The Russian Recovery: How Green are its Shoots? 38 Russia Economic Report November 2017 RUSSIA’S RECOVERY: HOW STRONG ARE ITS SHOOTS? 38 RUSSIA ECONOMIC REPORT NOVEMBER 2017 This report is produced twice a year by World Bank economists in the Macroeconomics and Fiscal Management Global Practice. The team that prepared this edition was led by Apurva Sanghi (Lead Economist for the Russian Federation, asanghi@worldbank. org) and consisted of Olga Emelyanova (Research Analyst), Mikhail Matytsin (Research Analyst), Irina Rostovtseva (Research Analyst), Katerina Levitanskaya (Senior Financial Sector Specialist), Christopher Miller (Program Leader, ECCRU), Yoki Okawa (Economist), John Baffes (Senior Economist), Naoko Kojo (Senior Economist, GMF11), Eva Gutierrez (Lead Financial Sector Specialist, GFM09) and Oleg Petrov (Senior Program Officer, GTI09). Artavazd Hakobyan (Senior Agriculture Economist, GFA03) authored the focus note on Russia’s agriculture sector based on a World Bank paper titled Russia: Policies for Agri-Food Sector Competitiveness and Investment. Peer reviewers included Kamer Karakurum Ozdemir (Senior Economist, GMF05), Yaroslav Lissovolik (Chief Economist, Eurasian Development Bank), Yaroslav Baklazhanskiy (Advisor, Macroeconomic Policy Department, Eurasian Economic Commission) and Kateryna Schroeder (Agriculture Economist, GFA03). The report was edited by Christopher Pala (Consultant). The team would like to thank Hans Timmer (Chief Economist of the Europe and Central Asia Region), Andras Horvai (Country Director for Russia), Maria De los Angeles Cuqui Gonzalez Miranda (Practice Manager, Macroeconomics and Fiscal Management Global Practice), and Sergei Ulatov (Director for coordination, Eurasian Development Bank) for their advice and support. The team also would like to express their gratitude to the Department for Research and Forecasting of the Central Bank, Department for Macroeconomic Forecasting of the Ministry of Economic Development and Department for the budget policy and strategic planning of the Ministry of Finance for the collaboration. This report went to press on November 29, 2017. TABLE OF CONTENTS PREFACE ................................................................................................................................................................ h EXECUTIVE SUMMARY.......................................................................................................................................... i References .......................................................................................................................................................... 47 I. Recent Economic Developments ............................................................................................................... 1 1.1 Growth.............................................................................................................................................................. 2 1.2 Balance of payments: A favorable external environment (recovering external demand and improved terms of trade) supported the balance of payments . ................................................................................................ 9 1.3 Labor Market and Poverty Trends: Unemployment is Stable, Wages are Recovering, but a High Share of the Population Remains Vulnerable........................................................................................................................ 11 1.4 Monetary Policy: The Central Bank continued a gradual approach to monetary easing aimed at anchoring inflation expectations........................................................................................................................................ 15 1.5 The Financial Sector: The banking sector’s fundamentals improved with the economic recovery, but some pockets of vulnerability remained..................................................................................................................... 16 1.6 Government Budget: the government followed the path of fiscal consolidation............................................. 20 II. Outlook for three years: modest growth ahead............................................................................... 27 2. Outlook for Three Years: Modest Growth Ahead.............................................................................................. 28 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity....................................... 33 3. Russia’s Agriculture Sector: Profits, Performance, and Productivity................................................................. 34 LIST OF FIGURES Figure 1a: Global growth gained momentum .............................................................................................................. i Figure 2a Global industrial production picked up ....................................................................................................... i Figure 3a: Growth momentum of the second half of 2016 spilled to 2017 ................................................................. j Figure 4a: Inflation was below the end-year target ..................................................................................................... j Figure 5a: Unemployment rate remains low . ............................................................................................................. k Figure 6a: The general government budget primary balance improved in the nine months of 2017 ......................... k Figure 7a: The federal budget registered a primary surplus in the first ten months of 2017 ...................................... l Figure 8a: In the firming global environment, Russia’s economy is expected to grow at a modest pace..................... l Figure 9a: The recovery is expected to be broad-based .............................................................................................. m Figure 10a: Government policy is making the GDP growth rate less sensitive to oil price volatility . ............................ m Figure 11a: The poverty headcount is likely to decline in 2017 and beyond.................................................................. n Figure 1: Global growth gained momentum .............................................................................................................. 2 Figure 2: Global industrial production picked up ....................................................................................................... 2 Figure 3: Cross-border bank lending and bond issuance to EMDE . .......................................................................... 2 Figure 4: World oil balance and oil price .................................................................................................................... 3 Figure 5: Russian compliance to agreed cuts is increasing ........................................................................................ 3 Figure 6: The positive growth momentum of the second half of 2016 spilled to 2017 . ........................................... 4 Figure 7: Growth remained positive, but slowed down in the third quarter ............................................................. 4 Figure 8: Domestic demand rebounded in the first half of 2017 ............................................................................... 4 Figure B1-1: ICT use is growing in Russia ......................................................................................................................... 5 Figure B1-2: Russia is not yet at the digital frontier . .............................................................................................. 6 Figure 9: Mineral resource extraction drove growth in tradables ...................................................................... 7 Figure 10: The contribution of non-tradable sectors to GDP turned positive and was the key factor of GDP growth in the second quarter of 2017 . ............................................................................................... 7 Figure 11: Growth in manufacturing was uneven................................................................................................. 7 Figure 12: Slowdown of investment to mineral resource extraction was the key factor behind fixed capital investment slowdown in the third quarter . ........................................................................................ 8 Figure 13: The Nominal Value of Imported Goods Increased by 25 percent in January-September 2017, y/y . . 9 Figure 14: In the first half of 2017, all export categories, except for machinery and other exports, demonstrated growth in real terms ............................................................................................................................ 9 Figure 15: The balance of services and factor income accounts deteriorated ..................................................... 10 Figure 16: Incoming FDI increased in the second quarter of 2017 . ..................................................................... 11 Figure 17: LFP and employment rates declined.................................................................................................... 12 Figure 18: ... while unemployment rate remains low . ......................................................................................... 12 Figure 19: Wages and pensions grow, but the overall disposable income stagnates ........................................... 13 Figure 20: Share of population with consumption per capita over 10 USD/day in 2005 PPP declined further .. 13 Figure B2-1: Formal wages account for 38 percent of total household income ..................................................... 13 Figure 21: The Central Bank cut the key rate by 175 basis points in January-November 2017 ............................ 15 Figure 23: The monetization of the economy increased ...................................................................................... 15 Figure 22: Inflation expectations trended downward during the year, but remained elevated . ......................... 15 Figure 24: Inflation is below the end-year target ................................................................................................. 16 Figure 25: The oil price remained an important factor of the Ruble exchange rate dynamics............................. 16 Figure 26: The number of banks has fallen by over a third between 2013 and 2017........................................... 17 Figure 27: Overall sector performance weakened slightly ................................................................................... 20 Figure 28: Credit growth in rubles picked up moderately .................................................................................... 20 Figure 29: The federal budget registered a primary surplus in the first ten months of 2017 .............................. 21 Figure 30: The GG budget non-oil/gas primary balance improved in the first nine months of 2017 ................... 22 Figure 31: The Regional Budget Primary Balance Improved in the First Nine Months of 2017............................ 22 Figure 32: Expenditures for all categories, except for national security, intergovernmental budgetary transfers and education, would drop in real terms in 2018................................................................................ 24 Figure B5-1: Russia’s public expenditures on health and education as % of GDP are low compared to other countries .................................................................................................................................... 25 Figure 33: In the firming global environment, Russia’s economy is expected to grow at a modest pace ............ 29 Figure 34: Non-tradable sectors are expected to drive growth in the medium-term........................................... 30 Figure 35: The poverty headcount is likely to decline in 2017 and beyond ......................................................... 31 Figure B6-1: Top 10 economies, Russia and BRICS in Doing Business 2018 ranking ................................................ 31 Figure B6-2 Russia ranks in top 20 globally on three indicators............................................................................. 32 Figure 36: Government policy made the GDP growth rate less sensitive to oil price volatility . .......................... 32 Figure B7-1: FDI and Fixed Capital Investment ........................................................................................................ 34 Figure B7-2: Top 10 countries with FDI Inflows in agriculture, 2000-13 .................................................................. 34 Figure 37: Overall continuous growth in food and agriculture sector value-added, 2003-16 .............................. 35 Figure 38: However, growth rate in value-added of food manufacturing sector is mixed, 2012-16..................... 35 Figure 39: The agri-food trade balance average has been negative but narrowing, 1998-2015 .......................... 36 Figure 40: Agri-food imports: High-value food products . .................................................................................... 37 Figure 41: Agri-food exports: Commodities.......................................................................................................... 37 Figure 42: Pork prices in Russia are higher than in Germany ............................................................................... 38 Figure 43: Milk prices in Russia are higher than the world prices . ...................................................................... 38 Figure 44: General services support estimates, 2009-14...................................................................................... 39 Figure 45: Dairy farm productivity........................................................................................................................ 41 Figure 46: Cost comparison of typical dairy farms, barns..................................................................................... 41 Figure 47: Depth of food manufacturing sector: Food manufacturing value-added/agriculture value-added, 2005-14 average .................................................................................................................................. 42 Figure 48: Composition of food-sector employment, 2010-2015 average . ......................................................... 43 Figure 49: Ratio of the average wage in the industry to the country’s average wage, 2000-2015....................... 43 Figure 50: Output and gross value-added per enterprise in food enterprises, millions of rubles at 2005 prices. 44 Figure 51: Changes in employment and labor productivity in food enterprises, 2005 and 2015......................... 44 Figure 52: Trends in labor intensity in total manufacturing and food enterprises, 2005 prices . ......................... 44 Figure 53: TFP index in food enterprises and total manufacturing, 1998-2015, 2005 prices . ............................. 45 LIST OF TABLES Table 1: Balance of payments, 2014–2017 (US$ billions).................................................................................. 10 Table 2: The poverty rate decreased slightly..................................................................................................... 14 Table 3: Federal budget revenue increased by 1.2 percent of GDP in 2017 ..................................................... 21 Table 4: The draft federal budget law for 2018-2020 is driven by expenditure cuts......................................... 25 Table 5: Global growth is broadly stable (GDP growth projections, percent).................................................... 28 Table 6: Modest growth rates are projected (Major macroeconomic indicators)............................................. 29 LIST OF BOXES Box 1 Russia explores the new digital frontier............................................................................................... 