line with productivity, the gap between real wages and total productivity leveled out. 130 However, the situation continued to differ across the 125 main economic sectors. In the largest sector of the 120 Russian economy, the non-tradable sector (market 115 services, construction, transport, etc.), which 110 accounts for half of all jobs wage growth, was in line 105 with productivity growth. But in the tradable sector (mining, manufacturing and agriculture), which is 100 experiencing price competition with foreign goods, 95 wage growth was actually lower than productivity 90 growth, improving its competiveness. The sector 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 where the gap between wages and productivity 2008 2009 2010 2011 2012 2013 remained the highest was the non-market services sector, which includes education, health, public Total Tradables Non-tradables Non-market administration and defense. Wages there continued to grow much faster than productivity. Source: Rosstat and World Bank staff estimates 1.4 Balance of Payments 2013 —A weakening current account and increased vulnerability Russia’s balance of payments (BoP) position weakened in 2013 while the current account surplus shrank to less than half of its 2012 level. During the second half of the year, capital outflows from the private sector picked up as a result of the scaling back of the US monetary stimulus and large external debt payments. R ussia’s BoP position has become more vulnerable to terms-of-trade shocks associated with a potential drop in resource values of crude oil and non-oil exports (Figure 15). Second, the balance of services deteriorated to a deficit of US$59.0 billion in 2013 from prices. The current account (CA) continued a deficit of US$46.5 billion in 2012. Finally, deteriorating, which was especially reflected the deficit of the investment income account in an increase of the non-oil CA deficit, which increased to US$66.2 billion (3.1 percent of reached US$315.8 (14.1 percent of GDP) GDP) in 2013 from US$56.8 billion (2.9 percent compared to US$274.8 (13.8 percent of GDP) in of GDP) in 2012 as companies increased interest 2012. The CA remained in surplus, but decreased payments on outstanding debt and scaled up by more than half, from US$72 billion (3.6 dividend payments (Figure 16). percent of GDP) in 2012 to US$33 billion (1.6 percent of GDP) in 2013 (Figure 15, Figure 16). BoP vulnerability was amplified by more Three main factors contributed to this decrease: volatile and weakening capital and financial first, the trade surplus shrank to US$177.3 billion accounts. In a flexible exchange-rate regime, CA (8.5 percent of GDP) from US$192.3 billion (9.7 deterioration is balanced out by improvements percent of GDP) in 2012 largely due to lower in the capital account, other things being equal. 10 Russia Economic Report | Edition No. 31 I. Recent Economic Developments Figure 15: Trade and services balances and oil prices Figure 16: Current account balance, percent of GDP 140 60 12 130 50 120 9 40 110 6 100 30 3 90 20 80 10 0 70 0 -3 60 -10 -6 50 40 -20 -9 Q1-07 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Q4-13 2008 2009 2010 2011 2012 2013 Crude oil, Brent, $/b (left axis) Trade balance, bln USD (right axis) Goods Services Remittances Services balance, bln USD (right axis) Investment Income Transfers Current Account Balance Source: CBR; and World Bank staff estimates Source: Rosstat and World Bank staff estimates Yet Russia’s capital and financial accounts The corporate sector reduced foreign deteriorated to a deficit of US$42.8 billion (2.1 borrowing in the second half of 2013. Apart percent of GDP) in 2013, compared to a deficit from slowing investment activities, the increased of US$26.5 billion (1.3 percent of GDP) in 2012, cost of borrowing and limited access to putting additional pressure on the Ruble. Net international capital market may have reduced capital flows from the private sector remained the borrowing and debt-rollover capacity of high and volatile. They were negatively affected Russian corporations. However, Russia’s external by uncertainty regarding QE tapering, poor debt increased to US$732 billion (35.5 percent investors’ sentiments and unrealized growth of GDP) by the end of 2013 from US$636 prospects. However, when adjusted for currency billion (31.7 percent of GDP) at the end of swaps, they amounted to US$62.5 billion dollars, 2012 (Table 6). It is noteworthy that the the same level as the year before. Partly due to new debt was predominantly accumulated large external debt payments, capital outflows by state or quasi-state companies and banks, from the non-financial corporations intensified while exposure of private banks and companies in the second half of 2013 to US$44.0 billion changed marginally.5 Also, the bulk of new credits from US$12.7 billion in H1 2013 (Table 5), by non-financial corporations (US$32.5 out of adding to the volatility in capital flows. Chronic US$35.8 billion) was acquired during Q1 2013. structural problems in the economy and falling To a large extent, this increase is related to the profit margins of Russian assets made them purchase of Rosneft shares by British Petroleum less attractive to investors, who increasingly as part of the TNK deal concluded in Q1 2013. preferred to move their funds abroad, adding to Foreign borrowing from the corporate sector in pressures on the BoP and its vulnerability. Russia decreased since Q2 2013. 5 Foreign liabilities of non-financial corporations increased by US$73 billion in 2013 amounting to US$437.8 billion by end-December, while banks’ exposure rose by only US$13.3 to US$214.9 billion in the same period. Russia Economic Report | Edition No. 31 11 12 Table 4: Balance of payments, 2007–2013, US$ billions Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2008 2009 2010 2011 2012 2013* 2012 2012 2012 2012 2013* 2013* 2013* 2013* Current account balance 103.9 50.4 67.5 97.3 72.0 33.0 39.5 16.2 5.8 10.5 25.1 2.6 0.6 4.7 Trade balance 177.6 113.2 147.0 196.9 192.3 177.3 59.0 49.3 38.5 45.5 48.3 42.5 43.2 43.3 Non-oil current account balance -206.2 -140.3 -186.6 -244.5 -274.8 -315.8 -50.7 -69.2 -75.4 -79.5 -61.7 -81.3 -86.8 -85.8 Capital and financial account -139.8 -40.6 -21.6 -75.6 -31.7 -43.4 -29.6 0.8 -4.2 1.3 -12.8 -8.8 -6.8 -14.9 Errors and omissions -3.1 -6.4 -9.1 -8.7 -10.3 -11.7 -5.3 -2.0 -0.1 -2.9 -7.3 1.8 -1.2 -5.0 Russia Economic Report | Edition No. 31 Change in reserves (- = increase) 38.9 -3.4 -36.8 -12.6 -30.0 22.1 -4.6 -15.0 -1.5 -8.9 -4.9 4.4 7.4 15.2 Memo: average oil price (Brent, US$/barrel) 96.9 61.5 79.7 111.1 112.0 108.9 118.7 108.7 109.9 110.5 112.9 103.0 110.1 109.4 Source: CBR * Preliminary estimates Table 5: Net capital flows, 2007–2013, US$ billions Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2008 2009 2010 2011 2012 2013 2012 2012 2012 2012 2013* 2013* 2013* 2013* Total net capital inflows to the private sector -133.6 -57.5 -30.8 -81.4 -54.6 -62.7 -33.8 -4.7 -7.9 -8.2 -28.2 -6.2 -11.6 -16.6 Net capital inflows to the banking sector -55.2 -32.2 15.9 -23.9 18.5 -6.0 -9.7 11.6 7.7 8.9 -17.4 -4.4 10.9 4.9 Net capital inflows to the non-banking sector -78.3 -25.3 -46.7 -57.4 -73.1 -56.7 -24.1 -16.3 -15.6 -17.1 -10.9 -1.8 -22.5 -21.5 Source: CBR * Preliminary estimates Table 6: Russia’s external debt, US$ billions Jan-11 Jal-11 Oct-11 Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Total debt 488.9 538.9 527.8 538.9 557.5 570.6 598.9 636.4 690.2 706.2 714.2 732.0 Corporate 442.4 491.0 482.6 492.6 509.1 517.1 538.8 566.4 613.2 631.3 634.1 652.8 Banks 144.2 159.0 157.3 162.8 169.2 175.4 189.9 201.6 205.9 211.9 207.1 214.9 of which Private Banks 80.8 89.1 86.8 89.5 90.6 78.7 84.1 86.2 81.1 82.4 79.4 n/a Non-financial corporations 298.2 332.0 325.3 329.8 339.8 341.7 348.9 364.8 407.4 419.4 427.1 437.8 of which Private Non-fin. Corporations 208.3 236.3 228.9 227.8 236.0 234.2 237.7 251.3 254.1 258.0 263.4 n/a Source: CBR. As for the beginning of the month I. Recent Economic Developments I. Recent Economic Developments 1.5 Monetary Policy and Financial Sector 2013 — Currency volatility and elevated credit risk The Ruble came under increased pressure as the current account deteriorated and investors became more risk-averse in anticipation of the impact of the scale-down of the US monetary stimulus. Credit risks rose as firms and households found it increasingly difficult to service their debts. Inflation pressure remained high in 2013, driven by food and service prices. V olatility of the Russian currency increased during 2013. The Central Bank of Russia (CBR) responded with a scaled-up intervention, by 5.5 percent to US$509.6 billion by end-2013 from US$537.6 billion at the end of 2012. drawing upon its foreign currency reserves. The 2013 Consumer Price Index (CPI) increased The Ruble was under increasing pressure by 6.5 percent, exceeding the Central Bank since Q2 2013, triggered by the ongoing target by 0.5 percentage points. Inflation deterioration of the CA and by higher volatility pressures remained high during most of 2013, in capital outflows. This was in part related to driven by non-monetary factors. Higher-than- uncertainties around the scaling back of the U.S. expected prices for food (7.3 percent) and monetary stimulus. However, unrealized growth services (8.0 percent) pushed inflation up, expectations and large foreign debt payments especially in the first and last quarters of 2013 by the corporate sector plaid a more prominent (Figure 18). The seasonal retreat in inflation role in Russia. Despite a considerably increase during the summer months did not bring it down of CBR’s exchange-rate interventions, the Ruble as much as expected. The CBR policy of keeping depreciated 2.4 percent against the US dollar the key policy rates unchanged during 2013 and 4.1 percent against the bilateral currency appeared to be consistent with the changing basket in 2013. The CBR spent about US$28.2 economic fundamentals of a tight labor market, billion to support the currency, compared to high credit growth and an increased level of US$5.6 billion in 2012 (Figure 17). As a result, monetization of the economy (M2/GDP ratio the CBR’s foreign-exchange reserves decreased increased to 47.1 percent in 2013 from 44.3 Figure 17: Exchange rate and its bilateral band Figure 18: CPI inflation by component, percent, y-o-y 16 51 48 14 45 12 42 10 39 8 36 6 33 4 30 2 27 0 2010 2011 2012 2013 2014 2007 2008 2009 2010 2011 2012 2013 2014 Rb/USD Rb/Eur Basket Lower bound Upper bound Food Non-Food Services CPI Source: CBR; and World Bank staff estimates Source: Rosstat and World Bank staff estimates Russia Economic Report | Edition No. 31 13 I. Recent Economic Developments percent in 2012). The central bank adhered decreasing profit margins during 2013. CBR to its regulatory commitment to complete its statistics shows that the share of NPLs of firms move to inflation targeting by the end of 2014 (categories IV and V) more than doubled last by resisting rising political and public pressures year to 3.3 percent at end-December 2013 to relax monetary policy. from 1.4 percent at the end of 2012. Moreover, the share of the worst-quality loans (category Credit growth remained significant in 2013, V, provisioned by 86 percent) increased the elevating credit risk as firms and households most, to 2.3 percent from 0.8 percent in the found it increasingly difficult to service debt. The corresponding periods. stock of bank credit reached 53.1 percent of GDP by the end of 2013, compared to 48.2 percent While aggregate financial indicators for the in 2012. Despite the slowing economy, average banking system remained solid, the CBR credit growth was still very high: for household, intensified its supervisory oversight and started 33.9 percent in 2013 (41.5 percent in 2012) and to clamp down on financially non-viable banks 19 percent for all lending. Credit growth to firms (Box 3). By Q3 2013, average lending interest rates remained the same during 2013, averaging 12.7 in the system hovered around 9.5 percent while percent as in 2012 (Figure 19). Households spent deposit rates held at around 5.5 percent—a very an increasing share of their income to service healthy 4.0 percent intermediation spread. Also, loans (see labor market section).6 As a result, the capital adequacy ratio for the system stood the share of non-performing loans (NPLs) for at 13.5 percent at end-December, well above the households (category IV and V) increased to 6.5 minimum. Gross NPLs were 6.0 percent of total percent in 2013 from 5.2 percent in 2012 (Figure loans at year-end, the same as at the start of the 20). The recent slowing trend in income growth year. As part of strengthening its supervisory and the gradual relaxation of the labor market function, the CBR revoked licenses of several are likely to contribute further to an increase in banks during the second half of 2013 and, in the NPLs share by households.7 Some companies first three months of 2014 alone, of 15 banks also lost their debt-servicing capacity, to and several non-bank credit organizations. Figure 20: Nonperforming loans and loan loss Figure 19: Credit growth, percent, y-o-y provisions, percent of total loans 60 10 50 9 8 40 7 30 6 20 5 10 4 0 3 -10 2 1 -20 0 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12 Sep-12 Dec-12 Mar-13 Jun-13 Sep-13 Dec-13 2007 2008 2009 2010 2011 2012 2013 Q4 2013 Non-financial Organisations Households Non-performing Loans: Total Loans Loan Loss Provisions: Total Loans Source: CBR; and World Bank staff estimates Source: CBR; and World Bank staff estimates 6 The Russian household debt/income ratio increased from 15 percent in 2010 to around 24 percent in 2013. 7 Also, there is a 1-2 year time-lag between households defaulting on loans and these loans actually showing up as NPLs, due to the definition of NPLs and the first immediate automatic restructuring attempts. 14 Russia Economic Report | Edition No. 31 I. Recent Economic Developments Box 3 Sanitizing the banking system in Russia During 2013, the risk of maintaining the quality of the credit portfolio increased and CBR started to revoke licenses of financially non-viable banks. CBR canceled the licenses of 29 banks between early 2013 and end- February 2014. While some egregious cases pertained to money laundering, several appeared to have been related to inappropriate-party lending, fraudulent reporting, an inability to pay creditors, overvalued assets and asset-quality issues. These factors have essentially made several banks insolvent (they became so-called ‘zombie’ banks) or illegal (in the case of anti-money laundering operations). A proposed increase by CBR in the minimum capital requirement for banks and other prudential requirements would adversely affect around 180 banks, of which 50 could be required to close or be bought out. The closure of these banks is unlikely to significantly affect household borrowing, as many banks being closed were pocket banks set up for specific businesses, individuals or related parties. The cleaning up of the banking system by CBR is a welcome initiative, but clear criteria by CBR for doing so should be set out to avoid generating any panic in the markets. 1.6 Government Budget 2013 – Balances under pressure The overall fiscal balance worsened slightly on a year-to-year basis and the non-oil deficit continued to exceed 10 percent of GDP. The consolidated budget ended in a deficit for the first time since the crisis period as sub-national public finances weakened. Russia’s fiscal buffers increased moderately, but their investment decisions became subject to political pressures. P reliminary numbers showed the federal budget was executed at a deficit of 0.5 percent of GDP in 2013, compared to a deficit import duties) decreased in 2013 to 9.8 percent of GDP from 10.3 percent of GDP a year before. At the same time, the average Urals oil price of 0.1 percent of GDP a year earlier (Table 7). (US$107.9 per barrel in January-December 2013) The non-oil deficit improved slightly from 10.4 was only US$2.5 below average Urals oil price for to 10.3 percent of GDP, but remained under the same period of 2012 and stayed above the the envisioned reduction to 9.7 percent of GDP oil prices envisaged in the 2013-2015 Budget at the beginning of the year. Federal budget Law (US$97 per barrel for 2013). This actually revenues dropped to 19.5 percent of GDP in increased oil revenue inflows in comparison to 2013 in from 20.5 percent in 2012. This decline the budgeted numbers. Federal budget non-oil was caused by a fall in both oil and non-oil revenues decreased by 0.5 percent of GDP from revenue. Federal budget oil revenue (export and 10.2 percent in 2012 to 9.7 percent in 2013, due Table 7: Federal budget 2011-2013, percent of GDP 2011 2012 2013 2013 2013 Execution Execution Budget Law 2013 Dec. Execution Amendment Expenditures 20.1 20.6 20.1 20.1 20.0 Revenues 20.9 20.5 19.3 19.4 19.5 Balance 0.8 -0.1 -0.8 -0.7 -0.5 Oil Revenues 10.4 10.3 8.9 9.7 9.8 Non-Oil Balance -9.6 -10.4 -9.7 -10.5 -10.3 Urals oil price, US$/barrel 109.3 110.4 97.0 97.0 107.9 Source: Ministry of Finance, Economic Expert Group, World Bank staff calculations Russia Economic Report | Edition No. 31 15 I. Recent Economic Developments to decline in VAT proceeds. Federal expenditures percent of GDP to 36.6 percent in 2012, and 37.4 shrank in 2013 slightly by 0.6 percent of GDP to percent in 2013. 20.0 percent of GDP over last year. On a year- to-year basis, federal expenditures were cut Increased fiscal pressures on consolidated primarily for social and healthcare expenditures: budget stemmed from lower-than-expected 0.6 percent of GDP less transfers to the Pension subnational revenues. As a share of GDP, Fund and 0.3 percent of GDP reallocation of the subnational revenues were steadily decreasing federal expenditure assignments to the Medical since 2011, dropping by 1.5 percent of GDP in Insurance Fund, as well as for subsidies to 2013 compared to 2011 and by 0.7 percent companies by 0.5 percent. On the other hand, compared to 2012. The trend was driven by lower defense expenditures increased by 0.2 percent corporate profits, especially in manufacturing, as of GDP over the same period. a result of the economic slowdown. Corporate- profit tax proceeds dropped at the subnational A weak sub-national public finance situation led level from 3.5 percent of GDP in 2011 to 3.2 to the first deficit of the consolidated budget8 percent in 2012, and 2.6 percent of GDP in since the crisis period. In 2013, the consolidated 2013. On the expenditure side, subnational budget balance continued its decline for the governments were unable to make adjustments second consecutive year, ending the year at a 1.3 in line with the decreasing revenues due to percent of GDP deficit (Table 8). This reflects a commitments to increase salaries of teachers deterioration of 1.7 percent of GDP compared to and medical personnel. In 2013, subnational the previous year. Consolidated budget revenues expenditures fell by a moderate 0.1 percent dropped in 2013 to 36.1 percent of GDP from 37.0 of GDP compared to 2012. Consequently, the percent a year earlier, again continuing a two- subnational fiscal outturn worsened during 2013 year trend in revenue decrease. Unfortunately, and the subnational budget deficit increased to this decline was accompanied by a reverse 1.0 percent of GDP compared to 0.1 percent in trend on the expenditure side. Consolidated 2011 and 0.4 percent in 2012. expenditures were growing from 2011 from 35.9 Table 8: Consolidated budget and consolidated subnational budget in 2011-2013, percent of GDP 2011 2012 2013 Execution Execution Execution Consolidated budget Expenditures 35.9 36.6 37.4 Revenues 37.5 37.0 36.1 Balance 1.6 0.4 -1.3 Consolidated subnational budget Expenditures 13.8 13.3 13.2 Revenues 13.7 12.9 12.2 Balance -0.1 -0.4 -1.0 Corporate Profit Tax 3.5 3.2 2.6 Source: Ministry of Finance, World Bank staff calculations 8 The consolidated budget includes the federal budget, the subnational budgets and extra-budgetary funds, e.g. pension and social security. 16 Russia Economic Report | Edition No. 31 I. Recent Economic Developments Russia’s fiscal buffers increased moderately in half of the amount accumulated by the end 2013, but some discretion in their investment of 2008. To allow for investments of the NWF was introduced following political pressures. into Ukrainian treasury bills, on December 23, By the end of 2013, the Reserve Fund increased 2013, Government passed a special resolution by 1.2 percentage points to 4.3 percent of to change the original law on investing NWF GDP after replenishment at the beginning of resources. It allowed the fund to invest up to the calendar year. The National Welfare Fund 10 percent of its volume into securities that (NWF) decreased by 0.1 percent of GDP over had lower ratings than the originally prescribed the same period, although both funds increased AAA, per special Government decision. Later in nominal terms due to the effect of the ruble in December, the first US$3 billion tranche (of devaluation, as their portfolio consists of a mix a planned US$15 billion) was used to acquire of different currencies. Both funds amounted Ukrainian treasury bills with NWF proceeds.9 to 8.6 percent of GDP, thus representing about 9 This was part of a broader package of about US$15 billion, which would have been partly funded through the purchase of Ukrainian T-bills by the National Welfare Fund. Russia Economic Report | Edition No. 31 17 PART II Economic Outlook G lobal markets have so far seen little disruption from the growing tension in between Ukraine and Russia, and oil markets remained stable. Growth of the world economy is projected to accelerate this year, with high-income economies appearing to finally turn the corner six years after the global financial crisis. However, markets are likely to remain volatile, as demonstrated by recent instability following the QE tapering commencement in the U.S. The World Bank projects oil prices to average US$103/bbl during 2014, given stable demand and increasing non-OPEC supply. The World Bank developed two alternative scenarios for Russia’s 2014-2015 growth outlook in response to the higher- risk environment since political uncertainties around the Crimean crisis in early March 2014 led to increased market volatility. Confidence weakness continues to weigh down on domestic demand suggesting, first, that consumption growth is likely to slow and stabilize at a lower level than in previous years. Second, our growth outlook projects that at the margin, the rate of growth will be increasingly dependent on the recovery in investment demand. Third, in the short-term, growth will be impacted by the geopolitical tension that started with the Crimean crisis and depend on how it will be resolved. The World Bank’s low-risk scenario assumes a limited and short-lived impact of the Crimea crisis and projects growth to slow to 1.1 percent in 2014 and slightly picking up to 1.3 percent in 2015. The World Bank’s high-risk scenario assumes a more severe shock to economic and investment activities due to the Crimean Crisis and projects a contraction in output of 1.8 percent for 2014. We expect in both scenarios that non-monetary inflation pressures from the ongoing Ruble depreciation will increase inflation and put our projection slightly higher than the upper end of the CBR targeted range for 2014. The Government’s medium-term fiscal outlook has consolidation at its core, but the targets for expenditure control and revenue increases are ambitious given the current low-growth environment and mounting political pressures. For that reason, our fiscal projections divert from the Government’s medium-term framework. Risks to the global outlook remain prominent and they suggest higher market volatility. Russia’s long-term outlook will depend on a sustained positive shift in investors’ and consumers’ confidence. There is the risk that as Russia’s government is put back into crisis mode, attention will be diverted to manage short-term issues, while the medium-term structural reform agenda languishes. II. Economic Outlook 2.1 Global Outlook - Improving growth prospects with higher market volatility Global markets have so far seen little disruption from the growing tension between Ukraine and Russia, and oil markets have remained stable. Growth of the world economy is projected to accelerate this year, with high-income economies appearing to finally turn the corner six years after the global financial crisis. However, markets are likely to remain volatile, as demonstrated by recent instability following the QE tapering commencement in the U.S. The World Bank projects oil prices to average US$103/bbl during 2014, given stable demand and increasing non-OPEC supply. G rowing tension in Ukraine and Russia since late February has so far caused relatively limited disruption in global financial markets, percent this year and 2.4 percent in 2015. Growth in developing and emerging countries is projected to pick up modestly from 4.8 percent but escalation of geo-political tension between in 2013 to 5.3 percent this year, and 5.5 percent Russia and the EU and the U.S. remains a key in 2015. Stronger high-income growth and risk. Although financial markets in Russia and import demand will be an important tailwind Ukraine have suffered large sell-offs in response for developing countries’ exports, which should to the crisis, global market reaction has so far help compensate for tighter global financial been relatively muted. The VIX index, a gauge of conditions. global risk aversion, jumped 14 percent in early March and gold prices, a gauge of geopolitical The Federal Reserve began tapering its QE risk, were up by 15 percent by mid-March, but program in January, prompted by the improving both have subsequently come down. Wheat growth prospects of the U.S. economy. Financial and maize prices, however, were up 15 percent market reaction was initially muted, with long- and 8 percent on March 19 compared with a term U.S. Treasury yields remaining stable and month earlier. volatility on currency markets remaining low, suggesting that a large part of the tapering Global GDP growth is projected to increase to impact had already been priced in. However, the 3.2 percent in 2014 and 3.4 percent in 2015, period of relative market calm was broken at the compared to 2.4 percent in 2013 (Table 9). Most end of January following the sudden depreciation of the acceleration is expected to come from of Argentina’s peso, worries about the Chinese high-income countries, as the drag on growth economy and other country-specific economic from fiscal consolidation and policy uncertainty and political factors. Gross capital flows to diminishes and private-sector growth gains a developing and emerging countries reached a firmer footing. High-income growth is projected new record low in February (Figure 21). Stock to strengthen from 1.3 percent in 2013 to 2.2 markets and currencies in a number of emerging Table 9: Global real GDP growth, percent 2009 2010 2011 2012 2013e 2014f 2015f World -1.9 4.3 3.1 2.5 2.4 3.2 3.4 High Income -3.6 3.0 1.8 1.5 1.3 2.2 2.4 Developing Countries 3.0 7.8 6.3 4.8 4.8 5.3 5.5 Euro Area -4.4 1.9 1.6 -0.6 -0.4 1.1 1.4 Russia -7.8 4.5 4.3 3.4 1.3 1.1 (-1.8)* 1.3 (2.1)* Source: World Bank Global Economic Prospects Group and World Bank Russia team 20 Russia Economic Report | Edition No. 31 II. Economic Outlook Figure 21: Gross capital flows to developing countries substitution away from oil. The key assumption 80 $ billions underpinning these projections reflects the 70 upper-end cost of developing additional oil 60 capacity from Canadian oil sands, currently estimated at US$80/bbl in constant 2014 dollars. 