5 Box 2 Is there a wage-income paradox? . ...................................................................................................... 13 Box 1 Russia moves towards a new bank resolution regime......................................................................... 18 Box 4 New Fiscal Rule–Third Time’s the Charm? . ......................................................................................... 23 Box 5 Public health and education expenditures are relatively low in Russia . ............................................. 25 Box 6 Russia is 35th out of 190 in the Doing Business 2018 ........................................................................... 31 Box 7 Foreign direct investment in the agri-food sector................................................................................ 34 Box 8 How the Russian agri-food sector responded to recent economic shocks . ........................................ 36 Box 9 Types of agriculture support measures in the Russian Federation...................................................... 38 Box 10 Russian farming sector......................................................................................................................... 40 Abbreviations and Acronyms AE Advanced Economies ASEAN-5 Indonesia, Malaysia, the Philippines, Singapore, and Thailand B2B Business-To-Business B2C Business-To-Consumer BRICS Brazil, Russia, India, China, and South Africa (emerging economies) BRRD Bank Recovery and Resolution Directive BSCF Banking Sector Consolidation Fund CBR The Central Bank of the Russian Federation CDS Credit Default Swap CIT Corporate Income Tax CPI Consumer Price Index DIA Deposit Insurance Agency EAEU Eurasian Economic Union ECB European Central Bank ECM Energy Corrected Milk EMDEs Emerging Markets and Developing Economies EU European Union FAOSTAT Food and Agriculture Organization Corporate Statistical Database FDI Foreign Direct Investment FDIA Federal Deposit Insurance Act FDIC Federal Deposit Insurance Corporation GDP Gross Domestic Product GVA Gross Value Added HSE- RLMS Higher School of Economics - The Russia Longitudinal Monitoring Survey ICT Information and Communication Technology IEA International Energy Agency IFCN International Farm Comparison Network MA Monthly Average NPL Nonperforming Loan NWF National Welfare Fund OECD The Organization for Economic Co-operation and Development OFZ Federal Loan Bonds OLA Orderly Liquidation Authority OPEC Organization of the Petroleum Exporting Countries PMI Purchasing Managers' Index REER Real Effective Exchange Rate Rosstat Russian Federal State Statistics Service SRF Single Resolution Fund TFP Total Factor Productivity WTO World Trade Organization EXECUTIVE SUMMARY G lobal growth gained momentum in 2017. After slowing to 2.4 percent in 2016 as investment and trade weakened, global growth reflecting subdued inflation trends. Capital flows to Emerging Markets and Developing Economies (EMDEs) remained resilient in 2017, reflecting the accelerated to a projected 2.7 percent for 2017 continued search of yield through cross-border (Figure 1a). Moreover, the recovery has been bank lending and bond issuance. The increase in broad-based. The economies of the United States capital inflows was particularly notable in China and Japan strengthened, while growth in the Euro and India. Area economies accelerated to 2.5 percent in Q1- Q3, well above its estimated potential growth of Amid these positive tailwinds, along with around 1 percent1. China–an important trading firming oil prices and growing macro-stability, partner for Russia–is expected to sustain growth the Russian economy returned to modest at 6.7 percent points for the year, amid strong growth in 2017. The growth momentum of the trade and supportive fiscal and financial policies. second half of 2016 spilled over to 2017 and was especially strong in the second quarter Global trade also continued to strengthen and (Figure 3a); this was supported by a rebound external financing conditions remain benign. in domestic demand in the first half of 2017— Trade began to recover in mid-2016 and continued which also contributed to a growth slowdown in 2017, supported by strong demand, especially starting in the third quarter. On the production in the manufacturing sector (Figure 2a). In the side, mineral resource extraction, transportation, financial markets, monetary policy remained on a and state management and provisioning for tightening trend. The U.S. Federal Reserve hiked national security drove growth in the first quarter its policy rate in March and June 2017 and began of 2017. Growth in non-tradables was the key reducing its balance sheet. The ECB signaled a contributor to GDP growth in the second quarter further reduction in its asset-purchase program of 2017. Manufacturing production expanded in 2018. However, bond yields in the U.S. and too, but at a modest pace. Non-public services, the Euro Zone remained at historical lows, in particular ICT, grew robustly (Box 1 in the main Figure 1a: Global growth gained momentum Figure 2a: Global industrial production picked up (Percent) (Percent, 3m-o-3m saar) 5 7 6 4 5 4 3 3 2 2 1 0 1 -1 Jan -12 Apr -12 Jul -12 Oct -12 Jan -13 Apr -13 Jul -13 Oct -13 Jan -14 Apr -14 Jul -14 Oct -14 Jan -15 Apr -15 Jul -15 Oct -15 Jan -16 Apr -16 Jul -16 Oct -16 Jan -17 0 2012 2013 2014 2015 2016 2017 World Advanced economies EMDEs Industrial production 2003- 08 average 2011-16 average Source: World Bank. Source: World Bank. 1 Source: Autumn 2017 Economic Forecast, European Commission. Russia Economic Report | Edition No. 38 i Executive Summary report discusses Russia’s foray into exploring though trending downward, remained elevated. the new digital frontier). Helped by a bumper Despite the marginal decline in the poverty rate harvest, agricultural growth was notable (Part in the first half of 2017, vulnerability is still on 3 analyzes the long-term performance of the the rise: the share of the economically secure sector). Unemployment declined slightly in population (with consumption above 10 US$/day the first half of 2017, while low inflation and in 2005 PPP) decreased from 48.2 percent in 2015 a recovering economy allowed real wages to to 46.3 percent in 2016. Even with historically low increase (Figure 5a). And the poverty rate (under unemployment rates due to low labor mobility, its national definition), also decreased marginally unemployment by regions remains unequal. The in the first half of 2017. lowest level of unemployment was registered in Moscow (1.3 percent in the third quarter of 2017) Monetary policy remained prudent and and Saint-Petersburg (1.7 percent), while the consistent with the inflation-targeting highest was in the Tuva Republic (18.7 percent) framework. A combination of relatively tight and Ingushetia (27 percent). Finally, though the monetary policy and tight fiscal policy, together banking sector’s fundamentals have improved with some one-off factors, led the Central Bank since the crisis years, pockets of weakness remain. to undershoot the CPI inflation end-year target as The bail-out of two large private banks (the early as July 2017 (Figure 4a). Annual consumer second- and fifth-largest private banks, jointly inflation had reached 3.9 percent y/y in July, and accounting for 5.2 percent of the banking sector stayed below the end-year target in July-October. assets) in August-September 2017 points to a continued fragility in the Russian banking system. However, improvement in headline indicators How the new banking resolution mechanism is masks underlying disparities and remaining implemented will be key to preserving stability vulnerabilities. Although real wages grew, real and preventing moral hazard (Box 3 in the main disposable-income growth remained negative, report analyzes the resolution mechanism). driven, in part, by contractions in other income While these recent failures of large private banks sources. Box 2 in the main report discusses the have not caused noticeable stress across the apparent discrepancy between wage growth broader banking sector, their long-term effect— and income growth. Inflation expectations, even absent full divestment—will likely increase public Figure 3a: Growth momentum of the second half of 2016 spilled to 2017 Figure 4a: Inflation was below the end-year target (GDP growth, percent, y/y and q/q, sa) (CPI index and its components, percent, y-o-y) 3.0 25 2.0 20 1.0 15 0.0 10 -1.0 -2.0 5 -3.0 0 Oct - 17 Jan - 14 Feb - 14 Mar - 14 Apr - 14 May - 14 Jun - 14 Jul - 14 Aug - 14 Sep - 14 Oct - 14 Nov - 14 Dec - 14 Jan - 15 Feb - 15 Mar - 15 Apr - 15 May - 15 Jun - 15 Jul - 15 Aug - 15 Sep - 15 Oct - 15 Nov - 15 Dec - 15 Jan - 16 Feb - 16 Mar - 16 Apr - 16 May - 16 Jun - 16 Jul - 16 Aug - 16 Sep - 16 Oct - 16 Nov - 16 Dec - 16 Jan - 17 Feb - 17 Mar - 17 Apr - 17 May - 17 Jun - 17 Jul - 17 Aug - 17 Sep - 17 -4.0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 Core in ation CPI in ation Food in ation SA q/q y-o-y Non-food in ation Services in ation Source: Rosstat, Haver Analytics. Source: Rosstat, Haver Analytics. j Russia Economic Report | Edition No. 38 Executive Summary Figure 6a: The general government budget primary Figure 5a: Unemployment rate remains low balance improved in the nine months of 2017 (Percent) (% of GDP, January to September) 6.5 2 1 6.0 0 -1 5.5 -2 -3 5.0 -4 -5 4.5 -6 -7 4.0 -8 2016 2017 2012 2013 2014 2015 2016 2017 Primary balance Non-oil/gas primary balance Total SA Source: Rosstat and Haver Analytics. Source: Haver Analytics. ownership of the banking sector, which raises The federal government has adhered to its fiscal concerns about competition and innovation in consolidation path, adjusting the budget system the financial system in the medium to long term. to fit into the new fiscal rule by 2019 through expenditure cuts, improved tax administration, Moreover, Russia’s growth momentum seems to and some revenue mobilization effort. In the have decelerated in the third quarter. Sluggish January-October 2017 period, buoyed mainly investment demand appears to be the key factor by higher revenues (both non-oil/gas and oil/ behind the slowdown. The growth composition gas revenues grew in January-October 2017 by of 2017 also remains broadly similar to that 0.8 and 0.5 percent of GDP respectively), the observed in the pre-crisis period, driven mostly federal budget registered a primary surplus by mineral-resource extraction and non- of 0.4 percent of GDP, compared to a deficit of tradable sectors. 1.4 percent of GDP in the same period last year (Figure 7a). Russia’s new fiscal rule, expected to In the first nine months of 2017, the general reduce the influence of external volatility on the government fiscal stance improved, mostly budget and the real exchange rate, comes into helped by higher revenues (Figure 6a). The effect in 2019 and will require fiscal consolidation overall general government deficit of 1.8 percent in 2018-2020. Box 4 in the main report discusses of GDP changed to a surplus of 0.6 percent of GDP the rule. Operationally simple and based on a in the first nine months of 2017. The consolidated fixed benchmark price, Russia’s new fiscal rule is a regional budget registered a primary surplus of major structural reform. And combined with the 0.9 percent of GDP, compared to 0.8 percent in move towards inflation-targeting, it underscores the same period last year. However, there remain the Russian authorities’ commitment to enhance substantial variations in debt levels among macro-stability. regions. As of October 1, 2017, there were eight regions (out of 80+ regions) with a share of debt Regarding expenditure cuts, care should be taken exceeding the region’s own revenues. Extra- to preserve growth-enhancing investments, budgetary funds registered a marginal surplus of especially in health and education. As Box 5 in 0.1 percent of GDP, compared to 0.1 percent of the main report discusses, at around 3.4 percent GDP deficit in the same period last year. of GDP in 2015 and 3.6 percent of GDP in 2016, public spending on health is well below the EU Russia Economic Report | Edition No. 38 k Executive Summary Figure 7a: The federal budget registered a primary Figure 8a: In the firming global environment, Russia’s surplus in the first ten months of 2017 economy is expected to grow at a modest pace (% of GDP, January to October) (Real GDP growth, percent) 1 4 0 3 -1 2 -2 1 -3 0 -4 -1 -5 -2 -6 -7 -3 -8 -4 2016 2017 2012 2013 2014 2015 2016 2017 2018 2019 Primary balance Non-oil/gas primary balance GDP growth Oil price, average (US$ per barrel) Source: Haver Analytics. Source: Rosstat, World Bank staff calculations. average of 7.2 percent of GDP and 6.5 percent Cup hosted by 11 Russian cities. Growth in gross for OECD countries. For education, Russia fixed capital formation, however, is expected to allocates only 3.6 percent of GDP compared to slow down after strong growth in the second the OECD average of 5.3 percent of GDP and 4.9 quarter of 2017. percent for EU countries. Further cuts in health and education may jeopardize both economic Non-tradable sectors are expected to drive growth and the well-being of the population, growth in the medium term. Supported by especially given Russia’s desire to be a leader in transportation, construction, real estate, the digital economy, which requires investments wholesale trade and the financial sector, services in education and skills. Additional resources are are set to resume growing in 2017 (Figure 9a). needed to improve health outcomes, although With the banking sector’s performance gradually these resources must be accompanied by reforms stabilizing, its near-term outlook is also improving. to increase the value for money spent. However, reviving credit growth, especially in the corporate and SME segment, will remain Uneven growth dynamics notwithstanding, a key challenge. Growth in the retail segment positive tailwinds, firming oil prices and growing is expected to be largely driven by mortgages, macro-stability have allowed consumer demand given a strong demand coupled with declining and consumption to rise as the business mortgage interest rates. Due to an anticipated environment improved. These green shoots flat oil production in 2018, industrial production underpin projections that Russia’s economy will growth is expected to slow down in 2018 and grow 1.7% both in 2017 and 2018, and then 1.8% bounce back in 2019 as oil production increases. in 2019. Compared to the forecast from spring 2017, in which growth estimates of 1.3 percent, 1.4 percent, and 1.4 percent were predicted The fiscal rule and the lead-up to it suggests there for 2017, 2018, and 2019, the new estimates will be less sensitivity of GDP growth to oil price have been upgraded to 1.7 percent, 1.7 percent volatility in the future. A simulated decrease of and 1.8 percent for the same years (Figure 8a). 