50 Since the start of 2014, crude oil prices have 40 continued to be range-bound. Meanwhile, 30 the U.S. mid-continent benchmark West Texas 20 Intermediate (WTI) has strengthened in recent 10 weeks as refineries’ utilization rates are high 0 Jan-12 Jun-12 Nov-12 Apr-13 Sep-13 Feb-14 and the pipeline capacity draws stocks from the Equity issuance Bank lending Bond issuance landlocked delivery point of Cushing, Oklahoma. Source: Dealogic and World Bank Prospects Group Stocks at Cushing were at a four-month low of 34.8 million barrels at the end of February. The economies came under pressure, and several spread between WTI and Brent, the international large middle-income economies embarked on benchmark, has narrowed to US$6.5/bbl, also a aggressive policy-tightening to relieve the stress four-month low. on their currencies and domestic inflation, including Argentina, Brazil, India, Indonesia, World demand for crude oil is expected to grow Turkey, and South Africa. The growth outlook at less than 1.5 percent annually over the next for developing countries still remains positive three years, with growth coming from non- in aggregate but, countries that have had to OECD countries, as has been the case in recent significantly increase interest rates in response years (Figure 22). Consumption growth in OECD to the recent market turmoil and where inflation economies will continue to be subdued by slow is rising on account of weaker currencies can face economic growth and efficiency improvements weaker growth prospects. Should global interest in vehicle transport induced by high prices, rates increase more abruptly or market volatility including a switch to hybrid, natural gas and prevail, more disorderly adjustments cannot be electrically powered transport. Pressure to ruled out. reduce emissions due to environmental concerns is expected to dampen demand growth at the Despite the Russia-Ukraine conflict, oil prices global level. In early 2014, demand from OECD have been remarkably stable. In fact, crude oil countries surprised on the upside, helped by the prices have been down 4.5 and 2.5 percent since extreme winter in the U.S. and a sharp decline in the beginning of March. Russia is the world’s commercial oil inventories during November and largest oil supplier, accounting for 13 percent December 2013 to the lowest levels since early of global oil production. It also contributes 30 2008. On the supply side, non-OPEC oil production percent of the natural gas consumed in Europe. is expected to continue its climb because high The World Bank expects nominal oil prices to prices have prompted an increased use of average US$103/bbl during 2014 (down from innovative exploration techniques (including US$104/bbl in 2013) and decline to US$100/bbl deep-water offshore drilling and extraction of in 2015. In the longer term, prices in real terms shale liquids) and the implementation of new are expected to fall due to growing supplies of extractive technologies to increase the output unconventional oil, efficiency gains, and (less so) from existing wells. For the first months of Russia Economic Report | Edition No. 31 21 II. Economic Outlook 2014, supply-side disruptions from Libya, Iran, from non-OPEC countries remains robust and is Iraq, South Sudan, Nigeria, Syria and Yemen do expected to grow by US$1.7 million barrels per not show signs of easing. Nonetheless, supply day during 2014. Figure 22: Growth of global oil demand by quarter, 2001-2014, percent change, y-o-y 4 mb/d, y/y 3 2 1 0 -1 -2 -3 -4 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Non-OECD, ex China China OECD Source: World Bank; IEA 2.2 Growth Outlook for Russia – A question of confidence and geopolitical risk The World Bank developed two alternative scenarios for Russia’s 2014-2015 growth outlook in response to the higher-risk environment since political uncertainties around the Crimean crisis in early March 2014 led to increase market volatility. Confidence weakness continues to weigh down on domestic demand suggesting, first, that consumption growth is likely to slow and stabilize at a lower level than in previous years. Second, our growth outlook projects that at the margin, the rate of growth would be increasingly dependent on the recovery in investment demand. Third, in the short-term, growth would be impacted by the geopolitical tensions which started with the Crimean crisis and depend on how it will be resolved. L ack of confidence is reflected in continuing depressed domestic demand and resulted in subdued economic activity in the beginning further, relative to Q4 2013 outcomes: retail trade grew 3.2 percent in January-February 2014 (compared to 3.4 percent in December of 2014. That has implications for the growth 2013) and fixed capital investment dropped outlook. Confidence remains at record-low 5.0 percent (compared to 0.3 percent growth levels (Figure 23 and Figure 24). High-frequency in December 2013). The overall weakness in indicators showed weak readings for many domestic demand led to two core assumptions economic sectors in January-February 2014. for our outlook: (1) consumption growth is Aggregate industrial growth increased 0.9 likely to continue its movement to a new percent (y-o-y) with manufacturing industries and slightly lower equilibrium level than in posting growth of 1.8 percent in the first two previous years; and (2) at the margin, the months of 2014 compared to 2.5 percent in rate of growth will be increasingly driven by Q4 2013 (y-o-y). Domestic demand weakened changes in investment demand. 22 Russia Economic Report | Edition No. 31 II. Economic Outlook Figure 23: Manufacturing and business surveys Figure 24: Consumption and consumer confidence 3 4 20 5 2 3 0 15 2 -5 1 1 10 -10 0 -15 0 5 -1 -20 -1 -2 0 -25 -2 -30 -3 -5 -3 -35 -4 -4 -10 -40 -5 -5 0 00 001 002 003 004 005 006 007 008 009 010 011 012 0134 2 2 2 2 2 2 2 2 2 2 2 2 2 2 Q Jan-12 Jun-12 Nov-12 Apr-13 Sep-13 Feb-14 Industrial Production, m-o-m Business Confidence PMI Consumption growth, y-o-y Consumer Confidence (RHS) Source: Rosstat, Haver Analytics and World Bank staff estimates Source: Rosstat and World Bank staff estimates Political uncertainties around the Crimean crisis tension could subside following an orderly led to high volatility on the Russian markets. resolution of the geopolitical tension around In early March, increased political risk greatly the Russia-Ukraine affairs and accommodation affected the markets which plummeted on with the West. Access to international capital the news of the authorization of Russian troop and financial market would be restored and deployment to the Crimea (Box 4). This suggests confidence would improve. that political risks could be a deciding factor in the short-term. If the Russia-Ukraine conflict Our low-risk scenario projects growth to slow escalates, uncertainty could rise around political to 1.1 percent in 2014, slightly picking up and economic sanctions from the West, and to 1.3 percent in 2015. The growth outlook Russia’s response to them. This could further in this scenario is based on the following worsen business and consumer confidence and expectations regarding domestic demand and raise market volatility with negative impact external conditions in 2014-1015. Consumption on domestic demand and growth prospects. is expected to be constrained by lower income To acknowledge this risk environment, we growth in previous periods, remaining inflation developed two alternative scenarios for the pressures due to devaluation (see outlook for Russia 2014-2015 growth outlook. inflation below) and, to a lesser extent, relaxation of labor market conditions. Thus, we estimate The World Bank’s low-risk scenario assumes a that consumption growth slows and stabilizes limited and short-lived impact of the Crimean at lower levels. The baseline scenario is based crisis. The crisis could be contained in a on global outlook and oil price trends described peaceful fashion with some political tension above. This essentially implies robust demand remaining in 2014. In that case, the economic for Russian exports in the projected period. impact is expected to be limited with no trade Import demand will continue slowing due to restrictions introduced trough sanctions. The lower income growth and devaluation of the main transmission channels of this contained national currency. As a result, the contribution of crisis would be through the capital account and net exports to growth will become positive over impacts on market confidence. In 2015, political the projection period. Russia Economic Report | Edition No. 31 23 II. Volatility in Russia Box 4 Market response to the Crimea events Speculative attacks on the Ruble considerably intensified during the first days of March as uncertainty rose over tensions between Russia and Ukraine (Figure 25). On March 3 alone, CBR spent US$11.3 billion, which is close to the historical maximum of US$15 billion on January 19, 2009 (at the time about 2.3 percent of its foreign currency reserves), to support the currency and moved the foreign exchange corridor up by 35 kopeks. To curb volatility on the financial market, CBR decided during an emergency meeting on March 3 to temporarily hike its main policy rates by 150 basis points to 7 percent. In addition, CBR switched to defining parameters for its foreign exchange interventions on a daily basis in accordance with the current situation on the domestic foreign exchange market. On March 3, the CBR raised the amount of cumulative interventions sufficient for moving of foreign exchange corridor by 5 kopeks from US$350 million to US$1.5 billion. Thanks to CBR’s strong response and the Ministry of Finance’s decision to temporarily put on hold its daily purchases of currency for the Reserve Fund, some confidence into the Ruble was restored. However, we expect that there will remain volatility and speculation in the foreign exchange market until the political crisis is resolved. The stock market reacted negatively to the news of the Russia-Ukraine conflict and saw massive sell-offs on March 3 (Figure 26) as the RTS index fell by 13.8 percent to 1092.48, the lowest level since August, 2009. The trading of several stocks has been suspended due to losses of more than 20 percent. The stock markets remain sensitive to daily news and will likely retain higher volatility until the crisis cool down. Figure 25: Exchange rate dynamics, Euro-Dollar basket Figure 26: Stock market reactions 44 1600 3500 43 1500 3000 42 2500 41 1400 40 2000 1300 39 1500 38 1200 1000 37 1100 500 36 1000 0 35 1-Nov-13 6-Jan-14 20-Mar-14 1-Jan 1-Feb 4-Mar 21-Mar 2014 2014 2014 2014 Trade volume, mln USD (right axis) RTS index Source: Rosstat and World Bank staff estimates Source: Rosstat and World Bank staff estimates The low-risk scenario assumes no changes projects in the Far East will commence in the in economic policy that could produce second half of 2014 and gradually pick up in 2015. significant positive shocks on investment or The aggregate impact of changes in inventories consumption over the projection period (Table is projected to be neutral due to no noteworthy 10). Consumption would decrease to 2.2 percent changes in business sentiments. As a result, in 2014 and to 2.0 percent in 2015, negatively gross capital formation is projected to shrink affected by slowing income growth in preceding 1.8 percent in 2014 and grow marginally at 0.4 periods. Investment activities would remain percent in 2015. Thus, without an additional subdued, with a marginal but positive impact stimulus, the economy’s growth is projected on gross fixed investment dynamics from some to slow further in 2014 before slightly picking recently announced infrastructure projects, up in 2015, supported by improved investment especially in 2015. We assume that construction demand, robust external demand and stable of the ring road around Moscow, stadiums for consumption. the soccer World Cup 2018 and infrastructure 24 Russia Economic Report | Edition No. 31 II. Volatility in Russia Table 10: Main economic indicators: low-risk scenario 2012 2013 2014 2015 GDP growth, percent 3.4 1.3 1.1 1.3 Consumption growth, percent 6.9 3.4 2.2 2.0 Gross capital formation growth, percent 1.4 -3.4 -1.8 0.4 General government balance (percent of GDP) 0.4 -1.3 -0.5 -0.2 Current account (US$ billion) 72.0 33.0 26.8 24.1 Percent of GDP 3.6 1.6 1.3 1.2 Capital account (US$ billion)* -42.0 -55.1 -68.0 -32.0 Percent of GDP -2.1 -2.6 -3.3 -1.6 Oil price assumption (US$ per barrel) 105.0 104.0 103.5 99.8 Source: World Bank staff estimates Note: *Current account minus change in reserves The World Bank’s high-risk scenario assumes • The relative risk for foreign investors would a more severe shock to economic and increases as profit margins fall. As a result, investment activities from the Crimean Crisis. a foreign investors and banks might pull out An intensification of political tension could funds as gross FDI inflows drop. lead to heightened uncertainties around • Exchange-rate volatility would intensify to a economic sanctions which would further degree that depends on the markets’ reaction depress confidence and investment activities. to the ongoing QE tapering and CBR’s path to Yet, this scenario assumes that the international implement the flexible exchange-rate regime. community would still refrain from trade As a result of higher depreciation, external sanctions. In 2015, political tension could borrowing could become more expensive just subside with an orderly resolution of the as international financial markets tighten. This political crisis. Domestic demand would stay could force companies into a wait-and-see depressed longer than we projected in our mode until volatility drops to levels where the low-risk scenarios as the following factors exchange-rate risks become more manageable. would assert additional negative pressure on • Banks’ credit portfolios would deteriorate sentiments and investment activities: faster as growth tumbles. Banks would charge • For companies, access to the international their creditors higher risk premiums and capital market would become increasingly would increase their collateral requirements. restricted. Large corporations that borrow Borrowing costs would increase. Reduced abroad (notably in the commodities sector) debt-servicing and rollover capacity would might find it increasingly difficult to access