15 percent in oil prices would reduce growth to Consumer demand is expected to be the main 1.4 percent in 2018 and 1.5 percent in 2019. A engine of GDP growth. In 2018, consumption is simulated rise of 15 percent in oil prices would likely to benefit further from the soccer World increase growth to 2.0 percent for 2018 and 2.1 l Russia Economic Report | Edition No. 38 Executive Summary Figure 9a: The recovery is expected to be broad-based (Projected growth by sector, percent) (Contribution to GDP growth, pp) 2.5 1.8 2.2 1.6 1.9 1.4 1.2 1.6 1 1.3 0.8 1.0 0.6 0.7 0.4 0.4 0.2 0.1 0 2017 2018 2019 2017 2018 2019 Agriculture Industrial production Services Agriculture Industrial production Services Source: World Bank staff calculations. percent in 2019 (Figure 10a). These estimates The outlook is subject to both upside and suggest reduced sensitivity of GDP growth to oil downside risks, and structural issues remain. The price volatility than in the past. upside risk comes from possible stronger-than- expected growth in large, advanced economies The poverty rate is expected to decrease and hence higher Russian exports other than slightly on the back of decelerated inflation and crude oil, which is limited by the OPEC+ agreement recoveries in private income and consumption. on production cuts. External downside risks stem Driven by a rebound in disposable income and from a significant drop in oil prices, a sudden consumption, the poverty headcount is projected tightening of global financial conditions and to decline in 2017 to 12.9 percent in the baseline possible additional negative impacts from the scenario after reaching 13.5 percent in 2016 expansion of sanctions. Domestic downside risks (Figure 11a). The poverty rate should continue stem from vulnerabilities in the banking sector declining in the baseline scenario in 2018 and and a remaining gap between real wages and 2019 to 12.6 and 12.2 percent, respectively, as real disposable incomes. While the authorities income and consumption grow further. have undertaken various legal and regulatory Figure 10a: Government policy is making the GDP Figure 11a: The poverty headcount is likely to decline growth rate less sensitive to oil price volatility in 2017 and beyond (GDP Growth, percent) (Percent) 106 14 13 104 12 102 11 100 2016 2017 2018 2019 10 GDP growth (baseline) GDP growth low (-15%) 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 GDP growth high (+15%) Poverty rate, % Forecast Source: World Bank staff calculations. Source: Rosstat, World Bank staff calculations. Russia Economic Report | Edition No. 38 m Executive Summary measures to increase the resilience of the banking While Russia continues its progress in improving system, preserving its stability and maintaining its regulatory environment (Box 6 summarizes public confidence in it will be a key challenge, Russia’s latest Doing Business performance), given the recent failures of some large banks. priority policy objectives should include limiting In the medium to long term, as was noted in the role of the state in the economy, improving Russian Economic Report #37 “From Recession to institutional and regulatory frameworks, and Recovery,” productivity growth in Russia has been promoting fair competition. To ensure that the declining over time. Addressing this constraint will shoots of recovery grow and strengthen, easing require deeper and speedier structural reforms. Russia’s productivity constraint remains central. PART I RECENT ECONOMIC DEVELOPMENTS I. Recent Economic Developments 1.1 Growth Global growth is on the uptick amidst strengthening global demand and firming oil prices. Global trade is strengthening as a result, with a noticeable increase in capital inflows to emerging economies, notably China and India. These external developments provide positive tailwinds for Russia’s economy. Global economic trends Q1-Q3, well above its estimated potential growth G of around 1 percent2. It was supported by the lobal growth gained momentum in 2017. After European Central Bank’s (ECB) stimulative stance slowing to 2.4 percent in 2016 as investment and and by a strengthening global demand. The Chinese trade weakened, it has accelerated to a projected economy is expected to sustain growth of 6.7 2.7 percent for 2017 (Figure 1). The recovery has percentage points for the year, amid strong trade been broad-based. The economies of the United and supportive fiscal and financial policies. States and Japan strengthened, while growth in the Euro Area economies accelerated to 2.5 percent in Global trade has continued to strengthen and Figure 1: Global growth gained momentum external financing conditions remain benign. The (GDP growth, percent, y/y) recovery of trade started in mid-2016 and has 5 continued in 2017, supported by strong demand, especially in the manufacturing sector (Figure 2). In 4 the financial markets, monetary policy has remained on a tightening trend. The U.S. Federal Reserve 3 hiked its policy rate in March and June 2017 and began reducing its balance sheet. The ECB signaled 2 a further reduction in its asset-purchase program in 2018. However, bond yields in the U.S. and the 1 Euro Zone remained at historical lows, reflecting subdued inflation trends (Figure 3). Capital flows 0 2012 2013 2014 2015 2016 2017 to Emerging Markets and Developing Economies World Advanced economies EMDEs (EMDEs) remained resilient in 2017, reflecting the Source: World Bank. continued search of yield through cross-border bank lending and bond issuance. Figure 3: Cross-border bank lending and bond issuance Figure 2: Global industrial production picked up to EMDE (Percent, 3m-o-3m saar) (US$ billions, 6-month moving average) 7 50 6 5 40 4 3 30 2 1 20 0 -1 10 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Jun-16 Jul-16 Jan -12 Apr -12 Jul -12 Oct -12 Jan -13 Apr -13 Jul -13 Oct -13 Jan -14 Apr -14 Jul -14 Oct -14 Jan -15 Apr -15 Jul -15 Oct -15 Jan -16 Apr -16 Jul -16 Oct -16 Jan -17 Industrial production 2003- 08 average 2011-16 average Cross- border bank lending International bond issuance Source: World Bank. Source: World Bank. 2 Source: Autumn 2017 Economic Forecast, European Commission. 2 Russia Economic Report | Edition No. 38 I. Recent Economic Developments Crude oil prices rose marginally, by 1.6 percent in Powered by higher oil prices and macro the third quarter (q/q) to $50.20 per barrel3 on stabilization, which improved business and average (Figure 4). Despite improved compliance consumer confidence, the Russian economy by 22 OPEC (Organization of the Petroleum returned to growth in 2017. GDP expanded by 1.6 Exporting Countries) and non-OPEC oil producers to percent in January-September 2017 (0.5 percent their production cut agreements, oil prices trended y/y, 2.5 percent y/y, and 1.8 percent y/y in the lower during the first half of the year, primarily first, second, and third quarter of 2017 respectively due to the presence of large inventories (Figure 5), (Figure 6). Growth momentum was especially recovery in U.S. shale oil production, and expanding strong in the second quarter, when growth reached output from OPEC members Libya and Nigeria, 1.2 percent, q/q sa. However, after a high base in which were exempted from the accord. In the third the second quarter and sluggish investment, the quarter, prices recovered moderately on declining growth momentum decelerated in the third quarter inventories due to the strong global demand, (Figure 7). improved compliance among OPEC and non-OPEC producers with the agreement, and stabilizing U.S. Domestic demand rebounded in the first half of shale oil production. 2017 after a significant contraction in previous years (Figure 8). Russia: Growth dynamics are positive but uneven • In the first quarter of 2017, after a contraction Supported by higher oil prices and macro of 12.2 percent in 2014-2016 driven by the stabilization, the Russian economy returned to drastic terms-of-trade shock and by economic modest growth in 2017. Yet, growth dynamics were sanctions, domestic demand rebounded and uneven. The growth momentum was especially expanded by 1.5 percent in the first quarter of strong in the second quarter, but it slowed down 2017. Supported by growth in real wages, the in the third quarter of 2017. Sluggish investment ruble’s appreciation and increased consumers’ demand appears to be the key factor behind the confidence, consumer demand was the main slowdown. Moreover, the growth composition of driver of domestic demand’s growth in the first 2017 remains broadly similar to the pre-crisis one, quarter. Fixed capital investment also expanded driven mostly by mineral resource extraction and as macro stabilization and a stronger ruble non-tradable sectors. increased business confidence and helped some Figure 4: world oil balance and oil price Figure 5: Russian compliance to agreed cuts is increasing (mb/d, quarterly) (Percent) US$/bbl, quarterly 110 3 120 100 Oil balance (LHS) 90 2 100 80 1 70 80 60 0 50 60 40 -1 30 40 -2 20 Price (RHS) 10 -3 20 0 Q1-2010 Q1-2012 Q1-2014 Q1-2016 Q12018 Jan Feb Mar Apr May Jun Jul Aug Sept Source: International Energy Agency, World Bank. Source: International Energy Agency. Notes: Shaded area (2017Q3-2017Q4) represents IEA projections. Balance is defined as the difference between world oil demand and supply. 3 The World Bank oil price, which is an average of three prices (Brent, WTI and Dubai oil prices). Russia Economic Report | Edition No. 38 3 I. Recent Economic Developments Figure 7: Growth remained positive, but slowed down Figure 6: The positive growth momentum of the in the third quarter second half of 2016 spilled to 2017 (Output in five basic sectors, IP, agriculture and cargo (GDP growth, percent, y/y and q/q, sa) turnover growth, percent, y/y) 3.0 110 108 2.0 106 1.0 104 102 0.0 100 98 -1.0 96 -2.0 94 92 -3.0 90 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 -4.0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 2017 PMI services (RHS) PMI manufacturing (RHS) Cargo SA q/q y-o-y Agriculture Output in five basic sectors Source: Rosstat, Haver Analytics. Source: Rosstat. firms catch up with their deferred demand negative in the first two quarters. Exports of goods on durable and investment goods, especially and services grew by 5.1 percent y/y in real terms imported ones (imports rose by 16.5 percent). in the first half of 2017. The export of goods was mainly supported by non-energy items: agricultural • In the second quarter of 2017, investment and food (wheat, fish, vegetable oil), metals and demand became the main factor driving GDP metal goods, wood and pulp. Despite strong natural growth. Fixed capital investment increased by 6.3 gas export growth4, the export of energy goods percent y/y, supported by public investment— increased only slightly in real terms, with declines both direct and by large state energy and in volumes of export of crude oil, oil-products, transportation companies. According to high- and electricity. According to Balance of Payments frequency statistics, mineral resource extraction data, export of services grew robustly, driven by (namely mining support service activities) transport, construction, travel and ICT services. contributed the most to the fixed capital Over the last five years, ICT exports have doubled investment increase in the second quarter of 2017. In addition, the fixed capital investment of Figure 8: Domestic demand rebounded in the first half small enterprises made a significant contribution of 2017 to investment growth in the first and second (Contribution to GDP growth by components, pp. GDP growth – percent, y/y) quarters of 2017. Improved business sentiment fueled an increase in inventories stock, which 9 contributed approximately 2 percentage points (pp) to GDP growth in the second quarter of 4 2017. Consumer demand continued expanding. A domestic demand growth of 6 percent drove a -1 hefty increase in imports (20.7 percent, y/y), with -6 import of machines, equipment and transport vehicles increasing by 32 percent in real terms in -11 the second quarter of 2017, y/y. Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 A stronger momentum in global demand supported Consumption Gross Fixed Capital Formation Change in inventories Export Import Stat error GDP growth exports, but prominent increases in imports made the contribution of net exports to GDP growth Source: Rosstat. 3 The World Bank oil price, which is an average of three prices (Brent, WTI and Dubai oil prices). 4 Russia Economic Report | Edition No. 38 I. Recent Economic Developments (Box 1 discusses Russia’s foray into the new digital of exports. However, using a different time frame, frontier). Meanwhile, the net export contribution import volumes in 2017H1 were still 18.4 percent to GDP growth was negative, especially in the below their level three years before, while the second quarter of 2017, as import increases fueled exports levels had increased 7.7 percent over that by growing domestic demand offset the growth 3-year period. Box 1 Russia explores the new digital frontier Digitization now affects all aspects of development as the digital revolution spans the entire globe, with half of the world’s population connected to the Internet. Russia has made significant strides in its own digital transformation process. Fixed-broadband penetration has reached 56.5%, while mobile penetration is at 81.6%. Internet access is affordable and fast. Russia has the highest number of fiber connections in Europe. A high 60% of the population now owns smartphones, while the number of users of online government and municipal services has doubled in just one year to reach 40 million. A network of over 2,600 E-government service centers has been set up and a new national education platform has been established to deliver open online courses. In B2B transactions, Russia is on par with the ASEAN region. E-commerce is also growing, as Russia comes close to the EU average and pulls ahead of Korea, Brazil, Mexico, South Africa, the ASEAN region and its Eurasian Economic Union neighbors in B2C sales (Figure B1-1). Financial inclusion in Russia is also advanced at 67.4% of residents having accounts in formal financial institutions, compared to other countries in Europe and Central Asia at 51.4%. Figure B1-1: ICT Use is growing in Russia ICT use for business-to-business transactions Business to consumer internet use B2C E-commerce index value, UNCTAD (2014) Score Score Score Russia 4.8 Russia 5.1 82.6 Kazakhstan 4.8 Kazakhstan 4.7 Armenia 4.7 Armenia 4.4 > 30% Kyrgyzstan 3.9 Kyrgyzstan 4.1 57.6 USA 5.7 USA 6.3 50 Japan 6.1 UK 6.4 36.6 36.5 EAEU 4.5 EAEU 4.5 ASEAN 4.8 ASEAN 4.7 23.8 EU 5.3 EU 5.2 OECD 5.4 OECD 5.4 USA Russia Belarus Armenia Kazakhstan Kyrgyzstan EAEU Developed economy EAEU Developed economy Source: World Bank research based on UNCTAD E-commerce Index Value 2017 and WEF Networked Readiness Index 2016. Over the last 5 years, ICT exports have doubled, reaching over US$7 billion in 2016, while several Russian ICT companies have emerged as global players. These include well-established firms like Yandex and Kaspersky labs as well as relative newcomers in ICT services, business-process automation and security. The use of emerging technologies such as data analytics, cloud computing, the internet of things, 3D printing, blockchain, etc. are also quickly gaining ground. Despite these strides, however, today Russia is not among the global leaders of Digital Transformation. The World Bank divided countries into three groups, depending on their level of development of digital technologies: emerging, transitioning, and transforming (Figure B1-2). Russia today is in the “transitioning” group of countries. Russia Economic Report | Edition No. 38 5 I. Recent Economic Developments There are several factors at play here. Despite the Figure B1-2: Russia is not yet at the digital frontier solid technical education foundation remaining 1.0 Transforming from Soviet times, broad, high-level ICT skills FIN CHE Transitioning are still lacking and the alignment between the 0.9 BEL NOR NLD IRL DNK SWE educational system and industry’s requirements 0.8 GBR ISL EST LUX DEU CYP SVN FRA needs to be improved. Business usage of ICT tools LTU Complements PRT AUT LVA 0.7 CZE by Russian companies still lags that of global leaders Emerging GEO HRV HUN SVK POL ROU ITA ESP BGR like Singapore, Finland, Denmark and the US. 0.6 GRC MKD ALB SRB ARM RUS UKR KAZ This in turn negatively affects the innovation and 0.5 TUR TJK KGZ entrepreneurial environment. UZB 0.4 Realizing the urgency of speeding up the digital 0.3 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 transformation process, the Russian government Technology (DAI) launched several key initiatives in 2017. In July 2017, Source: World Bank’s report “Reaping Digital Dividends: Russia adopted a new Digital Economy program Leveraging the Internet for Development in Europe and Central with an expected annual budget of US$1.8 billion Asia,” March 2017. until 2025 to address the current weaknesses that are preventing Russia from joining global leaders in the digital economy. The program is quite comprehensive, focusing on both analogue and digital foundations of Digital Transformation and addressing the