hamper investment activities. In addition, external financing. This could reduce their debt higher consumer credit defaults would further rollover capacity and lead to a scale-down of curtail consumption growth. their investment programs. • Russian banks would face new restrictions The World Bank’s high-risk scenario projects a in accessing international capital markets, contraction in output for 2014 of 1.8 percent as at a time when domestic money and capital a result of a deeply negative investment shock markets already suffer from high volatility due and further slowdown in consumption growth. to low confidence and increased political risks. The contraction in real GDP is mostly driven As a result, credit activities could slow down, by a sharp decline in gross capital formation negatively affecting the ability of firms to raise of 10.3 percent (Table 11) and an aggregate funds for their investment program. consumption slowdown to 0.8 percent, affected Russia Economic Report | Edition No. 31 25 II. Volatility in Russia by lower income growth, higher unemployment External Balances – Deteriorating CA and plummeting confidence. and volatile capital flows But if there is an orderly resolution of the Crimean Crisis, the economy would recover in F or our low-risk scenario, the BoP outcome will be largely driven by import performance, income account and capital flows. Export 2015. This would allow Russian authorities to performance will be affected in line with the refocus their attention on domestic policies to projected global outlook and oil prices. Low shore up business and consumer confidence, income growth and a weaker Ruble are expected which in turn would lead to higher growth. to result in slowing imports and stable trade Nevertheless, there would remain some tail risk of balances. As a result, the estimated deterioration continued tensions, which would adversely affect of the CA is not going to be as profound as it growth over a longer period. Real GDP growth is was in 2013. We estimate surpluses on the CA projected to rebound to 2.1 percent, largely due to decrease to US$ 26.8 billion (1.3 percent of to a low base in 2014. Investors’ access to capital GDP) in 2014 and further to US$ 24.1 billion (1.2 and financial markets is expected to be gradually percent of GDP) in 2015 (Table 10). Net capital restored and investment demand will improve. outflows are projected to increase somewhat Growth in gross capital formation would resume in 2014, largely driven by heightened political to 5.0 percent in 2015, which is still lower than uncertainty, and diminish gradually in 2015, its 2013 levels, as investors remain cautious along with the CA deterioration. The deficit on about long-term prospects. Consumption the capital account is estimated to amount to growth is expected to recover slightly to 1.1 US$ 68.0 billion in 2014 and US$ 32.0 billion in percent, still impacted by lower income growth 2015. Volatility of capital flows is likely to remain during the preceding periods. Economic high during the projection period and will be a recovery in 2015 and afterwards would depend key downside risk to BoP outcomes, especially on solid private investment growth. In addition in 2014. The Ruble is expected to depreciate to a stable macroeconomic environment, this according to changes in BoP fundamentals, would require a positive shift in business and both in 2014 and 2015. Also, the volatility of consumer confidence. Without significant the exchange rate will remain high as markets structural reforms directed to strengthening test CBR’s commitment to move to a flexible regulatory and market institutions and tackling exchange-rate regime, especially in the first half large inefficiencies in factor allocation across the of 2014 when nervousness about QE tapering is economy, this is unlikely to happen and would likely to persist and political tension around the subdue long-term growth prospects. Russia-Ukraine conflict remains. Table 11: Main economic indicators: high-risk scenario 2012 2013 2014 2015 GDP growth, percent 3.4 1.3 -1.8 2.1 Consumption growth, percent 6.9 3.4 0.8 1.1 Gross capital formation growth, percent 1.4 -3.4 -10.3 5.0 General government balance (percent of GDP) 0.4 -1.3 -0.9 -0.5 Current account (US$ billions) 72.0 33.0 60.2 49.4 Percent of GDP 3.6 1.6 3.0 2.5 Capital account (US$ billions)* -42.0 -55.1 -133.0 -62.2 Percent of GDP -2.1 -2.6 -6.7 -3.1 Oil price assumption (US$ per barrel) 105.0 104.0 103.5 99.8 Source: World Bank staff estimates Note: *Current account minus change in reserves 26 Russia Economic Report | Edition No. 31 II. Volatility in Russia In our high-risk scenario, BoP pressures are percent, which could require further tightening expected to increase with much larger net if the high-risk scenario materializes. capital outflows. However, the CA is projected to improve to US$60.2 billion as import demand In our forecast we assume that CBR completes decreases due to the contraction of GDP and the its move to a flexible exchange-rate regime by faster depreciation of the Ruble (Table 11). Yet 2015. Yet, we believe that CBR will continue using the improvement on the CA would not be enough active interventions on the foreign exchange to compensate for the sharp deterioration of market in the first half of 2014 to fight off the capital account. Restricted access to the excessive volatility largely related to remaining international capital market, reduced FDI inflows political tension around the Crimean crisis and and additional reallocation of assets away from continuing QE tapering: in Q1 2014 alone, it Russia would result in a sharp increase in net spent about US$38.9 billion on interventions capital outflows. As a result, the capital account to support the Ruble. Thus, we assume a loss is projected to deteriorate sharply to a deficit of of foreign reserves in 2014 and a stable reserve US$133.0 billion (6.7 percent of GDP) in 2014 position in 2015 in both scenarios. from US$55.3 billion (2.6 percent of GDP) in 2013. The CBR would need to finance the gap Fiscal Balances – Is consolidation achievable? between the CA surplus and the growing deficit on the capital account with its reserves. In 2015, uncertainty is expected to decrease and access O ur fiscal projections divert from Government’s medium-term framework of 2014-2016 (Box 5). Government’s medium-term to financial markets restored: the capital account fiscal outlook for 2014-2016 has consolidation at would improve to a deficit of US$62.2 billion (3.1 its core, but the targets for expenditure control percent of GDP) and BoP pressures would ease. and revenue increases are ambitious, given the current low-growth environment and mounting Inflation and credits – high devaluation political pressures. Government envisions that and credit default risks fiscal buffers decline moderately in in 2014- F or both scenarios we expect the ongoing Ruble depreciation is likely to impact inflation dynamics in 2014-2015. Inflation pressure 2016 (Figure 27).10 Our fiscal projection reflect the following underlying assumptions for both scenarios: (1) external conditions and oil prices remained high at the beginning of 2014, driven reflect the global outlook presented in the by food prices. As a result, 12-month CPI inflation report; (2) expenditures are projected in line totaled 6.2 percent in February 2014, compared Figure 27: Government projections for the reserve fund and to 6.1 percent in January and 6.5 percent at the national welfare fund, percent of GDP, e-o-p end of 2013. In 2013, CBR had limited capacity 18 to manage inflation expectations related to non- 16 monetary factors. We expect that the stricter 14 controls for utility prices that were introduced by 12 Government in 2014 should help the regulator 10 better control inflation dynamics. The recent 8 increase in main policy rates (from 5.5 to 7.0 6 percent) also curbed inflation expectations 4 in 2014. Yet, we believe that non-monetary 2 pressures, resulting from elevated depreciation 0 risk, will remain high. Amidst those pressures, we 2008 2009 2010 2011 2012 2013 2014 2015 2016 project inflation slightly higher than the upper Reserve Fund National Welfare Fund end of CBR targeted range for 2014 of 4.0-5.0 Source: Ministry of Finance Russia Economic Report | Edition No. 31 27 II. Volatility in Russia with the Government medium-term budget slowdown. They would be compensated by the parameters; (3) the fiscal rule remains effective positive effect of deprecation. As a result in low throughout projection period, with government risk scenario consolidated fiscal deficit will total having limited capacity to significantly increase 0.5 percent of GDP in 2014 and 0.2 percent in expenditures. Our projections suggest a 2015. As a result in the low risk scenario the stable fiscal position in both low and high risk consolidated fiscal deficit will total 0.5 percent scenarios. We do expect different revenue of GDP in 2014 and 0.2 percent in 2015. levels, depending on the size of the economic Box 5 Government’s medium-term budget framework for 2014-2016 Government’s medium-term budget envisages relative stability of fiscal outturns in 2014-2015 and improvements by 2016. This might be difficult to achieve, given the already mounting fiscal stress on the sub- national budgets and the increasing political pressure to increase transfers and grants. The key assumption of the medium-term budget framework is that a gradual reduction in the non-oil federal budget deficit will occur, decreasing from 10.3 percent of GDP in 2013 to 8.4 percent of GDP in 2016. This is envisioned to be achieved first of all through adjustments on the expenditure side, by 1.1 percent of GDP.11 The consolidated budget deficit is expected to decrease quite significantly from 1.3 percent of GDP in 2013 to 0.2 percent in 2016, accompanied by a sizeable increase in revenues by 0.7 percent points of GDP and only a moderate expenditure decline by 0.4 percent points of GDP over the three-year period (Table 12). Both the Reserve Fund and the NWF are projected to remain well below 2009 pre-crisis levels (of 9.8 percent of GDP and 6.3 percent of GDP respectively) and their new medium-term targets are modest at 7.7 percent of GDP in 2016. By 2016, the Reserve Fund is expected to stabilize at 4.3 percent of GDP. The NWF (currently at 4.3 percent of GDP) is forecasted to decline to 3.4 percent of GDP by 2016. It is expected that the NWF could invest up to 450 billion Rubles into domestic securities associated with priority infrastructure projects. Simultaneously the quality of the NWF’s portfolio is subject to increased risks, given the recent legal amendment by Government to allow for buying lower-than-investment grade securities for up to 10 percent of its funds, in effect allowing for higher discretionary investment decisions. Table 12: Medium-term government budget projections for 2014-2016, percent of GDP Execution Preliminary Draft Approved Law 2013 2014 2015 2016 2014 2015 2016 Consolidated Budget Expenditures 37.4 35.8 35.4 34.9 37.2 37.3 37.0 Revenues 36.1 35.1 34.9 34.4 36.4 36.4 36.8 Balance -1.3 -0.7 -0.5 -0.5 -0.8 -0.9 -0.2 Federal Budget Expenditures 20.0 18.7 18.6 18.0 19.0 19.3 18.9 Revenues 19.5 18.2 18.0 17.4 18.5 18.3 18.3 Balance -0.5 -0.5 -0.6 -0.6 -0.5 -1.0 -0.6 Non-Oil Balance -10.3 -8.5 -8.4 -7.8 -9.4 -9.6 -8.4 Urals crude oil price, US$/barrel 106.4 101.0 100.0 100.0 101.0 100.0 100.0 Source: World Bank staff estimates 10 These fiscal buffers are part of the Government’s fiscal rule. It includes funding a moderate federal budget deficit through the placement of Treasury bills and Eurobonds. The Reserve Fund was replenished in 2013 at the beginning of the fiscal year. However, for 2014 the replenishment remains delayed as the Ukraine- Russia crisis impacted negatively the exchange rate. Since earlier this year, Government also postponed the placement of its Treasury Bonds because of unfavorable market rates. 11 The projected decline in federal expenditure by 2016 is proposed through a number of quite radical measures. They include (1) federal budget spending cuts by 5 percent across almost all expenditure items, (2) a reduction of subsidies to budgetary and autonomous entities by 2 percent annually in 2014-2016 and (3) zero indexation of salaries of staff of federal state entities, civil servants, judges, prosecutors, investigators and, military personnel. However, there are exceptions to federal budget spending cuts under (1): (i) legally binding public commitments, expenditure commitments made according to the Orders of the President on May 7, 2012 (indexed by 4.5-5 percent); (ii) salaries of military personnel; (iii) transfers to extra budgetary funds; (iii) subsidies to budgetary and autonomous entities; (iv) federal equalization transfers to regions (indexed by 5 percent); (v) targeted federal transfers to regions; (vi) pensions (even increases in pensions of the retired military); (vii) stipends (indexed by 4.5-5 percent); (viii) expenditures for the judicial system; (ix) program on purchases of military equipment and (x) contributions to be made according to international treaties. 28 Russia Economic Report | Edition No. 31 II. Volatility in Russia 2.3 Other Risks Risks to the global outlook remain prominent and they suggest higher market volatility. Russia’s long-term outlook will depend on a sustained positive shift in investors’ and consumers’ confidence. There is the risk that as Russia’s government is put back into crisis mode, attention will be diverted to manage short-term issues, while the medium-term structural reform agenda languishes. R isks to the global outlook remain prominent and suggest higher market volatility. The recovery in high-income countries, led by the U.S., remain, however, concerns about the stock of refinanced and restructured loans in the system. We expect the share of restructured loans in the Germany and Japan, is fragile and could be offset total portfolio to increase, thus masking the rise by a gradual decline in investment and growth in credit risks. Restructured loans will be kept in emerging economies, especially in China. in or moved to a less-risky category of loans, Geopolitical and commodity risks, including thus allowing banks to keep the provisioning of those linked to the recent Russia-Ukraine crisis, non-performing loans at relatively low levels. could actually play out to the benefit of Russia by Given the overall lower-growth trajectory and pushing oil and gas prices temporarily up. This is increasing indebtedness of households, the the main upside risk for Russia’s growth outlook. risk that these loans will again become non- However, global markets appear to normalize to performing is rather high. a higher level of volatility and their reactions to the gradual withdrawal of the QE policies remain Russia’s long-term outlook will depend on erratic, preserving the already elevated risk for a sustained positive shift in investors’ and currency speculations and capital outflows. consumers’ confidence. In order to overcome Further interest increases are likely, keeping the the current confidence crisis and achieve cost of borrowing elevated and limiting access sustained long-term growth, structural reforms to international capital markets. Most of all, would need to be started in the coming years. confidence in a broad-based global recovery is The dearth of such reforms efforts is darkening still wavering and becomes increasingly driven Russia’s growth outlook. In order to mobilize by a higher differentiation into regional and private investments in a sustained manner country-specific sentiments. and on a larger scale, inefficiencies in factor allocation across the economy would need to be Credit growth in Russia is expected to slow addressed. It would also require creating a level while credit risk is likely to increase. Household playing field for such businesses by improving credit growth slowed from it record levels in the quality of regulatory and market institutions, 2012 of 39.4 percent to a still-high 28.7 percent so that rules are implemented evenly. Moreover, in 2013. Indebtedness will continue to rise and both of our scenarios are driven by short-term in the medium-term we expect relatively fast developments in the recent Crimean crisis. There credit growth that could increase credit risks.12 is the risk that as Russia’s government is put back Currently, these risks appear to be contained and into crisis mode, attention will be diverted to the CBR does not see any systemic risk, according manage short-term issues, while the medium- to the results of their recent stress tests. There term structural reform agenda languishes. Even 12 Compared to other eastern European countries the level of household debt is still low and Russia’s ratio of credit to GDP remains notably below its peers. In addition, the depth of financial intermediation is still very low in Russia with only about 25 percent of the population currently using formal financial services. Russia Economic Report | Edition No. 31 29 II. Volatility in Russia another positive investment shock through fiscal the state owned/controlled or financial sectors or quasi-public investments is unlikely to lift the (e.g. Russian Railways, Sberbank, VTB, Uralsib Russian economy’s long-term growth prospects. Bank, Avtovaz) announced labor optimization measures. This will dampen households’ income Stabilizing consumption at an altogether lower prospects and as a result consumption growth. rate would also dim the outlook on economic While in the medium to long-term labor market mobility and continued middle-class formation demand relaxation will be partly compensated by in Russia. The topic of economic mobility and its a shrinking in the labor force due to demographic recent trends in Russia is explored in the third factors such as aging of the Russian population, part of this report. We project in our low-risk in the short-term, upward economic mobility is scenario that consumption growth will decrease likely to slow down. Our special focus note in to about 2 percent in 2014-2015, compared to part three shows that most of poverty-reduction 3.4 percent in 2013 and 6.9 percent in 2012. In and middle-class growth was explained by high 2014, we expect some labor market relaxation. growth in average incomes and consumption In recent months, several large corporations in during 2000-2010. 30 Russia Economic Report | Edition No. 31 PART III Economic Mobility and Middle-Class Formation in Russia 13,14 A s in the rest of the emerging world, the Russian middle class, defined as those with per capita consumption levels of US$10/day or higher (2005 PPP), grew dramatically during 2001-2010. As a result, the Russian middle class is today one of the largest, in terms of its share of the population, in the Europe and Central Asia region and the even in emerging word. However, though living standards improved across the board, questions about economic mobility patterns and their determinants have re-entered the public debate in Russia in recent years. This reflects a renewed preoccupation with inequality (on the rise since the mid-2000s) and with the distribution of gains associated with the transition to a market economy and the accompanying policy reforms. The growth of the middle class in Russia was part of a broader trend of upward economic mobility during 2001-2010. Upward economic mobility was the result of both increases in average income levels and changes in the distribution of income. This paper documents the rapid rise of the Russian middle class during 2001-2010 and its main drivers. Though demographic factors (related to aging and other social changes) and economic factors both matter for middle class entry, it is the latter that best explain most of the observed changes in the period of study. Wage and pension growth accounts for over half of the observed income growth among middle class entrants in 2001-2010, with demographics factors playing a secondary role. Access to good, productive jobs—i.e. jobs that require a higher level of skills and thus pay higher wages—and wage growth in both the private and public sectors have served as the main platforms for the rise of the middle class in Russia. In addition, significant increases in pensions have helped many escape poverty and vulnerability and join the middle class, particularly during 2006-2010. Further expansion of the middle class will require continued job creation, combined with an increase in labor force participation among youth, women and older workers, so as to increase the overall employment rate in the economy and strengthen the role of labor income as the main driver of middle income growth. 13 This note summarizes selected results from a forthcoming World Bank report on economic mobility in Russia, “Social Mobility and Opportunities”, to be launched in the spring of 2014. The results presented in this note draw from background work done by the authors and by Maria Ana Lugo (Economist in the Poverty Unit of the Latin America and the Caribbean region of the World Bank). 14 Moritz Meyer is an Extended-Term Consultant in the Poverty Unit of the Europe and Central Asia region of the World Bank. Carolina Sanchez-Paramo is the Sector Manager of the unit. III. Economic Mobility and Middle-Class Formation in Russia 3.1 Introduction O ver the past decade or so, the emerging world has been witness to unprecedented growth in household welfare, lifting many out with per capita consumption levels equal to or above US$10/day, grew from 30 percent to 60 percent of the total population (see Box 5, Meyer of poverty and allowing many others to join the and Sanchez, 2013, for details on the definitions ranks of a growing middle class. As a result, the used in this paper). These developments have subject of the middle class has received much been documented in a number of thematic attention in the literature in recent years.15 This surveys and reports in recent years.16 discussion has covers a variety of topics, ranging from how to define and measure the middle class However, even as living standards have to how to best characterize it as distinct from improved across the board, questions about other social classes to its the potential economic inequality, economic mobility patterns and and social role. their determinants have re-entered the public debate in Russia in recent years. This reflects a Russia has been no exception to these global renewed preoccupation with inequality, which trends. The poverty rate, defined as the share has been on the rise since the mid-2000s, and of the population with per capita consumption with the distribution of gains associated with levels equal to or below US$5/day, fell from 35 the transition to a market economy and the percent in 2001 to 10 percent in 2010. At the accompanying policy reforms. same time, the middle class, defined as those Box 6 Mobility and the middle class – Definition and measurement There is no single way to define or measure the middle class. Some researchers have proposed “relative” measures, where the middle class is defined as the share of people “in the middle” of the income distribution (Barro, 1999; Birdsall, at alia, 2000, Easterly, 2001; Thurow, 1997); others have used absolute measures instead, where middle-class households are those “above an absolute poverty threshold, but that lack the economic assets to ensure complete protection against poverty” (Banerjee and Duflo, 2008; Birdsall, 2010; Kharas, 2012; Milanovic and Yitzhaki, 2002; Ravallion, 2009).17 These two concepts reflect different perceptions of the role of the middle class and can potentially lead to significant differences in outcomes. Consider, for example, a fairly egalitarian but low-income country. Under a “relative” definition, such a country would have a large middle class, but under the “absolute” definition, the middle class might be fairly small. In this paper, the middle class is defined using a monetary measure. Specifically, households with per capita consumption equal or higher than US$10/day (real 2005 PPP values) will be considered middle-class households. In addition, households with per capita consumption equal or below US$5/day will be considered poor and households with per capita consumption between US$5/day and US$10/day will be considered vulnerable. The choice of the US$10/day cut-off for the middle class is not arbitrary, but rather draws from a growing body of work by WB teams and others. This cut-off has been used in Latin America and the Caribbean (World Bank, 2012), and increasingly in other regions, to identify the middle class (in middle-income countries). This was also the value chosen for the discussion on middle class societies during the MIC Forum at the 2012 Annual Meetings. Following the same criteria therefore allows us to compare Russia to other middle-income countries. Similarly, the choice of the US$5/day cutoff for poverty reflects the current practice in the Europe and Central Asia (ECA) region of the World Bank, where two standardized poverty lines are used to measure extreme poverty ($2.5/day) and poverty ($5/day) in all countries in the region. Following the same practice therefore allows us to compare Russia to other ECA countries. 15 See, for instance, Banerjee and Duflo, 2008; Birdsall, 2007 and 2010; Easterly, 2001; Kenny, 2011; Kharas, 2012; Milanovic and Yitzhaki, 2002; Pressman, 2007; Ravallion, 2009; World Bank, 2012. 16 See, for instance, Bogomolova and Tapilina, 1999; Bogomolova, 2011; Carnegie Moscow center, 2003; Denisova, 2007; Expert Journal, 2006; Fedorov, Lvov and Baskakov, 2009; Gerry and Li, 2010; Gorshkov, 2008; Gorshkov and Tichonova, 2006; Gorodnichenko and Peter and Stolyarov, 2010; Grigoryev, 2012; Hayashi, 2007; Maleva, 2002 and 2008; Maleva and Ovcharova, 2009; Nissanov, 2012; Ocharova, 2012; Tichorova, 2007 and 2008; Tichorova and Gorunova, 2008; Tichorova and Marreva, 2009; Trusova, 2001; World Bank, 2009. 17 See Torche and Lopez-Calva, 2010 for a complete discussion. 