legal, technical, organizational and financial aspects of this process. Drawing on international best practices, the program prioritizes changes in the legal and regulatory framework, addresses key aspects of building digital skills, education and R&D, proposes investments in digital infrastructure and cybersecurity, emphasizes strict program management requirements and suggests specific initiatives in E-government, Smart Cities and E-health. Given the priority assigned to this program at the highest levels of government as well as funding allocated in the federal budget, there is reason to believe that if properly implemented, this program will allow Russia to make significant progress in its Digital Transformation process. The program also provides for Russia’s participation in the Digital Agenda of the Eurasian Economic Union, another key digital transformation initiative announced in 2017. The agenda is aimed at the creation of a single digital space across Eurasia. It focuses on the use of digital technologies to eliminate obstacles to economic cooperation across Eurasia. According to a joint study by the Eurasian Economic Commission and the World Bank, this digital integration agenda could, if properly implemented, yield economic benefits such as GDP growth, job creation and services transformation to all EAEU members, with Russia as the Union’s largest economy standing to gain significant competitive advantages. By 2025, the World Bank estimates that the digital transformation of Russia could create between 7 and 13 million new digital-economy jobs in the country, and lead to productivity gains of over US$38 billion. These forecasts imply not only the digitization of existing business processes, but also the adoption of new business models, platforms and ecosystems, as well as the use of emerging technologies, such as industry 4.0, robotics, blockchain and the Internet of things. The government has also recently passed a decision to complete cryptocurrencies regulation legislation by July 2018, to consider the launch of a national cryptocurrency and to pilot the establishment of the first crypto-advisory and crypto-detective agencies in the city of Vladivostok. The potential digital dividends for Russia are considerable. Given the recent government focus on digital transformation as a national priority, the country is well-positioned to make the leap from the group of transitioning countries to that of transforming ones and join the world’s digital economy leaders, while reaping all the economic and social benefits this implies. 6 Russia Economic Report | Edition No. 38 I. Recent Economic Developments Mineral resource extraction, transportation, contribution to GDP growth increased, compared state management and provisioning for national to the previous quarter, as agriculture resumed security drove growth in the first quarter of 2017. growing and natural gas production sped up. Yet, Mineral resource extraction, mainly natural gas, was GDP growth was underpinned by recovery in non- the top contributor to growth (Figure 9). According tradables: retail and wholesale trade, real estate, to high-frequency statistics, in the first quarter of and construction. Retail trade high-frequency 2017, gas production expanded by 8.2 percent statistics points to increasing growth momentum, y/y, which reflected higher external and domestic but showed it was still quite limited in the second demand, as well as more space available in the quarter of 2017. It was mainly wholesale trade underground storage from the cold winter of 2016- that drove the growth of non-tradables on the 2017. Growth in crude oil production was limited back of inventory restocking. In addition, strong as Russia joined the agreement among OPEC and gas production also contributed to wholesale trade non-OPEC countries to cut production. growth. Lower interest rates for mortgages buoyed real estate growth, while recovery in construction Growth in non-tradables was the key contributor was partly related to the large state infrastructure to GDP growth in the second quarter of 2017. In projects, both public and conducted by state the second quarter of 2017, the tradable sectors’ companies. In the second quarter of 2017, all Figure 9: Mineral resource extraction drove growth in non-tradable sectors recorded growth except for tradables scientific research and public services, which were (Contribution of tradable sectors to GDP growth, pp) restrained by tight budgetary spending (Figure 10). 0.7 Manufacturing production expanded, yet at a 0.6 modest pace. Despite the ruble appreciation in the 0.5 first three quarters of 2017, the REER index was 0.4 below the level of December 2013, still providing 0.3 a competitive advantage to manufacturing. Manufacturing increased by 1 percent y/y in 0.2 the first three quarters of 2017. Growth within 0.1 manufacturing was uneven (Figure 11). However, 0.0 fixed capital investment in manufacturing (large Q1 2017 Q2 2017 0.1 and medium-sized enterprises) continued a Agriculture, forestry and fishing Mineral extraction Manufacturing contraction that began in 2014. While a lot of manufacturing industries demonstrated fixed Source: Rosstat. Figure 10: The contribution of non-tradable sectors Figure 11: Growth in manufacturing was uneven to GDP turned positive and was the key factor of GDP (Growth in manufacturing by sector, percent; fixed capi- growth in the second quarter of 2017 tal investment growth in manufacturing by sector [large (Contribution of non-tradable sectors to GDP growth, pp) and medium enterprises], percent) -40 -20 0 20 40 60 80 2.0 Food products Beverages 1.5 Tobacco products 1.0 Clothes Leather Wood processing 0.5 Paper and pulp Polygraph 0.0 Coke and oil products Chemicals -0.5 Medicines Other nonmetal products -1.0 Q1 2017 Q2 2017 Metallurgy products Metal products Housekeeping services Other services Culture, sport and entertainment Health and social services Electrical equipment Education State management, national security, social security Machines and equipment Administrative and other services Professional, scientific and technical activity Vehicles Real estate Finance and insurance Information and communication Hotels and restaurants Furniture Transportation and storage Retail and wholesale trade Other finished goods Construction Water Electricity and gas Investment growth in 1H 2017, % Source: Rosstat. Source: Rosstat. Russia Economic Report | Edition No. 38 7 I. Recent Economic and Policy Developments capital investment growth in the first three annual growth decelerated in the third quarter of quarters of 2017, investment in some industries 2017, compared to the previous quarter. According with high shares in manufacturing decreased to available high frequency statistics, the slowdown (metallurgy, metal goods, vehicles). of fixed capital investment in the third quarter comes largely from large and medium enterprises Growth momentum decelerated in the third investment in mineral resource extraction (mining quarter of 2017 after the high base of the second support service activities) (Figure 12). Meanwhile, quarter—likely caused by a slowdown in gross transportation, financial services, retail and capital formation. In the third quarter of 2017, wholesale trade, culture and sport (most likely quarterly GDP growth fell close to zero levels, while related to the soccer World Cup) continued annual GDP growth slowed down to 1.8 percent, supporting fixed capital investment in the third y/y. National accounts data for GDP composition by quarter of 2017. Thus, high fixed capital investment type of economic activity are not available yet. High- growth in the second quarter was mainly due to frequency statistics show that output in five basic temporary factors, with third quarter fixed capital sectors5 increased by 2 percent y/y, compared investment growth more in line with trend. A to 3.8 percent in the second quarter (Figure 7). slowdown in investment demand (both from fixed Slowdown of growth was registered in mineral capital investment and from inventory restocking, resource extraction. Growth in crude oil production which contributed 2 pp to GDP growth in the second slowed down and turned negative in September, quarter of 2017) is likely to have led to decelerating largely due to a high base of oil production in the growth momentum in the third quarter. end of 2016. The growth of gas production also decelerated, partly because of warmer weather Figure 12: Slowdown of investment to mineral resource extraction was the key factor behind fixed conditions. In September, Rosstat revised its high- capital investment slowdown in the third quarter frequency series on construction. As a result, the (Contribution to fixed capital investment [large and increased growth momentum noted previously medium enterprises], by sector, pp, percent) turned to a rather flat performance. Output Culture, sport growth was at 0 percent in the third quarter, y/y, Health Education as opposed to about 7 percent y/y growth in July Public administration and defence Administrative activities and August recorded previously. Agriculture was Professional, scientific and technical activitites Real estate the only basic sector in which the growth rate Finance ICT increased notably, helped by a bumper harvest Accomodation and food service Transportation (Part 3 discusses developments in the agricultural Wholesale and retail trade Construction sector in more detail). Water supply Electricity, gas, steam Manufactuiring Mining and quarrying Demand-side high-frequency statistics suggest Agriculture -1 -0.5 0 0.5 1 1.5 2 2.5 continued growth momentum in retail trade, thus pointing to continued momentum in growth of Q1-Q3 2017 I half 2017 consumption. Meanwhile, fixed capital investment Source: Rosstat. 6 Output in five basic sectors is an aggregate indicator, which includes agriculture, industrial production, construction, transport, retail and wholesale trade. 8 Russia Economic Report | Edition No. 38 I. Recent Economic Developments 1.2 Balance of Payments: A favorable External Environment (Recovering External Demand and improved Terms of Trade) Supported the Balance of Payments Higher oil prices supported the current account through energy exports. Energy export revenues more than compensated for the significant growth in imports that accompanied a stronger ruble and a recovering domestic demand. Non-oil exports and exports of services also expanded in the first half of 2017, supported by a recovering external demand and higher prices for other commodities. While short-term capital flew into the government sector on the back of continued interest in the financial assets of emerging and developing economies (EMDEs), net capital outflows from the non-government sector increased. I mproved terms of trade for Russia, together with the continued accommodative monetary policies of advanced economies, stimulated investors’ three quarters of 2017, compared with the same period last year. Favorable price trends for metals and chemicals and the growth of interest in EMDE assets, resulting in some REER exports volumes for certain categories (Figure appreciation. Despite the Ministry of Finance’s 14) supported non-oil/gas exports, compared purchases of currency, which sterilized part of oil to 2016. On the back of adverse terms-of-trade and gas export revenues, the REER appreciated by shock and restrictions on food imports from 19.6 percent y/y in the first three quarters of 2017. Western countries, imports sharply contracted In January-September 2017, the current account in the second half of 2014 and in 2015 before surplus increased to US$26.6 billion from US$15.3 rebounding in the second half of 2016. The billion last year, as the improvement in the trend rolled over to 2017 as domestic demand trade balance more than compensated for the hardened and the ruble strengthened. The deterioration in the balance of services and factor nominal value of imported goods increased by income accounts: 25 percent in January-September 2017, y/y. Yet an increase in the nominal value of exports • The trade balance improved (Table 1). Higher more than compensated for an increase in the oil prices, especially in the first quarter of 2017 nominal value of imports and the trade balance (Figure 13), boosted exports in oil (negative strengthened to US$80.3 billion from US$63 volume growth, but positive price effect) and billion in the same period last year. gas (growth in volume, positive price effect), which increased by 29 percent in the first Figure 14: In the first half of 2017, all export Figure 13: The nominal value of imported goods categories, except for machinery and other exports, increased by 25 percent in January-September 2017, y/y demonstrated growth in real terms (Contribution of tradable sectors to GDP growth, pp) (Percent) 110 Other 100 Machinery 90 Metals 80 70 Textiles 60 Wood, pulp 50 Leather, fur 40 Chemicals, rubber 30 Oil products 20 Minerals (incl. oil) Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 Food products Oil price (Brent), Dec 13 = 100 Import of goods, Dec 13 = 100, SA REER, Dec 13 = 100 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 Source: CBR, Haver Analytics. Source: Russian Customs statistics. Russia Economic Report | Edition No. 38 9 I. Recent Economic Developments Table 1: Balance of payments, 2014–2017 (US$ billions) Q1 Q2 Q3 9m 2013 2014 2015 2016 2017 2017 2017e 2017e Current account balance 33.4 57.5 68.8 25.5 22.6 2.8 1.2 26.6 Trade balance 122.3 133.7 111.5 66.4 34.5 25.1 20.7 80.3 Non-oil current account balance -315.6 -266.9 -134.5 -128.5 -27.2 -43.5 -43.9 -114.4 Capital and financial account -46.6 -89.0 -69.4 -11.1 -11.0 2.5 9.4 0.8 Errors and omissions -8.9 8.0 2.9 -4.6 -0.4 2.7 -4.2 -1.9 Change in reserves (- = increase) 22.1 107.5 -1.7 8.2 -11.3 -7.5 -6.5 -25.4 Memo: average oil price (Brent, US$/barrel) 108.4 97.5 54.4 45.9 54.7 49.9 54.2 52.9 Source: CBR. • The balance of services and factor income economy. The non-oil/gas current account worsened accounts deteriorated (Figure 15). Exports of to negative USD114.4 billion from negative US$94.2 services, driven by transport, construction, billion. The share of oil and gas exports remained ICT and travel services, registered substantial high (above 50 percent of exported goods) and growth of 15 percent in nominal value. The the increase in exports of non-oil/gas goods and companies providing these services were helped services was not sufficient to compensate for the by the sharp ruble depreciation of 2014. In 2017, growing imports. The improvement in the overall the REER was still about 10 percent lower than current account was driven primarily by external its level in December 2013. Improved external factors, such as hydrocarbon prices. demand also helped. Meanwhile, a substantial increase in foreign travel caused by growing Short-term capital flew into the government sector, real wages and a stronger ruble in the first nine driven by a resilient risk appetite for EMDE financial month of 2017 worsened the overall deficit of assets and supported by the still-accommodative the services account to US$21.8 billion from monetary policy in advanced economies. Net US$17.8 billion in the same period last year. capital outflows6 from the non-government sector increased. In January-September 2017, the The non-oil/gas current account deficit increased, government sector registered net capital inflows underlining the challenges in diversifying the that were mainly due to OFZ (federal loan bonds) Figure 15: The balance of services and factor income accounts deteriorated (US$ billion) 60,000 40,000 20,000 0 -20,000 -40,000 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q -60,000 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 2016 2017 2017 Goods Services Compensation of employees Investment income Transfers Current account balance Source: CBR. 6 Adjusted for currency swaps and correspondent accounts of resident banks in the central bank, and repayments of foreign-currency loans by large banks to the central bank. 10 Russia Economic Report | Edition No. 38 I. Recent Economic Developments purchases by non-residents. The overall nominal Figure 16: Incoming FDI increased in the second quarter of 2017 value of OFZ held by non-residents increased to (US$ billion) US$34.7 billion as of September 1, 2017, compared 45,000 to US$25 billion as of January 1, 2017. 