32 Russia Economic Report | Edition No. 31 III. Economic Mobility and Middle-Class Formation in Russia This paper uses information from the Russian middle class that is relevant for (high) middle- Longitudinal Monitoring Survey (RLMS-HSE) income countries, the paper is able to present and other data sources (see Meyer and Sanchez- international comparisons with other middle- Paramo, 2014) to analyze the emergence and income countries so as to place numbers and growth of the middle class in the Russia in trends in Russia in the global context. Second, 2001-2010 and discuss how these trends relate the paper provides both a characterization of to broader patterns of economic mobility in the Russian middle class and a discussion of the the country. The paper builds on the existing main drivers underlying its growth during 2001- literature on the topic and aims to add value 2010, distinguishing the roles of demographics, to this literature in two complementary ways. markets and public policy. First, by using a standardized definition of the 3.2 Russia in the global context D uring 2000-2010, the size of the middle class grew the world over and in particularly in middle-income regions and countries. The share (ECA), the middle class grew rapidly from close to 20 percent of the population circa 2000 to close to 40 percent circa 2010 (Figure 28.A). of the population whose per capita consumption levels at or above US$10/day (the middle Not all middle-income countries are middle- class definition used in the paper) increased class societies however. Despite rapid growth in marginally in South Asia and the Middle East 2000-2010, only a few countries in the world and Northern Africa, and a bit more noticeably can be considered middle-class societies in in Sub-Saharan Africa, East Asia and the Pacific. which a large fraction of the population is in However, in all cases, less than 10 percent of the the middle class. Not surprisingly, most of population belonged to the middle class in 2010. these countries are middle-income countries In contrast, in Latin America and the Caribbean and many of them are in LAC and ECA. Russia (LAC) and, especially, in Europe and Central Asia is part of this group (Figure 28B). Figure 28: A panorama of the middle class in the emerging world A. Rapid growth of the middle-class, particularly in middle income regions and countries Percentage of population in each economic group by region, circa 2000-2010 100 90 80 Percentage of population 70 60 50 40 30 20 10 0 2000s 2010s 2000s 2010s 2000s 2010s 2000s 2010s 2000s 2010s 2000s 2010s South Asia Middle East Sub Saharan East Asia Latin America Europe and and North Af rica Af rica and Pacifi c and Caribbean Central Asia Extreme Poor Poor Vulnerable Middle Class Source: Staff calculations using data from the PovCal Netdatabase. Estimates for LAC are based on income, for the other regions on expenditures. Estimates in panel A are population-weighted. Note: Numbers for Russia are based on a 2008 Household Budget Survey. Russia Economic Report | Edition No. 31 33 III. Economic Mobility and Middle-Class Formation in Russia B. Middle income countries versus middle class societies Percentage of population in middle class and GDP per capita 70 20 GDP per capita (PPP, Thousands of $) 18 60 Percentage of population 16 50 14 12 40 10 30 8 20 6 4 10 2 0 0 h do c) Tu and (c) yz os re ) in (l) ra ru ) te eo pt ) ilip lan (c) m Ec rke (c) ai ca ) p ) B bi ) Pa raza (l) Se ico c) kh va ) n or ) M FYR c) d’ rg (c) Po hile c) S an ) E rb an l) Uk amil (l) Az Jor as ) So l Sa aija (c) ia ria ) a n l) Ur atvi (c) B bi l) ia Li gen ay ) ru ) A ine (c) Ka ol ia ) et ia ) m ) at ina (c) lo via ) Re ov (c) ed ul ay ) L ry ) Be tion (c) jik dia ) st sia c) Ph azi lic ) Gu Ch an ) n th tin (l) c) nd nia (l) do n c) ) In rme an ( ) rg K Ivoi a (c Pa Pe . (l Co G Egy (c Th Afri r (l Re (l m (l Hu Ric (c) ra ia ) za do (c ica ad (c ist (c ur (c on ga (l Ar gu a (c la (c M lban s (c Vi nes (c na (c Co oli a (c ac B gu (l a l Ta In a (c b c st (c Ro em (c A ud (c e d ( de an (l M la ( r ( ut lva n ( ng a ( ex ) ( ( ( C e( Co lay d ( Sw pu o ( s( ra a Ho ma ala in u y p d Fe u a ia i ri ge n l a u Ni Do Ky M ss Less than 30% 30%-50% More than 50% GDP per capita (PPP) Ru Source: Staff calculations using data from the PovCal Netdatabase. Estimates for LAC are based on income, for the other regions on expenditures. Estimates in panel A are population-weighted Note: Numbers for Russia are based on a 2008 Household Budget Survey At 60 percent of the population, the Russian 50 percent of the population in the middle class, middleclass is one of the largest, in terms of its Russia is in the group of emerging economies with share of the population, in the ECA region and the largest share of its population in the middle the emerging word. The size of the middleclass class (Figure 28B). Although there are small among ECA countries ranges from a low2-3 differences in the size of the middle class across percent in Tajikistan and Armenia to a high Figure 28B and Figure 29 due to differences in 80 percent in Belarus (Figure 29). Within this the data harmonization process, the results are spectrum, very few countries surpass the 50 qualitatively consistent across both figures and percent mark. These are Russia, Latvia, Hungary, with the analysis presented below. Lithuania and Belarus. Similarly, with more than Figure 29: The Russian middle class is the largest in the Europe and Central Asia region Percentage of population in each economic group by country, circa 2010 Percent 100 90 80 70 60 50 40 30 20 10 0 n nia yz vo ia ia va n nia ria bia y e nd ssi a via ary ia us sta me rg so org an ldo sta ma lga Ser rke rai n la Ru Lat ng an lar jiki Ar Ky Ko Ge Alb Mo zakh Ro Bu Tu Uk Po Hu Lit hu Be Ta Ka Extreme Poor Poor Vulnerable Middle Class Source: Staff calculations using the ECAPOV database Note: Numbers for Russia based on 2008 Household Budget Survey 34 Russia Economic Report | Edition No. 31 III. Economic Mobility and Middle-Class Formation in Russia 3.3 Aggregate trends and developments: A bird’s eye view T he Russian middleclass, defined as those with per capita consumption levels of US$10/day or higher, grew dramatically during Figure 30: Share of total population whose per capita consumption is equal or higher than US$10/day (2005 PPP) Percent 2001-2010. According to data from the Russian 70 Longitudinal Monitoring Survey (RLMS-HSE, see 60 box 1 for details), the relative size of the middle 50 class doubled, from 27 percent to almost 60 percent of the Russian population in a span of 40 10 years (Figure 30). And although the middle 30 class was disproportionally affected in Russia 20 and many other middle-income countries by the 10 global financial crisis in 2008/09, the number of middle-class households recovered quickly and 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 continued to grow after the crisis, albeit as a Source: Staff calculations using data from the RLSM-HSE, 2001-2010 slower pace.18 behavior of private consumption and consistent And with growing numbers came increased with the notion of Russia as a middle-income aggregate economic weight and purchasing society (Figure 31). power. The middleclass controlled almost 50 percent of total household income and The growth of the middleclass in Russia was accounted for over 60 percent of total household part of a broader trend of upward economic consumption, as measured in the RLMS-HSE, in mobility during 2001-2010. Positive and 2001. By 2010, these numbers were 74 percent sustained economic growth for most of the period and 86 percent respectively, making the middle translated into strong per capita consumption class the only game in town when it comes to the growth from US$9/day in 2001 to almost US$17/ Figure 31: The middle class controls a large share … and accounts for most aggregate private of total income… consumption in Russia Percentage of total income held by poor, vulnerable and Percentage of total private consumption accounted for by poor, middle income households, 2001 and 2010 vulnerable and middle income households, 2001 and 2010 90 100 80 90 70 80 60 70 50 60 40 50 40 30 30 20 20 10 10 0 0 2001 2010 2001 2010 Poor Vulnerable Middle Class Poor Vulnerable Middle Class Source: Staff calculations using data from the RLSM-HSE, 2001-2010 18 Data for RLMS-HSE 2011 and 2012 are currently being processed and the analysis will be updated as soon as results for these years are available. Russia Economic Report | Edition No. 31 35 III. Economic Mobility and Middle-Class Formation in Russia day in 2010 (2005 PPP) and a significant decline into the group of vulnerable and middle class in poverty and, to a lesser extent, vulnerability.19 households respectively, while 15.6 percent remained in poverty. Underlying these aggregate changes are movements of households in and out of During 2001-2005, 20 percent of the total different economic groups. To examine the population (or 75 percent of the poor) moved nature of these movements, we constructed out of poverty, with an additional 15 percent two panel datasets for the periods 2001- following suit in 2006-2010. Similarly, 22 percent 2005 and 2006-2010 using the RLMS-HSE of the total population became part of the and compare the economic status of each middle-class in 2001-2005, and an additional 25 household at the beginning and the end of each percent did the same in 2006-2010. As a result, period. The results are presented in Table 1. 10 percent, 30 percent and 60 percent were Panel A and panel B correspond to 2001-2005 poor, vulnerable or middle-class respectively and 2006-2010 respectively. Within each panel, in 2010, compared to 36 percent, 37 percent rows capture economic status in the first year and 27 percent in 2001 (Table 13). Overall, 35 of the period and columns capture economic percent of the total population climbed up the status in the last year of the period. The number economic ladder to join a better-off economic in each cell represents the percentage of the group between 2001 and 2005, and 34 percent total population that belongs to the economic did the same between 2006 and 2010 (in green group described in the row heading for the in Table 13). first year of the period and the economic group describe in the column heading for the last year Still, not all households moved up the social of the period. Thus, between 2001 and 2005 ladder during the period. In fact, in both 2001- (first panel), 13.2 percent and 7.1 percent of the 2005 and 2006-2010, approximately 15 percent total population transitioned out of poverty and of the total population experienced large Table 13: The emergence of the middle class is part of a broader pattern of strong upwards mobility Percentage of total population classified by economic status in 2001 and 2005 Status in 2005 Status in 2001 Poor Vulnerable Middle class Total 2001 Poor 15.6 13.2 7.1 35.9 Vulnerable 6.8 14.8 15.3 36.9 Middle class 3.6 7.0 16.5 27.1 Total 2005 26.0 35.0 38.9 100 Percentage of total population classified by economic status in 2001 and 2005 Status in 2010 Status in 2006 Poor Vulnerable Middle class Total 2006 Poor 5.8 9.0 6.0 20.8 Vulnerable 3.2 12.9 19.3 35.4 Middle class 1.4 9.0 33.3 43.7 Total 2010 10.4 30.9 58.6 100 Source: Staff calculations using data from the RLSM-HSE, 2001-2010 19 An individual is considered poor if his consumption is equal or less than US$5/day (in real 2005 PPP values); similarly, an individual is considered vulnerable is his consumption is high enough to be above the poverty threshold but too low to be considered middle class (i.e higher than US$5/day but less than US$10/day in real 2005 PPP values). 36 Russia Economic Report | Edition No. 31 III. Economic Mobility and Middle-Class Formation in Russia enough declines in per capita income to push in poverty could be explained by changes in them into a lower socio-economic group (in red average income, while the remaining fourth in Table 13), suggesting that vulnerability to was be explained by changes in the distribution shocks remains an issue at all socio-economic of income. In contrast, growth in average levels. For instance, more than 30 percent of income levels accounted for “only” half of the those considered middle class in 2001 were movements into the middle class, with the either vulnerable or even poor in 2005; and the remaining half was linked to changes in the same can be said about 2006-2010. distribution of income.20 This differed from the experience of other European and Central Combined, these data revealed a more complex Asian (ECA) countries, where changes in the picture of economic mobility in which both distribution of income had a negative (albeit upward and downward mobility took place at very small) impact on the growth of the middle the same time, producing a dominant upward class during the same period, as well as with that trend accompanied by significant churning. of countries in Latin America and the Caribbean This differed from the experience of other (LAC), where income growth explained almost middle-income regions and countries. For of the observed growth in the middle class in instance, a comparable exercise for the LAC 1995-2010.21 region covering the period circa 1995-2009 Figure 32:The distribution of income shifted to the right showed upward mobility of similar magnitude, and widened during 2001-2010 with approximately 50 percent of the poor (23 Kernel distribution of per capita household income in 2001 and 2010 (USD percent of the population) exiting poverty and Household income in Russia in 2001 and 2010 over 30 percent of the population joining the middle class. But there was less downwards .15 mobility and thus churning as only 3 percent of the total population fell into a worse-off .1 Kernel density economic group during the period. The figure for those initially in the middle class was 4 0.5 percent (World Bank, 2012). 0 Upward economic mobility was the result of 0 10 20 30 40 Household income per capita both increases in average income levels and Year 2001 Year 2010 changes in the distribution of income. The Source: Staff calculations using data from the RLSM-HSE, 2001-2010 distribution of household per capita income Note: Graph includes 10 US$ PPP middle class line changed significantly between 2001 and 2010 as both average household per capita income Upward economic mobility was accompanied and its variance rose (Figure 32). We use a well- by a widening income gap, in absolute terms, established decomposition technique (Datt and between the middle class and the rest of Ravallion, 1992) to further examine the impact society (the bottom 40 percent in 2010). In that these changes had on economic mobility 2001, the average per capita income level of and, particularly, the emergence of the middle the middle class was US$12/day, compared to class. Over three-fourths of the observed decline under US$4/day among the poor. By 2010, both 20 These results are robust to the use of consumption instead of income as the welfare aggregate. 21 Based on calculations prepared by ECA and LAC staff as background material for a discussion on “inclusive middle income societies” at the Middle Income Forum in the 2012 Annual Meetings, using data from the PovCalNet database (see Box 1 for details). Reference years are 1995-2010 for LAC and (circa) 2000-2010 for ECA. Russia Economic Report | Edition No. 31 37 III. Economic Mobility and Middle-Class Formation in Russia groups had seen their per capita income levels There is however no evidence in the survey of grow significantly—to US$18/day for the middle increasing accumulation of income at the top class and US$7/day for the poor. As a result of end of the distribution. The income shares of the these changes, the ratio of the average per top 10 percent and 20 percent of the distribution capita income of the middle class to the average (equivalent to the top 30 percent of the middle per capita income of the poor declined slightly class in 2001 and 2010 respectively) remained (i.e. income differences in relative terms were relatively constant throughout the period at smaller in 2010 than in 2001). In contrast, around 24 percent and 40 percent respectively. the absolute difference in per capita incomes Although this would appear to be at odds with between both groups increased from US$8/ the widespread perception of high and growing day to US$11/day during the same period, income inequality in Russia, it is important to suggesting a wider dispersion in per capita keep in mind that this perception refers mostly income in 2010 than in 2001. to the very rich and wealthy. These households are seldom represented in household surveys. 3.4 The role of assets, markets and the state in the middle-class formation I n this section, we examine the potential micro- economic drivers of the trends described earlier, with a particular focus on the emergence household in the 2010 RLMS-HSE survey is 3.3 people, compared to 4.1 and 3.8 for poor and vulnerable households. In addition, the ratio of the middle class. For this purpose, it is useful of older (65+) and younger (<18) household to think of per capita/household income as members to working-age adults is significantly the sum of market (primarily labor) and non- lower among middle income households—0.2 market income (primarily public transfers and 0.4 respectively, compared to 0.2 and and remittances). Households and individuals over 0.5 among poor households (Figure 33). endowed with more and/or higher-quality This implies that every working-age adult in a human capital and other assets and with higher middle-income household has to (potentially) access to markets are likely to both enjoy higher provide for a smaller number of dependents, income levels and have high income growth other things being equal. In addition, working- potential than others, other things being equal. age adults in middle-income households have Similarly, public and private transfers could levels of education that are significantly higher compensate for the lack of assets. than those of their counterparts in poor and vulnerable households. Specifically, almost 30 Profile of the middle class in Russia percent of working-age adults in middle-income H uman capital endowments are significantly higher among middle-income households than among poor or vulnerable households. households have completed higher education. An additional 38 percent holds a PTU or a technical diploma, compared to 8 percent and Although middle-class households are smaller 34 percent respectively for poor households and than poor and vulnerable households, they 18 percent and 39 percent among vulnerable contain a relatively larger number of working- households (Figure 34). age adults. The size of average middle-class 38 Russia Economic Report | Edition No. 31 III. Economic Mobility and Middle-Class Formation in Russia Figure 33: The ratio of older (65+) and younger (<18 years) household members to working-age adults is smallest among middle income households Ratio of household members ages 65 and up to working-age adults Ratio of household members ages 17 and under to working-age adults 0.35 0.6 0.30 0.5 0.25 0.4 0.20 0.3 0.15 0.2 0.10 0.05 0.1 0.00 0.0 Poor Vulnerable Middle Class Poor Vulnerable Middle Class 2001 2010 2001 2010 Source: Staff calculations using data from the RLSM-HSE, 2001-2010 Figure 34: A third of working-age adults in middle income urban areas are normally associated with a households had completed tertiary education in 2010 higher concentration of economic activity and Percentage of all working-age adults with different levels of education diversification, middle-income households are Percent likely to enjoy better access to markets than 100 90 poor and vulnerable ones, which are more likely 80 to reside in rural areas. At the same time, it is 70 likely that urbanization itself contributes to the 60 growth of the middle class. 50 40 30 Employment rates are higher and unemployment 20 rates lower among middle-income households. 10 Seventy percent of working-age adults in middle- 0 Poor Vulnerable Middle Class income households are employed, compared Incomplete Secondary Complete Secondary PTU Diploma Tekhnikum Diploma Complete Higher to 60 percent in vulnerable households and Source: Staff calculations using data from the RLSM-HSE, 2010 50 percent in poor households. Similarly, the unemployment rate among middle-income Access to markets and economic opportunities households is 3 percent, half of that experienced is also higher among middle-income households by vulnerable households and a third of the rate than among poor or vulnerable households. for poor households. A large fraction of middle-income households reside in urban areas, compared to other Ultimately, better human capital and higher groups (70 percent versus 58 percent and 37 access to economic opportunities translate percent among vulnerable and poor households into higher shares of labor and capital income respectively). But middle-class status is not in total income for middle class households just an urban phenomenon and became less and, consequently, lower levels of dependency so during 2001-2010. In fact, 25 percent of on non-labor sources of income, such as public middle-class households resided in rural areas in transfers or family support. Income derived 2010, compared to 17 percent in 2001. Because from wages or self-employment accounts for Russia Economic Report | Edition No. 31 39 III. Economic Mobility and Middle-Class Formation in Russia the lion’s share of total per-capita household across countries and time (Kenny, 2011), many income for households in all income groups, traits of the Russian middle class identified although relatively more so for middle-income here are similar to those described elsewhere households. There are also differences across in the literature, particularly the literature economic groups in terms of the source of the on developed countries (see footnote 4 for labor income. Specifically, earnings from private relevant references). These traits include a employment (i.e. in a private firm or from self- lower number of children, a higher probability employment) account for more than 50 percent of living in urban areas, working in stable jobs of the total labor income among middle- and/or specific occupations (usually skilled and/ income households, but it’s less than half for or white collar) and investing in human capital other economic groups. In addition, while the (both education and health), higher levels of contribution of capital income is negligible for asset ownership and increased ability to cope poor and vulnerable households, it accounts for with shocks and smooth consumption over time. almost 10 percent of total per capita household The middle-class profile is also consistent with income among middle-income households. the Russian literature, which identifies it on the Combined, these numbers show that the share basis on a series of quantitative and qualitative of total per-capita household income derived traits as opposed to a single monetary cut- from productive assets (both human and off as is done here, including education level, physical/financial) is 15 percent higher among occupation, income level and self-identification middle-income households than among poor (see, for instance, Nisanov, 2012; Beliaeva, 2011, and vulnerable households). Tichonova, 2009; Maleva and Ovcharova, 2009). In contrast, the contribution of public transfers, This characterization of the Russian middle both pensions and safety-net programs, to total class is broadly consistent with the existing income is a modest 15 percent (over 10 percent literature on the topic. Although there is from pensions alone), compared with almost 35 no single set of characteristics that can be percent among the poor and 25 percent among consistently associated with middle-class status the vulnerable (Figure 35, left panel). Figure 35: Labor earnings are relatively more important for middle-income households, while public transfers are relatively more important for poor and vulnerable households Percentage of total household income accounted for by Percentage of total household income accounted for by different income sources by economic group, 2010 different income sources Middle class only in 2001 and 2010 Percent Percent 100 100 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 2001 2010 Poor Vulnerable Middle Class Earnings From Public Employment Earnings From Private Employment Earnings From Public Employment Pensions Other Social Benefits Capital Income Pensions Earnings From Private Employment Capital Income Private Transfers Other Social Benefits Private Transfers Other Income Other Income Source: Staff calculations using data from the RLSM-HSE, 2001-2010 40 Russia Economic Report | Edition No. 31 III. Economic Mobility and Middle-Class Formation in Russia 3.5 Demographic and economic drivers of middle-class emergence D ifferences in endowments and access to markets and to economic opportunities between the middle class and other economic are both stepping stones into middle-class status. In this respect, education levels have changed slowly and only modestly in Russia during 2001- groups remained stable over 2001-2010. A 2010, making human-capital accumulation an middle-class profiling exercise in 2001 generated unlikely candidate when it comes to explaining results that were remarkably similar to the one middle-class growth. In contrast, employment presented above for 2010. Even though it was grew at an average of 2 percent per year for significantly smaller at that time (30 percent of the most of the decade, bringing unemployment total population), the middle class could already levels to record lows even after the crisis. be characterized as having better endowments Wages increased rapidly (13 percent per year on (both in terms of household demographics and average) until 2008 and continued to grow at a education levels), a higher probability of living slower rate afterwards. On the other hand, the in urban areas and access to more and better government proactively used fiscal policy for (more productive) jobs. redistributive purposes during this period, and especially as a policy response to the 2008 global At the same time, the composition of financial crisis, when pensions and other public household income varied significantly over the transfers increased substantially. Finally, labor period for middle-class households. The share market and public policy changes took place of labor income in total per-capita household against the background of the demographic income fell from 73 percent to 64 percent over pressure generated by the rapid aging of the the decade. This decline was coupled with a Russian population and the associated shrinkage substantial change in the composition of labor of the labor force and growth of the old-age income as the share of earnings from the public dependency ratio. sector in total per-capita household income fell from 40 percent in 2001 to a little above In this section, we examine the role that 30 percent in 2010. Meanwhile, that of economic and demographic factors played in earnings from the private sector grew from 25 the emergence of the Russian middle class over percent to 30 percent during the same period the last decade. For this purpose, we present (Figure 35, right panel). At the same time, the two complementary empirical exercises. The share of capital income and public transfers, first one focuses on those who joined the middle particularly pensions, increased significantly, class during 2001-2010 and decomposes the suggesting that their growth exceeded that of observed growth in their average per capita labor income during the period—at least for household income into three basic components: middle-class households.22 demographics, market income and non-market income, as well as the elements within each of This suggests that both markets and public policy them. The second exercise uses information on played a role in the growth of the middle class the characteristics of all poor and vulnerable in Russia. On the one hand, asset ownership and households at the beginning of the period of the ability to make productive use of such assets study, as well as information on shocks that may 22 An alternative explanation for the rise in the share of public transfers in total income among middle class households could be an increase in the number of beneficiaries, particularly pensioners. However, given that the old-age dependency ratio remains constant during the period, this seems unlikely. Russia Economic Report | Edition No. 31 41 III. Economic Mobility and Middle-Class Formation in Russia have occurred during the period (e.g. change in Wage and pension growth accounted for over employment status, change in eligibility status half of the observed income growth among for a particular social program) to predict which middle-class entrants in 2001-2010. Increases of these households will transition into the in employment, measured through changes in middle class at the end of the period (see Meyer the employment rate of working-age adults, and Sanchez for details on both exercises). explained 8 percent or so of the observed increase in income while wage growth accounted Middle class entry: A first look for over 40 percent, playing a similar role in the E conomic rather than demographic factors drove middle-class growth in 2001-2010. Changes in the household ratio of members aged public and private sectors. This is in line with the macroeconomic developments discussed earlier and consistent with the recent literature on labor 65 and up versus working-age adults (the old- market adjustments in Russia, which suggests age dependency ratio) and changes in the ratio that prices (wages) are relatively flexible and of households members aged 17 and under to thus adjust significantly over the business cycle working-age adults (the child-dependency ratio) while quantities (employment) remain relatively explained less than 10 percent of the observed stable (Gimpelson and Kapeliushnikov, 2011). In changes in per-capita household income among addition, pensions account for 35 percent of the households that joined the middle class in 2001- observed change in income, more than other 2010, or during any of the sub-periods under social transfers and almost overshadowing the consideration. In contrast, changes in income impact of wage growth (Figure 36). from labor due to changes in the employment rate of working-age adults, along with changes in The relative role of labor markets and public wages or both, accounted for almost 50 percent transfers changed over the decade. During 2001- of the observed growth in income, while changes 2005, employment and especially wage growth in public transfers made up an additional 40 explained over 60 percent of the observed change percent (Figure 36). in per-capita household income among middle- class entrants. Wage growth in the private sector Figure 36: Wage and pension growth were the two main alone accounted for almost 30 percent, or half drivers of middle class growth in 2001-2010 Contribution to observed inflow into middle class of the impact of labor markets, compared to 10 (in percentage) percent for employment changes and 20 percent Percent 100 for public-sector wage growth. In contrast, in 2006-2010, the contribution of employment and 80 especially wage growth declined significantly. 