40,000 35,000 In January-September 2017, an increase in net 30,000 capital outflows came from the banking sector. 25,000 Banks continued deleveraging, but their net foreign 20,000 assets decreased less strongly than they did last 15,000 10,000 year, which could be largely associated with the 5,000 Rosneft privatization deal closing. Meanwhile in the 0 non-banking sector, the acquisition of net foreign -5,000 assets stayed at the same level as last year and Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4 Q1 Q4 Q1Q2 net foreign liabilities rose by US$18.2 billion. This 08 08 09 09 10 10 11 11 12 12 13 13 14 14 15 15 16 16 17 17 increase was mainly due to a boost in FDI, especially Source: CBR. in the second and third quarters of 2017. FDI data for the first two quarters suggest that the hike conducted by the Central Bank on behalf of the happened both on the back of investment in capital Ministry of Finance from February 2017. The Central (including reinvestment of profit) and investment Bank refrained from intervening on its own, in in debt instruments. In the first quarter of 2017, it line with its flexible exchange-rate regime. As of largely came from offshore zones usually associated September 1, 2017, international reserves reached with capital flight (Figure 16). Overall, net capital US$424.8 billion up from US$377.7 billion in the end outflow in the non-banking sector decreased to of 2016. The import cover stays at a comfortable level, US$1.6 billion from US$13.5 billion last year. although slightly lower, compared to end 2016 (16.3 months of goods and services in the end of September The international reserves of the Central Bank 2017, compared to 17 months of goods and services in increased by US$14.2 billion7 in the first three the end of 2016). High levels of international reserves quarters of 2017, compared to a marginal decrease and the flexible exchange-rate regime continue to of US$1.1 billion in the same period last year. The help the economy navigate external shocks. increase was mostly due to currency purchases 1.3 Labor Market and Poverty Trends: Unemployment is Stable, Wages are Recovering, but a High Share of the Population Remains Vulnerable Unemployment declined slightly in the first half of 2017, while low inflation and a recovering economy allowed real wages to increase. However, real disposable income growth remained negative, driven by contractions in other income sources. The poverty rate in Russia, under its national definition, decreased marginally in the first half of 2017, while the share of the vulnerable population continued to grow. T he employment and labor force participation rates both decreased slightly in the first half of 2017, while unemployment was close to a labor force participation and employment rates by about 0.5 percentage points. These rates are still above 69 and 65 percent, respectively (Figure 17). minimum. The absolute numbers of economically However, because of the continued decline in the active people decreased by 800,000 to 76 million working-age population (over 2016, the working- and those of employed people fell by 600,000 age population decreased by almost a million from people to 73 million in September 2017. This led 84.2 to 83.2 million people), the decrease in the to a marginal decline of the seasonally adjusted employment rate did not translate into an increase 7 Not accounting for the price effects. Russia Economic Report | Edition No. 38 11 I. Recent Economic Developments in the unemployment rate. The latter even dropped disposable income (Figure 20) and to a widening to 5.1 percent in the first ten months of 2017, of the gap between disposable income and real compared to 5.4 percent a year ago (Figure 18). Due wages (See Box 2). to low labor mobility, unemployment by regions remained unequal. The lowest unemployment The economically secure share of the population was registered in Moscow (1.3 percent in the third declined further in 2016. The threshold of 10 US$ quarter of 2017) and St. Petersburg (1.7 percent), a day or more in 2005 PPP, which corresponds while the highest was in the Tuva Republic (18.7 to almost 11,000 Russian rubles per person per percent) and Ingushetia (27 percent). month in 2016 prices, is commonly used to define the economically secure population, while the Other labor-market indicators have not been population below is considered vulnerable. Half overly affected. The job vacancy rate8 increased of this threshold (5 US$/day or less in 2005 PPP or slightly to 2.7 percent in second quarter of 2017, 5,500 rubles per person per month in 2016 prices in compared to 2.5 percent a year ago, reflecting a Russia) is the limit for the international moderate- gradual recovery in the real sector. The number of poverty rate. Using these criteria, the population in part-time employees decreased in the first half of Russia became much more vulnerable in 2015 and 2017 and remained far below the levels of the 2009 situation worsened further in 2016. The share of crisis period. The average number of hours worked the population under 5 US$/day increased from 10 remains stable. percent in 2014 to 13.2 percent in 2015 and 13.8 percent in 20169. And the share of the vulnerable With inflation low, wages continued to grow in population, spending between 5 and 10 US$/day in real terms. Real wages started growing in August 2005 PPP, increased from 33.5 percent in 2014 to 2016 (Figure 19). In the first nine months of 2017, almost 40 percent in 2016. At the same time, the their average growth was 3.1 percent compared to economically secure population (with consumption the same period of 2016. Pensions were indexed above 10 US$/day in 2005 PPP) decreased by 10 at close to the current inflation rate and stayed percentage points from 56.5 percent in 2014 to broadly constant in real terms. Other components 48.2 percent in 2015 and further to 46.3 percent of household incomes, including incomes in 2016. This contraction was driven by a massive from business activity and the informal sector, decline in disposable incomes and wages in 2015, continued to decline. This led to a stagnation in and a continued fall in incomes in 2016. Figure 17: LFP and employment rates declined Figure 18: ... while unemployment rate remains low (Percent) (Percent) 71 6.5 70 69 6.0 68 5.5 67 66 5.0 65 64 4.5 63 62 4.0 2012 2013 2014 2015 2016 2017 2012 2013 2014 2015 2016 2017 LFP rate Employment rate LFP rate, MA Empl. rate, MA Total SA Source: Rosstat and World Bank staff estimates. Source: Rosstat and Haver Analytics. Note: MA – 12 month moving average. 8 Ratio of vacancies to the total numbers of jobs. 9 Note that this numbers should not be compared to the official poverty rate reported by Rosstat. Although the thresholds for poverty are lower in this case, the welfare aggregate that is used (consumption expenditures instead of incomes) is also different. These calculations are also based on another source of data (HSE-RLMS) that provides similar trends in time, but the levels might be different. 12 Russia Economic Report | Edition No. 38 I. Recent Economic Developments Figure 19: Wages and pensions grow, but the overall Figure 20: Share of population with consumption per disposable income stagnates capita over 10 USD/day in 2005 PPP declined further (Percent to previous year) (Percent) 100 15 90 10 80 70 5 60 50 0 40 30 -5 20 -10 10 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 -15 2012 2013 2014 2015 2016 2017 More than 50 USD/day 25-50 USD/day 10-25 USD/day Wages Pensions Disp income 5-10 USD/day Less than 5 USD/day More than 10 USD/day Note: pension dynamics adjusted for January 2017’s one-time Note: Consumption is defined as consumer expenditures on food, payment. non-food and services and excludes taxes, savings and other pay- Source: Rosstat and World Bank staff estimates. ments in various forms as well as non-consumption expenditures. Source: World Bank staff estimates using HSE-RLMS data. Box 2 Is there a wage-income paradox? Prima facie, there is a growing discrepancy between growing wages and contracting incomes in Russia. Wages have grown faster in boom periods and contracted more in recessions than disposable incomes in Russia. Cumulative wage growth was higher than that of disposable income in the past 15 years. Wages increased more than disposable incomes during periods of economic expansion. During economic contractions—in 2009 and from 2015—, wages fell more than disposable incomes. The situation is the opposite in most of OECD countries, including resource-rich Australia, Canada and Norway, where disposable income has grown faster than real wages in recent decades. In the first half of 2016, real wages in Russia stopped contracting and flattened, while real disposable income declined at the same rate as in 2015 (Figure 18). The difference between the two indicators is driven by the non-wage component of disposable income. Wages are responsible for a relatively small share of disposable income, because regular wage statistics cover only Figure B2-1. Formal wages account for 38 percent of large- and medium-sized enterprises and there is a total household income big informal labor market for which wages are not (Structure of Total Household Income in 2015, percent) well captured by official statistics. Other Wages, 38.3% Formal wages account for less than half of total (unobserved incomes) 26.2% household income.10 Only 38.3 percent of household incomes comes from wages that are officially reported. Public transfers (mainly pensions and social assistance) make up almost a fifth of household income, and property income (dividends and interest rates, renting out or selling real estates, selling Social transfers currency, etc.) and income from entrepreneurial 18.2% activity also contribute (Figure B2-1). The rest, nearly Business incomes 7.9% Property incomes a quarter of all income, is not recorded by statistical 9.2% methods. Instead, it is estimated in order to make Source: Rosstat and World Bank staff calculations. 10 The real disposable-income indicator is used to analyze trends over time, while total income is used to analyze structure by sources. This is done to be consistent with commonly used definitions and does not affect conclusions. The difference is that disposable income does not include taxes and other mandatory payments. Russia Economic Report | Edition No. 38 13 I. Recent Economic Developments reported incomes consistent with the total amount of consumer expenditures, which are better captured by statistics than incomes. Unreported incomes mainly come from self-employment or employment in the informal sector. Informal-sector activity is not covered by macroeconomic statistics and for detailed analyses, micro-survey information is used, but is released with a lag of one to several years. A large share of unreported incomes is due to the informal sector of the labor market. The total amount of jobs in the formal sector (all types of legal entities: registered business, public and non-commercial organizations) is 45 million, while according to the Labor Force Survey, there are 73 million employed people. The others are employed in the non-corporate sector11 and partly in the informal sector, including in self-employment, working as individuals or without official contracts. Wage statistics are based on information collected from enterprises, not from employees. This means that for those who are not employed in organizations—almost one third of all employees—there is almost no systematically collected wage data. Real wage-growth numbers are based only on statistics covering wages in large and medium enterprises, which is why they contribute even less to real disposable income dynamics than total wages. Monthly and quarterly wage-growth statistics are related not to those employed in all organizations, but only to those who are working in large and medium enterprises,12 which covers 35 million people, or less than half of the total employed population. This accounts for 70 percent of all observed wages or 28 percent of total household incomes. The number of people employed in large and medium enterprises declined, but their wages grew faster than the rest of incomes, so their share remained relatively stable in time. While not fully conclusive, it therefore seems that the wage-income paradox is a combination of two things: (i) contraction in non-wage incomes and (ii) reporting, data and statistics issues. The official poverty rate decreased slightly in the by a slow nominal growth of the subsistence first half of 2017. Despite the continued contraction minimum that increased in the first quarter by of real disposable income, the official poverty only 1.4 percent, which is far below the inflation rate, measured as the share of the population rate. This means that some households whose real with incomes below the subsistence minimum, as incomes declined might have escaped from official reported by Rosstat, decreased in the first half poverty only because the poverty line decreased of 2017 compared to the same period a year ago more in real terms. However, in the second quarter, (Table 2). The contraction of poverty was especially the growth of the subsistence minimum was strong in the first quarter of 2017, when it dropped closer to inflation, explaining why the poverty rate by 1 percentage point to 15 percent, compared to returned almost to the levels of the previous year the first quarter of 2016. This was mainly explained (14.4 percent in 2017). Table 2: The poverty rate decreased slightly 2016 2017 2010 2011 2012 2013 2014 2015 Jan- Jan- Jan- Jan- Jan- Jan- Mar Jun Sept Dec Mar Jun Poverty rate, percent, average 12.5 12.7 10.7 10.8 11.2 13.3 16.0 14.6 13.9 13.5 15.0 14.4 for the period Number of poor, million people 17.7 17.9 15.4 15.5 16.1 19.5 23.4 21.4 20.3 19.8 22.0 21.1 Source: Rosstat. 11 Non-corporate sector employment is the difference between total employment and employment in legal entities (large, medium and small enterprises). 12 With the number of employed above 100 people or annual revenue more than 400 million rubles. 