60 Employment growth accounted for less than 7 40 percent of the observed changes, and private sector and public sector wage growth explained 20 about 20 percent and 14 percent respectively. 0 This is likely the reflection of the impact of the -20 2001-2010 2001-2005 2006-2010 financial crisis which, as mentioned before, did Dependency (Young) Dependency (Old) Wage (Private) Wage (Public) Employment Rate Private Transfers Pensions Capital not eliminate many jobs but substantially slowed Other Public Transfers Other Income wage growth in Russia. On the other hand, the Source: Staff calculations using data from the RLSM-HSE, contribution of pensions to overall per-capita 42 Russia Economic Report | Edition No. 31 III. Economic Mobility and Middle-Class Formation in Russia income growth climbed from less than 20 the old-age dependency ratio over the period percent in 2001-2005 to over 50 percent in 2006- decreased the probability of entry into the middle 2010 (Figure 36). class in 2001-2005 and 2006-2010. In contrast, increases in the child-dependency ratio had no The size and direction of the contribution of significant effect. Notice that these results are other variables considered in the decomposition consistent with those from the decomposition also changed between 2001-2005 and 2006- exercise discussed above. Combined, these two 2010, but their overall impact on income growth sets of results suggest that while changes in among middle-class entrants is very small household composition had a significant impact relatively to that of wages and pensions. Perhaps on the probability of joining the middle class not surprisingly, capital income had a small at the household level (i.e. among households but positive impact on per-capita household that did experience such changes), the number income growth in 2001-2005 and a negative of households that actually experienced these impact in 2006-2010. Public transfers other than changes and the magnitude of the changes pensions had a positive impact in both periods, were relatively small when aggregated across all while private transfers (e.g. remittances, inter- households, and hence their impact on overall household transfers such as alimony payments, dynamics was also limited. charity donations, etc.) also contributed positively to income growth in 2001-2005 (about Access to economic opportunities, as well as the 6 percent percent) and virtually disappeared nature of jobs, mattered for middle-class entry. from the picture in 2006-2010, suggesting a Whether the household head was employed, in potential shift of the burden of income support either the public or private sector, significantly from private to public hands over the decade. modified the household’s probability of middle- class entry in 2001-2005, but had no significant Middle class entry: A deeper look impact in 2006-2010. In both periods, the impact W e now turn to the results from the regression analysis.23 The characteristics of household heads and the composition of of private employment on middle-class entry was slightly larger that of public employment, irrespective of whether the household head held households both affected the probability of a formal or an informal job.24 Households headed middle-class entry. Households headed by more by individuals employed in highly skilled white- educated individuals, and particularly individuals collar jobs were also more likely enter the middle with tertiary education, were more likely to rise class over the period compared to those headed into the middle class, but this effect was only by individuals employed in other occupations or significant in 2006-2010. In addition, female- without a job. headed households were less likely to enter the middle class than male-headed households Households were less likely to enter the middle in both 2001-2005 and 2006-2010. Bigger class if, other things being equal, the household households and households with larger shares of head became unemployed during the period (i.e. dependents (particularly elderly dependents) in the household head was employed in 2001 and 2001 or 2006 were less likely to become middle unemployed in in 2005, or employed in 2005 and class than their counterparts during both periods. unemployed or out of the labor force in 2010). In addition, increases in household size and in The opposite was true when the household head 23 Regression results can be found in Meyer and Sanchez (2014). 24 Results on the impact of formal versus informal employment have to be interpreted with caution as the RLMS contains limited information to this effect and, as a result, informal is likely to be significantly underestimated. Russia Economic Report | Edition No. 31 43 III. Economic Mobility and Middle-Class Formation in Russia became employed during the period, although individuals and/or with individuals who were this effect was not always significant or robust. employed for longer periods benefited the most from strong wage growth and hence were Impacts were not limited to the employment more likely to join the middle class, other things status of the household head. Households being equal. with a larger number of employed adults at the beginning of the period (i.e. 2001 and 2006), Higher-than-average increases in benefit as well as those experiencing an increase in payments, rather than receipt of benefits, the number of employed adults during the impacted the probability of entering the middle period, were more likely to rise into the middle class. Receiving a public pension or other form of class than other households. And, even if the public transfers in 2001 or 2005 had no significant employment rate at the household level was impact on middle-class entry. But a more similar at the beginning and end of the period, detailed look at the role of pensions and other the occurrence of one or more employment transfers revealed some interesting, though shocks, measured as job loss by any adult in the not statistically significant, results. In particular, household, negatively impacted the probability households where pensions accounted for more of joining the middle class (more significantly than 20 percent of total per-capita income—that in 2006-2010). This suggests that these events is, households with relatively higher dependency were associated with a relatively large drop on public transfers—were less likely to become in household income. As before, these results middle class during the periods under study, were consistent with the discussion above on while households that received higher-than- the importance of employment and particularly average pensions in 2001 or 2006 and/or wage increases for middle class growth since experienced larger-than-average increases in only those holding a job (especially a formal pension payments during 2001-2005 or 2006- job) could benefit from these increases. In 2010 were more likely to do so. other words, households with more employed 3.6 Conclusions T his paper has documented the rapid rise of the Russian middle class during 2001- 2010 and identified its main drivers. Though in pensions helped many escape poverty and vulnerability and join the middle class, particularly during 2006-2010. In the current demographic factors (related to aging and other environment of slower economic growth and social changes) and economic factors were both constrained fiscal resources, further expansion found to affect middle-class entry, the latter of the middle class will require continued job explained most of the observed changes in the creation combined with an increase in labor- period of study. Access to good, productive force participation among youth, women and jobs—i.e. jobs that required a higher level of skills older workers, so as to increase the overall and thus paid higher wages—and wage growth employment rate in the economy and strengthen in both the private and public sectors served as the role of labor income as the main driver of the main platforms for the rise of the middle middle-income growth. class in Russia. In addition, significant increases 44 Russia Economic Report | Edition No. 31 3.7 References ▪ Banerjee, Abhijit V., and Esther Duflo (2008) “What is middle class about the middle classes around the world?” Journal of Economic Perspectives, 2008: 22(2), 3-28. ▪ Barro, Robert J. (1999) “Determinants of democracy.” Journal of Political Economy, 1999: 107(6), 158-183. ▪ Birdsall, N., C. Graham, and S. Pettinato (2000) “Stuck in the Tunnel: Is Globalization Muddling the Middle Class?”, Working Paper No. 14, Center on Social and Economic Dynamics. 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The World Bank, Washington, D.C. 46 Russia Economic Report | Edition No. 31 Annex: Main Indicators 2013 Output Indicators 2007 2008 2009 2010 2011 2012 2013 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb 1/ GDP, % change, y-o-y 8.5 5.2 -7.8 4.5 4.3 3.4 - - 1.6 - - 1.4 - - 1.3 - - 1.3 1.3 - - Industrial production, % change, y-o-y 6.8 0.6 -10.7 7.3 5.0 3.4 -0.4 -3.1 -0.1 1.1 -0.5 1.7 0.8 -0.2 1.3 1.0 2.8 0.4 0.4 -0.2 2.1 Manufacturing, % change, y-o-y 10.5 0.5 -15.2 10.6 8.0 5.1 -1.1 -2.2 -0.9 0.4 -1.9 2.0 1.5 -0.7 1.1 0.6 4.8 1.7 0.5 0.0 3.4 Extraction of mineral resources, % change, y-o-y 3.3 0.4 -2.8 3.8 1.8 1.0 0.2 -2.0 0.9 1.7 1.7 1.7 0.1 1.0 1.9 1.7 1.8 2.0 1.1 0.9 0.8 Fixed capital investment, % change, y-o-y 23.8 9.5 -13.5 6.3 10.8 6.8 2.9 0.3 -2.0 -0.5 0.1 -2.9 2.4 -1.8 -1.3 -0.1 0.4 0.6 -0.2 -7.0 -3.5 Fiscal and Monetary Indicators Federal government balance, % GDP 1/ 5.4 4.1 -5.9 -4.1 0.8 -0.1 -0.3 -1.8 -0.4 0.0 0.7 1.2 0.8 0.9 1.2 1.1 1.0 -0.5 -0.5 9.3 0.3 2/ M2, % change, p-o-p 51.3 27.2 -3.5 30.6 23.3 17.9 -2.4 1.6 1.1 1.4 0.9 1.5 0.8 0.2 -0.5 -0.3 2.2 7.7 15.4 -4.0 Inflation (CPI), % change, p-o-p 11.9 13.3 8.8 8.8 6.1 5.1 1.0 0.6 0.3 0.5 0.7 0.4 0.8 0.1 0.2 0.6 0.6 0.5 6.8 0.6 0.7 Producer price index (PPI), % change, p-o-p 25.1 -7.0 13.9 16.7 13.0 6.8 -0.4 0.8 0.5 -1.2 -1.0 0.4 2.0 2.8 1.4 -1.2 -1.5 1.0 3.5 0.4 -0.4 Nominal exchange rate, average, Rb/US$ 25.6 24.8 31.7 30.4 29.4 31.1 30.3 30.2 30.8 31.3 31.2 32.3 32.7 33.0 32.6 32.1 32.6 32.9 31.8 33.5 35.2 Reserve Fund, billion US$, e-o-p 137.1 60.5 25.4 25.2 62.1 86.2 84.7 83.9 84.9 84.4 84.7 85.4 85.4 86.4 87.2 86.9 87.4 87.4 87.1 87.3 National Wealth Fund, billion US$, e-o-p 88.0 91.6 88.4 86.8 88.6 89.2 87.6 86.8 87.3 86.7 86.5 86.9 86.8 88.0 88.7 88.1 88.6 88.6 87.4 87.3 Reserves (including gold) billion US$, end-o-p 478 427 439 479 499 538 532 526 528 533 518 514 513 510 523 524 516 510 510 499 493 Balance of Payment Indicators Trade Balance, billion US$ (monthly) 123.4 177.6 13.2 147.0 196.9 192.3 17.2 15.3 15.8 14.3 14.6 13.6 13.3 14.0 15.9 12.7 16.6 15.8 180.3 18.9 Current Account, billion US$ 72.2 103.9 50.4 67.5 97.3 72.0 - - 24.3 - - 1.1 - - -1.5 - - 8.9 32.8 - - Export of goods, billion US$ 346.5 466.3 297.2 392.7 515.4 528.0 38.9 41.9 44.5 44.5 41.0 41.9 43.8 42.6 44.8 43.6 46.7 49.2 523.3 39.5 Import of goods, billion US$ 223.1 288.7 183.9 245.7 318.6 335.7 21.7 26.5 28.7 30.2 26.4 28.3 30.5 28.6 28.9 30.9 30.2 33.4 343.0 20.6 1/ Gross FDI, million US$ 27,797 27,027 15,906 13,810 18,415 18,666 - - 6,384 - - 12,139 - - 18,610 - - 26,118 26,118 - - Financial Market Indicators Average weighted lending rate for enterprises, % 3/ 10.8 15.5 13.7 9.1 9.3 9.4 8.8 9.6 10.0 10.2 9.9 9.5 9.2 9.3 9.5 9.2 9.0 9.4 9.4 9.2 CBR policy rate, %, end-o-p 10.0 9.5 6.0 5.0 5.3 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 5.5 Real average rate for Ruble loans, % (deflated by PPI) -3.4 -6.8 -0.1 -6.5 -3.2 3.9 3.5 4.7 6.4 8.5 7.0 5.6 2.4 4.5 7.5 7.1 7.3 5.5 5.5 4.3 Stock market index (RTS, ruble term, eop) 2,291 632 1,445 1,770 1,382 1,527 1,622 1,534 1,460 1,407 1,331 1,275 1,313 1,291 1,437 1,496 1,413 1,450 1,450 1,324 1,268 Income, Poverty and Labor Market Real disposable income, (1999 = 100%) 245.6 251.5 259.3 272.5 274.7 286.2 205.0 270.8 279.2 297.4 258.1 298.4 283.8 288.9 277.3 292.3 301.6 425.0 295.7 204.4 272.7 Russia Economic Report | Edition No. 31 Average dollar wage, US$ 532 697 588 698 806 859 887 883 932 958 951 960 923 885 899 938 928 1,205 942 883 843 1/ Share of people living below subsistence, % 13.3 13.4 13.0 12.5 12.7 10.9 - - 13.8 - - 13.0 - - 12.6 - - 47 Unemployment (%, ILO definition) 6.1 7.8 8.2 7.2 6.1 5.1 6.0 5.8 5.7 5.6 5.2 5.4 5.3 5.2 5.3 5.5 5.4 5.6 5.6 5.6 5.6 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 NOTES The World Bank Russian Federation 36/1 Bolshaya Molchanovka Str., 121069 Moscow, Russia Telephone: +7-495-745-7000 Fax: +7-495-745-7002 http://www.worldbank.org/eca/rer http://www.worldbank.org/russia Produced by the Poverty Reduction and Economic Management Unit of the Europe and Central Asia Region of the World Bank Photo credits: © World Bank