14 Russia Economic Report | Edition No. 38 I. Recent Economic Developments 1.4 Monetary Policy: The Central Bank Continued a Gradual approach to Monetary Easing Aimed at Anchoring Inflation Expectations Monetary policy remained prudent and consistent with the inflation-targeting framework. A combination of relatively tight monetary policy and tight fiscal policy, together with some one-off factors, led the Central Bank to undershoot the CPI inflation end-year target as early as July 2017. T he Central Bank continued its gradual approach to monetary easing in 2017. The Central Bank reduced the key rate by 175 bp in January- tight. The monetization of the economy increased with the ratio of M2 to GDP, rising from 41.5 percent at the end of 2016 to 42.5 percent at the end of the November 2017 from 10 to 8.25 percent in annual second quarter of 2017 (Figure 23). The observed terms (Figure 21). Meanwhile, annual consumer moderate relaxation in monetary stance led to a inflation had almost reached its end-year target by reduction in money market rates from 10.5 percent April 2017. It undershot the end-year target in July, y/y at the end of 2016 to 8.1 percent y/y in early reaching 3.9 percent y/y. Annual consumer inflation November 2017. However, real interest rates are stayed below the end-year target in July-October. sufficiently positive, keeping monetary conditions Core inflation decreased from 6 percent y/y in relatively tight. December 2016, to 2.5 percent y/y in October 2017, Figure 23: The monetization of the economy increased reflecting subsiding inflation pressures. Meanwhile, inflation expectations trended downward during 25 44 the year, but remained elevated (Figure 22). To 20 42 anchor inflation expectations and make them 40 15 sustainable and consistent, the Central Bank 38 continued with its gradual approach to monetary 10 36 easing. In the October statement, the Central Bank 5 24 confirmed that its transition from moderately tight to neutral monetary policy will be gradual, but 0 32 Q1 2012 Q2 2012 Q3 2012 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 acknowledged possible key rate cuts during the upcoming meetings. Average Money Supply growth, y-o-y, sa, percent (LHS) Average Money Supply, percent of GDP (RHS) Despite the resumption of a gradual monetary easing, monetary conditions remain relatively Source: CBR and World Bank staff calculations. Figure 22: Inflation expectations trended downward Figure 21: The Central Bank cut the key rate by 175 during the year, but remained elevated Basis Points in January-November 2017 (Median expected inflation, percent, y/y) 18 20 17 16 18 15 16 14 13 14 12 12 11 10 10 9 8 8 Aug-15 Aug-16 Aug-17 Aug-14 Dec-15 Dec-16 Dec-14 Feb-17 Feb-15 Feb-16 Apr-16 Apr-17 Apr-15 Oct-15 Oct-16 Oct-17 Oct-14 Jun-15 Jun-16 Jun-17 Jun-14 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Aug-15 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Aug-17 Sep-17 Jul-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Jul-17 Oct-17 Expected inflation Source: CBR. Source: CBR. Russia Economic Report | Edition No. 38 15 I. Recent Economic Developments Moderately tight monetary policy combined geo-political tensions exercised some downward with tight fiscal policy helped by some one- pressure (Figure 25). While oil prices trended off factors eased inflation pressures, letting slightly lower in the first half of 2017, the ruble consumer inflation reach the end-year target by exchange rate against the US dollar appreciated July. In January-October 2017, annual average slightly, helped by continued demand for ruble- consumer inflation decelerated to 3.9 percent denominated financial assets, which offered compared to 7.4 percent in the same period of attractive returns in view of soft monetary conditions 2016. The inflation slowdown was largely due in major developed countries. This demand was to the deceleration of non-food inflation from supported by a perception of decreased risk of 8.6 percent y/y in January–October 2016 to 4.3 these assets, as Russia’s CDS spreads continued percent in the same period this year (Figure 24). declining. Yet, with rising geo-political tensions in Inflationary pressures subsided, especially in the June and the expansion of sanctions against Russia third quarter of 2017, partly supported by the in July, the ruble depreciated. It bounced back with stronger ruble and a good harvest. the moderate recovery of oil prices in July-October. Despite oil prices trending upwards in November, In January-October 2017, the improved terms of the ruble depreciated. Such dynamics was broadly trade and the continued interest of investors in in line with other EMDE currencies and reflects the EMDE markets supported the ruble, while temporary decrease of investors’ interest in EMDEs Figure 25: The oil price remained an important factor of the Ruble exchange rate dynamics Figure 24: Inflation is below the end-year target (Changes in oil prices and the nominal exchange rate, (CPI index and its components, percent, y-o-y) logarithmic scale) 25 5 4.8 20 4.6 4.4 15 4.2 4 10 3.8 3.6 5 3.4 3.2 0 3 Oct - 17 Jan - 14 Feb - 14 Mar - 14 Apr - 14 May - 14 Jun - 14 Jul - 14 Aug - 14 Sep - 14 Oct - 14 Nov - 14 Dec - 14 Jan - 15 Feb - 15 Mar - 15 Apr - 15 May - 15 Jun - 15 Jul - 15 Aug - 15 Sep - 15 Oct - 15 Nov - 15 Dec - 15 Jan - 16 Feb - 16 Mar - 16 Apr - 16 May - 16 Jun - 16 Jul - 16 Aug - 16 Sep - 16 Oct - 16 Nov - 16 Dec - 16 Jan - 17 Feb - 17 Mar - 17 Apr - 17 May - 17 Jun - 17 Jul - 17 Aug - 17 Sep - 17 1/1/14 3/1/14 5/1/14 7/1/14 9/1/14 11/1/14 1/1/15 3/1/15 5/1/15 7/1/15 9/1/15 11/1/15 1/1/16 3/1/16 5/1/16 7/1/16 9/1/16 11/1/16 1/1/17 3/1/17 5/1/17 7/1/17 9/1/17 11/1/17 Core in ation CPI in ation Food in ation Non-food in ation Services in ation Oil price (Brent), ln Rub/USD, ln (rhs, reverse order) Source: CBR and Haver Analytics. Source: CBR and World Bank staff calculations. 1.5 The Financial Sector: The Banking Sector’s Fundamentals Improved with the Economic Recovery, but some Pockets of Vulnerability Remained The Russian Central Bank bail-out of two large private banks (the second- and fifth-largest private banks, jointly equal to 5.2 percent of the banking sector assets) in August-September 2017 pointed to a continued fragility in the Russian banking system. Concerns over asset quality due to rapid credit growth and connected lending weakened their liquidity positions. The banks, bailed out under a newly established resolution framework, received liquidity support from a new emergency liquidity window with expanded eligible collateral. They also will be given capital injections from the Banking Sector Consolidation Fund (BSCF). Full details of the bailout are yet to be revealed, including the extent to which shareholders will have to contribute to the rescue of their banks. How the mechanism is implemented will be key to preserving stability and preventing moral hazard. While these recent failures of the large private banks have not caused noticeable stress across the broader banking sector, their long-term effect—absent full divestment—will likely be increased public ownership of the banking sector, which raises concerns about competition and innovation in the financial system in the medium- to long-term. 16 Russia Economic Report | Edition No. 38 I. Recent Economic Developments T he 2014-2016 economic recession amplified vulnerabilities that had been accumulating over time in the banking system. The ongoing In 2017, the Russian authorities strengthened the bank resolution framework to allow for a faster resolution of problem banks. In July, the CBR sector consolidation and continuing bank failures established the Banking Sector Consolidation Fund point to the underlying problems that need to be (BSCF). This new resolution tool allows the CBR to addressed to ensure stable and sustainable growth provide direct capital injections to banks instead in the future. While the Central Bank’s recent bail- of using long-term soft loans from the Deposit out of two large private banks, Otkritie and B&N Insurance Agency (See Box 3). In addition, the CBR Bank, helped avoid noticeable stress across the introduced a new emergency liquidity facility with broader banking sector, the scale and magnitude an expanded eligible collateral to support banks in of the interventions point to the remaining case of stress. The new resolution mechanism was vulnerability in the Russian banking system. implemented for the first time during the bailout of Otkritie and B&N Bank. The CBR (via BSCF) has Since the CBR stepped up its efforts to clean become a major shareholder in each of the banks up the banking system in 2014, the number of and has appointed temporary administrations banks in Russia fell by over a third (Figure 26). consisting of both CBR and BSCF staff to run these Flawed business models, over-aggressive growth, banks. There was no credit moratorium13 or bail-in14 high exposure to related-party lending and of unsecured senior creditors, but subordinated misrepresentation of asset quality were the most instruments will be written off as well as bank common problems that led to the bank failures. As liabilities due to shareholders and top managers. the pace of the banking sector consolidation has Full details of the bailouts are yet to be revealed, been increasing over time, the size and systemic including the extent of resources to be injected importance of the banks that required intervention in the banks. According to the CBR’s preliminary has also increased. Several banks among the top estimates, the amount required to restore their fifty by assets have recently lost their licenses or capital to regulatory levels could be in a range of undergone a resolution. In 2017, five of the largest RUB 800-820 billion (approx. US$13.9-14.3 billion). fifty banks were closed (Yugra, Tatfondbank) or resolved via creditors bail-in (Peresvet) or with the Despite the failure of some large private banks use of public funds (Otkritie, B&N Bank). in 2017, the overall performance of the banking sector has been stable. The banking sector’s Figure 26: The number of banks has fallen by over a fundamentals have improved through August 2017, third between 2013 and 2017 following the rest of the economy. Throughout 1,000 923 the year, the key risk and performance indicators 900 834 remained largely unchanged and credit growth 800 733 picked up moderately. The aggregate capital 700 623 adequacy ratio remained stable throughout the 574 600 year at around 13 percent, against a regulatory 500 minimum of 8 percent, due to modest lending 400 growth and profitable bank performance earlier in 300 the year. 200 100 0 Jan-14 Jan-15 Jan-16 Jan-17 Oct-17 Number of banks in Russia Source: CBR. 13 According to the Russian bankruptcy law, a moratorium on satisfaction of creditors’ claims could be imposed by the temporary administration. It extends to monetary obligations and mandatory payments of the entity under the resolution. 14 Bail-in is a statutory power to restructure the liabilities of a distressed financial institution by converting into equity and/or writing down unsecured debt. Russia Economic Report | Edition No. 38 17 I. Recent Economic Developments Box 3 Russia moves towards a new bank resolution regime “Resolution” is the restructuring of a bank by a resolution authority designed to ensure the continuity of its critical functions, the preservation of financial stability and the restoration of the viability of all or part of that institution, while the remaining parts are put into normal insolvency proceedings. In normal insolvency procedures, the primary objective is to maximize the value of assets of the failed firm in the interest of creditors. However, these may take many years, especially for complex institutions undermining confidence in the sector. In contrast, the primary objective of a bank resolution is to preserve financial stability. Effective resolution should also discourage banks from undertaking excessive risks (moral hazard) by ensuring that shareholders and creditors, as opposed to taxpayers, bear the losses in the value of the bank’s investments. Recent financial crises have exposed shortcomings in bank resolution regimes around the world and prompted a revision of resolution frameworks to adhere to best practices. At the Cannes Summit in November 2011, the G20 endorsed the Financial Stability Board core recommendations for effective resolution (“Key Attributes of Effective Resolution Regimes for Financial Institutions”) that jurisdictions should implement to achieve the G20 commitments. Effective resolution tools include the power to sell the bank or merge it with another bank, to set up a temporary bridge bank to operate critical functions, to separate good assets from bad ones and to convert to shares or write down the debt of failing banks (bail-in). In May 2017, the Russian authorities introduced a law amending the bank resolution framework.15 While the Deposit Insurance Agency (DIA) retains its ability to take part in rehabilitation of banks, the new mechanism allows the Central Bank of Russia (CBR) to take part in the rehabilitation of banks through the Banking Sector Consolidation Fund (BSCF). BSCF is set up as an asset management company with the authorized share capital of RUB 1.5 billion (approx. US$26mln), which is fully owned, financed and managed by the CBR.16 The amounts of the CBR’s further contributions to BSCF are to be authorized by the CBR’s Board of Directors. BSCF does not carry an explicit arrangement for federal government funding and its size would be determined on a case-by-case basis. The new mechanism allows the CBR to provide an equity capital injection, but only after writing down shareholders’ equity and writing off subordinated debt. Some elements of the bail-in are contemplated for individuals who are managers or/and exercise control over the bank–obligations of a bank under BSCF resolution towards those individuals have to be terminated. BSCF can also provide loans (including subordinated loans), place deposits, issue bank guarantees, acquire assets of problem banks and rights to claims to them. It is assumed that the CBR will sell the acquired shares of the banks in an open auction after the rehabilitation process is complete. There are no strictly defined eligibility criteria for the banks to receive BSCF support, and the scheme can be used to bail out non-systemic banks, if there is a major threat to financial stability. After the assessment of the problem bank is performed, CBR’s Committee on Banking Supervision proposes a way forward and then CBR’s Board of Directors approves the plan of financial rehabilitation of the bank, either under BSCF or DIA. In contrast to the Russian framework, EU and US regulations either severely limit or outright forbid the possibility of injecting capital to support failing banks (bail-out). The European Bank Recovery and Resolution Directive (BRRD) of May 2014 only allows that in exceptional circumstances, and only where it is critical to financial stability. Public funds can be used to bear bank losses (up to 5% of bank liabilities) only when shareholders and creditors have borne sufficient losses (i.e. 8% of the liabilities of the bank under resolution) through write-downs or conversions. In most cases, public funds will be limited to providing loans to a bridge institution, purchasing specific assets of an institution under resolution, guaranteeing certain assets or liabilities of the institution under resolution, compensating shareholders or creditors who incurred greater losses than under normal insolvency proceedings. The application of the resolution tools goes hand in hand with the recovery and reorganization measures that are reflected in the Business Reorganization Plan that aims at restoring the bank’s long-term viability. 15 Federal Law No. 84-FZ from May 1, 2017. 16 Limited liability company «Fund of Banking Sector Consolidation Asset Management Company», «FBSC AMC» Ltd. 18 Russia Economic Report | Edition No. 38 I. Recent Economic Developments For banks that are solvent and not failing or likely to fail, the BRRD contains the possibility of precautionary recapitalization. State aid in this context can only be granted to prepare for the possible capital needs of a bank that would materialize if economic conditions were to worsen. It does not trigger resolution of the bank. The main conditions for such injection are (i) the European Central Bank (ECB) needs to declare that the bank is solvent; (ii) the State support shall not be used to offset losses that the institution has incurred or is likely to incur in the future, (iii) the State support is temporary (i.e. the State should be able to recover the aid in the short- to medium-term), and (iv) the State support has received final approval under EU State aid rules, which involve burden-sharing measures (shareholders and subordinated debt holders contribute), a credible and effective restructuring plan to ensure the bank is viable and distortions of competition are limited through proportionate remedies. In the case of the USA, the Dodd-Frank Act creates an orderly liquidation authority (OLA) that allows the Treasury Secretary to close, and the Federal Deposit Insurance Corporation (FDIC) to unwind, failing bank holding companies or other financial companies that at the time of resolution are deemed as systemically important by the Treasury Secretary. The FDIC can use resolution procedures it deems appropriate, including selling of its assets, merging it with another company, purchasing and assuming transactions or creating a bridge financial company. This process is known as a closed bank bail-in, in which all creditors are “bailed-in” by having their claims impaired in proportion to the bank’s losses and the creditors’ seniority under the statutory claims hierarchy. Insured depositors are protected under FDIA, but uninsured depositors may suffer losses. Shareholders and unsecured creditors bear losses, and management is removed. The new resolution frameworks in both Europe and the US aim to limit the costs to taxpayers by ensuring that resolution costs are born by the entities, its shareholders and creditors and through resolution funds financed by the industry. The Single Resolution Fund (SRF) is funded with contributions from credit institutions and certain investment firms in the 19 participating States in the Banking Union. The SRF will be gradually built up during the first eight years (2016-2023) and shall reach the target level of at least 1% of the amount of insured deposits of all credit institutions within the Banking Union. Country members have committed to provide contingency funding to the SRF in case accumulated resources are insufficient under a harmonized Loan Facility Agreement. In the US, funds spent in the liquidation must be recovered from the assets of the company. If not, other systemically important financial companies will be charged the cost of the liquidation through assessments. The FDIC can issue debt to bridge funding for resolution costs. The new Russian resolution framework presents important advantages over the previous mechanism by promptly restoring the solvency of the institution to support financial sector stability. Before this new mechanism was put in place, to facilitate the operation of undercapitalized banks, a long-term (10-15 years) soft loan was extended by the DIA, while the CBR granted regulatory forbearance during the recovery period. However, BSCF support has only limited bail-in requirements (e.g. senior creditors are not subject to bail in) and the fact that resolution funds are provided by the CBR, as opposed to being funded by/recouped from the industry, may induce moral hazard. If approved, authorities’ ongoing efforts to pass legislation that would force bank owners to surrender assets in exchange for bailouts of their banks would help mitigate moral hazard and reduce resolution costs. Furthermore, BSCF funding through CBR currency issuance, if large enough, may result in monetization of resolution costs given CBR’s profitability (albeit its capitalization level mitigates this concern). Usage of budget rather that CBR funding could address this issue. However, loss of capital and recognition of 3Q17 declined to RUB 675 billion (US$11.7 billion) negative financial results of banks under resolution from RUB 997 billion (US$17.3 billion) seen from weakened the overall sector performance in January to August. This drop observed in banking September (Figure 27). The failure of some of the profits was attributed to the one-off recognition largest private banks negatively affected Russia’s of negative financial results caused by additional aggregate banking sector profits, which declined for provisioning for non-performing loans of banks the first time since the beginning of 2017. The total under the BSCF resolution. net profit of the Russian banking sector from 1Q- Russia Economic Report | Edition No. 38 19 I. Recent Economic Developments Non-performing loans fluctuated at around 10 sector and SMEs (Figure 28). Corporate lending percent, which is high by historical levels (pre-crisis experienced modest, single-digit growth, while NPLs stood around 6% in January 2014), but they retail lending in rubles grew 10.7% in the first remain adequately provisioned. In comparison, ten months of 2017. The strongest growth was the other BRICs and large emerging markets observed in the mortgage segment (25 percent such as Turkey and Mexico have on average NPLs in the first nine months of 2017 compared to the around 4 percent. same period last year), supported by a large unmet demand for housing and more favorable conditions Lending growth was uneven as demand recovered brought by declining interest rates, which are at faster in the retail sector than in the corporate their historical minimum. Figure 27: Overall sector performance weakened Figure 28: Credit growth in rubles picked up slightly moderately (Key credit and performance indicators, percent) (y-o-y, percent) 16 15 14 12 10 10 8 5 6 0 4 2 -5 0 Jan-14 Jan-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-15 Nov-16 Oct-17 -10 Jan -15 Mar -15 May -15 Jul -15 Sep -15 Nov - 15 Jan -16 Mar -16 May -16 Jul -16 Sep -16 Nov - 16 Jan -17 Mar -17 May -17 Jul -17 Sep -17 Capital adequacy ratio NPLs to total loans Loan loss provisions to total loans Return on assets Return on equity In Rub In foreign currency (RHS) Source: CBR. Source: CBR. 1.6 Government Budget: The Government Followed the Path of Fiscal Consolidation In the first nine months of 2017, the general government fiscal stance improved, mainly helped by higher revenues. The Russian Government adhered to a path of fiscal consolidation and introduced a new fiscal rule that is expected to smoothen the influence of external volatility on the budget and the real exchange rate. The rule comes into effect in 2019 and will require fiscal consolidation in 2018-2020. In the January-October 2017 period, buoyed largely by higher revenues, the federal budget registered a primary surplus of 0.4 percent of oil/gas revenues increased by 0.5 percent of GDP, compared to the same period last year, largely due to improved tax administration and higher CIT18, GDP17 compared to a deficit of 1.4 percent of GDP excise, and VAT receipts from a recovering domestic in the same period last year (Figure 29). In January- demand. Compared to the same period last year, October 2017, the federal budget revenue totaled primary expenditures decreased by 0.6 percent of 16.5 percent of GDP, an increase of 1.2 percent of GDP but slightly increased in real terms. In 2017, GDP compared to the same period last year, with pensions were indexed at the inflation level, but oil revenues higher by 0.8 percent of GDP (Table 3). civil servant salaries and the savings pillar of the Despite the appreciating ruble, oil and gas revenues pension system were frozen, as in 2015-2016 (2014- grew, mostly due to increases in energy prices. Non- 2016 for the savings pillar). In the first ten months 17 On a cash basis. 18 An increase in CIT receipts comes largely from a higher share of CIT channeled to the federal budget, compared to 2016: out of 20 pp tax rate, 3 pp belongs to the federal level, compared to 2 pp last year. Meanwhile, in the first nine months of 2017, general government budget receipts from CIT demonstrated substantial growth of 16.2 percent, y/y. 20 Russia Economic Report | Edition No. 38 I. Recent Economic Developments Table 3: Federal budget revenue increased by 1.2 In preparation for the introduction of the new percent of GDP in 2017 fiscal rule, the government created a system of (Main indicators, January-October, percent of GDP) currency interventions in the domestic market 2016 2017 in February 2017. Foreign currency is purchased Revenue 15.3 16.5 when the price of oil exceeds US$40/bbl and is sold Oil revenues 5.6 6.4 if the opposite happens. The amount of currency Non-oil revenue 9.7 10.1 purchased is defined by additional oil and gas fiscal Expenditure 17.5 16.9 revenues received by the federal budget compared to the baseline scenario, as stipulated in the Balance -2.2 -0.4 federal budget for 2017. By November 22nd, 2017, Primary expenditure 16.7 16.1 the government had purchased US$9.7 billion via Interest 0.8 0.8 these interventions, and planned to transfer about Primary balance -1.4 0.4 US$12 billion to the National Welfare Fund in the Non-oil primary balance -7.1 -6 beginning of 2018. Source: Haver analytics. • The general government’s19 fiscal stance also of 2017, federal budget spending decreased largely improved (Figure 30). In the first nine months due to lower spending on defense (-0.5 percent of of 2017, the general government registered a GDP), security (-0.2 percent of GDP), and health primary surplus of 1.6 percent of GDP, compared (-0.2 percent of GDP). In this period, the non-oil to a deficit of 0.8 percent in the same period primary deficit narrowed by 1.1 percent of GDP. last year. The consolidated regional budget Overall, the federal budget deficit narrowed to registered a primary surplus of 0.9 percent of 0.4 percent of GDP from 2.2 percent of GDP last GDP in 2017, compared to 0.8 percent of GDP year. As of November 1, 2017, federal debt stock in in the same period last year (Figure 31). Higher domestic currency increased to about 9.7 percent revenues helped reduce the regional debt stock of GDP from 9.3 percent of GDP in the end of 2016, by 7.7 percent in nominal terms, compared to as the federal budget deficit was mainly financed the beginning of the year. The Ministry of Finance from the ruble debt issuance and the government continued to ease the regional debt burden, has not started using the Reserve Fund. By the end increasing budgetary loans with lower interest of 2017, the federal government debt (in domestic rates to regions. The stock of commercial credit and foreign currency) is expected to reach 13.6 decreased by about 20 percent in nominal terms percent of GDP, compared to 12.9 percent in the and the share of budgetary loans increased to end of 2016. 48 percent from 42 percent by the end of 2016. Figure 29: The federal budget registered a primary surplus in the first ten months of 2017 (% of GDP, January to October) 18 1 16 0 14 -1 12 -2 10 -3 8 -4 6 -5 4 -6 2 -7 0 -8 Primary expenditure Oil/gas revenue Non-oil/gas revenue 2016 2017 2016 2017 Primary balance Non-oil/gas primary balance Source: Haver Analytics. 19 The general government budget includes the federal budget, the subnational budgets and extra-budgetary funds, i.e. pension, mandatory medical insurance and social security funds. Russia Economic Report | Edition No. 38 21 I. Recent Economic Developments Figure 30: The GG budget non-oil/gas primary balance improved in the first nine months of 2017 (% of GDP, January to September) 35 2 1 30 0 25 -1 20 -2 -3 15 -4 10 -5 -6 5 -7 0 -8 Primary expenditure Oil/gas revenue Non-oil/gas revenue 2016 2017 2016 2017 Primary balance Non-oil/gas primary balance Source: Haver Analytics. Yet the aggregate debt dynamics concealed The federal government has adhered to its fiscal substantial variations in debt levels among consolidation path, adjusting the budget system to regions. As of October 1, 2017, there were eight fit in the new fiscal rule (see Box 4) by 2019 through regions, out of more than 80, with a share of expenditure cuts, improved tax administration debt exceeding the region’s own revenues (the and some revenue mobilization effort. The draft same number as at the end of 2016). federal law on the federal budget for 2018-2020 was • Extra-budgetary funds registered a marginal approved by the State Duma in the third reading. surplus of 0.1 percent of GDP, compared to a The draft law is based on GDP growth forecasts of deficit of 0.1 percent of GDP in the same period 2.1 percent, 2.2 percent, and 2.3 percent in 2018, last year. Federal transfers to the Pension Fund, 2019, and 2020, respectively, and conservative oil covering pension fund financing gap, reached prices projections of US$43.8/bbl, US$41.6/bbl, about 28 percent of the pension fund revenues. and US$42.4/bbl for the respective years (Table 4). The overall general government deficit of 1.8 Federal budget revenues are projected to fall from percent of GDP changed to a surplus of 0.6 percent 16 percent of GDP in 2017 to 14.8 percent of GDP of GDP in the first nine months of 2017. in 2020, mainly on the back of lower oil and gas Figure 31: The regional budget primary balance improved in the first nine months of 2017 (% of GDP, January to September) 11.8 1.0 11.6 0.9 11.4 0.8 0.7 11.2 0.6 11.0 0.5 10.8 0.4 10.6 0.3 10.4 0.2 10.2 0.1 10.0 0.0 2016 2017 2016 2017 Primary expenditure Revenue Primary balance Balance Source: Haver Analytics. 22 Russia Economic Report | Edition No. 38 I. Recent Economic Developments revenues due to lower prices, a decreasing share of administration and revenue mobilization, including the oil sector in the economy and a lower effective by channeling 50 percent of state companies’ tax rate with the increased depletion of stocks. Non- profits to the budget via dividend20. The draft law oil/gas revenues are projected to increase from 9.7 was developed in accordance with the new fiscal percent of GDP in 2017 to 10 percent, 10 percent rule provisions. In 2018, transitional provisions are and 9.8 percent in 2018, 2019, 2020 respectively. to be applied: primary expenditures are expected The increase is projected to come from a growing to be larger by 1 percent of GDP than the ones tax base, continued efforts on improving tax stipulated by the fiscal rule. Box 4 New fiscal rule–Third Time’s the Charm? In 2019, the government will adopt a new fiscal arrangement to manage its oil/gas revenue more effectively. Starting in 2019, a portion of the oil/gas revenue the federal government can spend in a given year will be determined by a fixed oil price benchmark (US$40 per barrel in 2017 prices), unlike the previous two rules based on historical oil prices. If actual oil prices exceed the benchmark price, the difference will be saved in the National Welfare Fund (NWF), which will be merged with the Reserve Fund in February 2018. If actual prices are below the benchmark price, the government can supplement the oil/gas revenue shortfall by withdrawing an equal amount from the NWF. The new rule is therefore symmetrical. The fiscal rule limits the budgetary use of the NWF, only to smooth out the volatility of oil/gas revenue. In the event the balance of the NWF falls short of 5 percent of GDP, withdrawals from the NWF in the following year will be limited to one percent of GDP. In principle, full implementation of the new fiscal rule should help moderate fiscal cyclicality by de-linking federal expenditure from commodity-price volatility and protect the NWF by restricting the use of oil/gas windfalls. The transition from a short, backward-looking formula to a fixed-price one will provide greater predictability of medium-term expenditure paths at a conservative oil price. The new rule is simple to carry out, monitor, and communicate to the public—important operational considerations for their effective implementation and greater accountability. Russia’s new fiscal rule–a major structural reform–is a solid step in the right direction, with the following considerations: • First, by focusing exclusively on oil price volatility and federal expenditure, Russia’s new rule does not directly address business cycles in the non-oil/non-gas sector. A major and temporary output expansion in the non-oil/non-gas sector could translate into an increase in federal spending, potentially creating overheating pressures. Similarly, large-scale off-budget expenditure could give rise to fiscal cyclicality, as the fiscal rule applies only to federal outlays. Effective monetary and exchange-rate policies can dampen pressures arising from such cyclicality, but with a limit. • Second is the aspect related to escape clauses, meant to accommodate rare and exceptional circumstances such as wars or calamities. A well-defined escape clause is increasingly being recognized as an integral part of modern fiscal rules. By allowing it to deviate from the rule temporarily, an escape clause can prevent the government from violating or exiting the fiscal rule. Repeated reinstatement or revisions can hence be avoided by an effective escape clause. Over the past decade, many of the fiscal rules without an escape clause were either abandoned (Chad, Ecuador, Papua New Guinea), or modified in an ad hoc manner (Kazakhstan, Oman, Trinidad and Tobago), to counter exceptionally large shocks, such as the global financial crisis. Against this backdrop, formal escape clause provisions are become increasingly common in newly introduced fiscal rules (Brazil, Germany, Slovakia, Switzerland). Even though Russia has separate budgetary provisions for Force Majeure events such as wars or catastrophic disasters, codifying such circumstances, and allowing for other events beyond war and disasters (such as global financial crises) in an explicit escape clause, would be closer to current practice. 19 The general government budget includes the federal budget, the subnational budgets and extra-budgetary funds, i.e. pension, mandatory medical insurance and social security funds. Russia Economic Report | Edition No. 38 23 I. Recent Economic Developments • Third, in the long run, Russia could consider introducing an additional provision in the rule to accumulate more fiscal savings in the NWF. With a relatively long oil/gas reserve horizon and low public-debt levels, the most important policy consideration for Russia at present is to shield the economy from short-term oil-price volatility. However, considering the aging population and an eventual depletion of oil and gas, it may be desirable to build more assets in the NWF for the increased future cost of aging while keeping fiscal sustainability in check. • Finally, while Russia’s new rule targets a zero primary fiscal deficit at the benchmark price, it does not constrain federal government borrowing. Unlike deficits resulting from lower-than-benchmark actual oil prices, fiscal deficits created by other factors—for example, due to overly optimistic projection of non-oil/gas revenue or volume of oil/gas production as well as large swings in the exchange rate—will need to be closed by borrowing, or through a discretionary expenditure adjustment over the 3-year budget cycle. Different countries have experimented with different approaches. Chile’s structural balance rule, for example, addresses both cyclicality and sustainability concerns, by setting annual expenditure appropriations based on structural revenue, calibrated by using potential GDP and longer-term copper prices. To reduce political economy considerations, an independent panel of experts sets key parameters for the fiscal rule. Norway’s fiscal rule limits the non-oil structural deficit to the long-term return on the Government Pension Fund assets. However, the implementation of structural balance rules is generally disappointing, due to technical and institutional constraints. As an alternative, some commodity exporters combine an expenditure rule with a debt, (nominal) balance, or revenue rule, and supplement them with effective monetary and exchange-rate policies. There is, of course, no one-size-fits-all fiscal rule that can address all policy concerns. Ultimately, successful implementation of any fiscal rule depends on political commitment. Operationally simple and based on a fixed benchmark price, the reinstatement of Russia’s fiscal rule is a major structural reform. And combined with the move towards inflation targeting, it further underscores the Russian authorities’ commitment towards enhancing macro-stability. The draft federal budget law for 2018-2020 is it should keep it at zero beginning in 2019. The non- largely driven by expenditure cuts. oil/gas primary fiscal deficit is expected to reach 6.2 percent of GDP, 5.1 percent of GDP, and 5.0 percent Federal budget primary expenditures would of GDP in 2018, 2019, and 2020, respectively, decrease from about 17.3 percent of GDP in 2017 compared to 7.8 percent of GDP in 2017. to 14.8 percent of GDP in 2020. In 2018, the federal budget’s primary expenditures are to decrease Figure 32: Expenditures for all categories, except by 1.1 percent of GDP, a 6.6 percent decrease in for national security, intergovernmental budgetary transfers and education, would drop in real terms real terms. Expenditures for all categories, except in 2018 education, national security and intergovernmental budgetary transfers would drop in real terms in Intergovernmental transfers Mass media 2018 (Figure 32). In 2016, general government Sport expenditures for education dropped by 19.6 Social policy percent in real terms compared to the level of Health Culture 2013. Expenditures for health increased just by 0.9 Education percent in real terms in 2014-2016. Both health Environment Housing and communal services and education expenditures are relatively low, National economy compared to other countries (See Box 5). Social National security National defense policy21, national economy, and national defense State management would contribute the most to expenditure cuts in Primary expenditures 2018. Expenditure consolidation should bring the -45 -35 2018 -25 2019 -15 2020 -5 5 15 primary deficit to 0.5 percent of GDP deficit in 2018, from 1.3 percent of GDP deficit in 2017, and Source: Ministry of Finance. 21 Social policy spending cuts are largely attributed to the one-time payment to pensioners, conducted in 2017. 24 Russia Economic Report | Edition No. 38 I. Recent Economic Developments Table 4: The draft federal budget law for 2018-2020 is driven by expenditure cuts 2017 2018 2019 2020 Expected Forecast Revenues 16.0 15.7 15.1 14.8 Expenditures 18.1 17 15.9 15.6 Balance -2.2 -1.3 -0.8 -0.8 Primary expenditures 17.3 16.2 15.1 14.8 Primary balance -1.3 -0.5 0.0 0.0 Oil and gas revenues 6.3 5.6 5.1 4.9 Non-oil and gas revenues 9.7 10 10 9.8 Non-oil and gas balance -8.5 -6.9 -5.9 -5.7 Non-oil and gas primary balance -7.6 -6.2 -5.1 -5.0 Oil price (Urals) 49.9 43.8 41.6 42.4 Source: Ministry of Finance. Box 5 Public health and education expenditures are relatively low in Russia Public health spending in Russia is relatively low. At around 3.4 percent of GDP in 2015 and 3.6 percent of GDP in 2016, it is well below the EU average of 7.2 percent of GDP and 6.5 percent for OECD countries (Figure B5-1a). Compared to the BRIC countries, in 2014, Russia’s public health spending (3.2 percent of GDP) only exceeded health expenditures in China (3.1 percent of GDP) and India (1.4 percent of GDP). Relatively low public health spending in Russia results in high out-of- pocket spending on health for its citizens. In addition to its low levels, with an emphasis on expensive, tertiary care, Russia’s health care spending is also inefficiently allocated. Additional resources are needed to improve health outcomes, but these resources must be accompanied by reforms to increase the value for money spent. The current configuration of health care provision emphasizes high-cost hospital and specialist care, limits the capacity of the system to adapt to emerging patient needs and reduces both its efficiency and its effectiveness. Despite a gradual reduction of hospital capacity in the last decade, the number of hospital beds per 1,000 population in Russia is 1.6 times higher than the EU average and the average length of stay is 1.5 times longer. The difference in public spending on education is slightly less. Russia allocates 3.6 percent of GDP compared to the OECD average of 5.3 percent of GDP and 4.9 percent of GDP for EU countries. (Figure B5-1b) Figure B5-1: Russia’s public expenditures on health and education as % of GDP are low compared to other countries (a. Health) (b. Education) 10 7 9 6 8 7 5 6 4 5 4 3 3 2 2 1 1 0 0 USA Czech Rep Canada EU-28 OECD Estonia Poland Brazil Latvia Russia China USA Estonia Brazil Latvia Canada OECD Poland EU-28 Czech Rep Russia average average (27 (27 countries) countries) Source: OECD, Federal Treasury of the RF, Eurostat, WDI. Source: OECD, Federal Treasury of the RF, Eurostat, WDI. Note: The latest available data for Canada, Brazil and China is 2014. Note: The latest available data for Canada, Brazil and China is 2014. Source: Ministry of Finance. Russia Economic Report | Edition No. 38 25 PART II OUTLOOK FOR THREE YEARS: MODEST GROWTH AHEAD II. Outlook and Risks 2. Outlook for Three Years: Modest Growth Ahead Global growth is expected to remain stable. Oil prices are anticipated to average $53/bbl in 2017 and rise to $56/bbl in 2018 on strong oil demand and restraint in OPEC and non-OPEC production. The medium- term growth forecast for Russia has been slightly increased since the last Russia Economic Report (May 2017) following a somewhat stronger-than-expected recovery of domestic demand and higher exports. G lobal growth is expected to remain stable. Global growth outlook is expected to remain broadly stable at 2.9 percent in 2018-19 (Table 5). An the forecast. Supply to the global market from politically stressed oil producers, including Iraq, Libya, Nigeria, and Venezuela, could be volatile. acceleration in Emerging Markets and Developing The agreement among OPEC and non-OPEC Economies, especially commodity exporters, is countries to cut production more deeply could expected to offset the moderation of advanced materially tighten markets—the next OPEC economies. For Russian trade partners, growth meeting is on November 30. Conversely, failure in the Euro Area is expected to slow as policy to extend the agreement could exert downward accommodation is gradually unwound and labor pressure on prices. Efficiency gains among U.S. market slack continues to diminish. Because of shale producers could boost global oil supplies. tighter policies and a rebalancing of the economy, China will see a slight slowdown in growth in The medium-term growth forecast for Russia has 2018-19. A sudden tightening of global financial been slightly increased following higher exports conditions and rising geopolitical risks remain and a somewhat stronger-than-expected important downside risks. The possibility of recovery of domestic demand. In an environment stronger-than-expected growth in large advanced of relatively high oil prices, macro stabilization, economies, notably in the United States and the and improved business and consumer confidence, Euro Area, poses an upside risk to the outlook. we expect Russia’s economy to continue to grow. Compared to the forecast from spring 2017, our Oil prices are expected to average $53/bbl in growth estimates of 1.3 percent, 1.4 percent, and 2017 and rise to $56/bbl in 2018 on strong oil 1.4 percent in 2017, 2018, and 2019, respectively, demand and restraint in OPEC and non-OPEC have been upgraded to 1.7 percent, 1.7 percent production (despite projected increases in and 1.8 percent. (Figure 33 and Table 6). U.S. shale production). There are some risks to Table 5: Global growth is broadly stable (GDP growth projections, percent) 2014 2015 2016 2017f 2018f 2019f World 2.8 2.7 2.4 2.7 2.9 2.9 Advanced economies 1.9 2.1 1.7 1.9 1.8 1.7 United States 2.4 2.6 1.6 2.1 2.2 1.9 Euro Area 1.2 2 1.8 1.7 1.5 1.5 Emerging and developing economies 4.3 3.6 3.5 4.1 4.5 4.7 China 7.3 6.9 6.7 6.7 6.3 6.3 Russia 0.7 -2.8 -0.2 1.7 1.7 1.8 Crude oil (Brent, WTI and Dubai average, US$/bbl) 96.2 50.8 42.8 53.0 56.0 59.0 Crude oil (Urals, US$/bbl)22 97.6 51.2 41.7 51.6 54.6 57.5 Source: World Bank staff projections. 22 Growth rates for crude oil average WB price are applied to Urals oil price. 28 Russia Economic Report | Edition No. 38 II. Outlook and Risks Figure 33: In the firming global environment, Russia’s likely to benefit further from the soccer World economy is expected to grow at a modest pace Cup hosted by 11 Russian cities. (Real GDP growth, percent) 4 In 2018-2019, growth in gross fixed capital 3 formation is expected to slow down after 2 strong growth in the second quarter of 2017. 1 Public investment in several big infrastructure 0 projects is expected to decelerate in 2018-2019, -1 and fiscal consolidation is expected to take its -2 toll on public-sector investment expenditures. -3 Meanwhile, growth in fixed capital investment -4 2012 2013 2014 2015 2016 2017 2018 2019 in big state energy companies should continue. GDP growth Oil price, average (US$ per barrel) Cheaper credit is expected to support fixed capital Source: Rosstat, World Bank. investment in 2018-2019, and with a recovering economy, improved business sentiment and a Consumer demand is expected to be the main stable macroeconomic environment, investment engine of GDP growth in 2017-2019. With growth is expected to become more broad-based. headline inflation stabilizing around 4 percent in 2018-2019, real wages are expected to be The economy’s adjustment to the terms-of-trade on an upward growth trajectory. Resumed shock of 2014 and the sanctions regime increased indexation of public employees’ salaries, frozen the role of export as a GDP growth driver. In 2015- in 2015-2017, will also support real incomes 2016, domestic demand shrank, absorbing the and consumption. Other sources of income, terms-of-trade shock and increased geopolitical such as informal wages, are expected to grow uncertainty resulting from the introduction of as economy recovers. In 2018, consumption is sanctions. This brought a drop in the shares Table 6: Modest growth rates are projected (Major macroeconomic Indicators) 2016 2017f 2018f 2019f Oil price (US$ per barrel, WB average) 42.8 53 56 59 GDP growth, percent -0.2 1.7 1.7 1.8 Consumption growth, percent -3.5 2.1 1.9 1.9 Gross capital formation growth, percent 1.5 5.2 3.4 1.6 Gross fixed capital formation growth, percent -1.8 3.6 3 3 General government balance, percent of GDP -3.7 -2.2 -1.2 0.2 Current account (US$ billions) 25.5 31.9 32.9 40.5 Current account, percent of GDP 2 2 2.1 2.4 Exports (GNFS), bln US$ 332.4 392.2 415.5 441 Imports (GNFS), bln US$ 266 318.7 338.6 356.8 Trade balance (GNFS), bln US$ 66.4 73.5 76.8 84.2 Trade balance (GNFS), percent of GDP 5.2 4.7 4.8 5.1 Capital and financial account (US$ billions) -16.2 -22.6 -15.3 -23.8 Capital and financial account, percent of GDP -1.3 -1.1 -1 -1.4 CPI inflation (average) 7.1 3.7 4 4 Source: CBR, Rosstat, World Bank staff calculations. Russia Economic Report | Edition No. 38 29 II. Outlook and Risks of consumption and gross capital formation in industrial production growth is expected to GDP in 2015-2016. Domestic demand is not slowdown in 2018, and bounce back in 2019 as expected to go back to the 2013 levels during the the oil production increases. projection period. Meanwhile, as some exporting companies managed to benefit from the relative The current account surplus is set to increase. price adjustment, exports experienced growth in An increase in the current account surplus is 2014-2016. Their share of GDP increased in 2015- expected as moderately strengthening oil prices 2016 and is projected to increase in 2017-2019. support exports and growth of imports slows We anticipate some slowdown in export volume down in 2018-2019 (Table 6). Growth in export growth in 2018 on the back of flat oil production. volumes will also support the current account. Growth of exports is expected to accelerate in 2019 with higher oil production. Meanwhile, The poverty rate is expected to decrease the increased importance of exports as a growth slightly on the back of decelerated inflation and driver amplifies government policies aimed at recoveries in private income and consumption. improvement of the external trade regulatory Driven by a rebound in disposable income and environment (See Table 6). consumption, the poverty headcount is projected to decline in 2017 to 12.9 percent in the baseline Non-tradable sectors are expected to drive scenario after reaching 13.5 percent in 2016 growth in the medium term. Supported by (Figure 35). The poverty rate should continue transportation, construction, real estate, declining in the baseline scenario in 2018 and wholesale trade and the financial sector, services 2019 to 12.6 and 12.2 percent, respectively, as are set to resume growth in 2017 (Figure 34). income and consumption grow further. Among With the banking sector’s performance gradually the factors that could fuel real income growth are stabilizing, its near-term outlook is also improving. a deceleration in inflation and a general recovery Reviving credit growth, however, especially in in the economy. As to public transfers, they the corporate and SME segment, will remain a may see additional support with the upcoming key challenge. Growth in the retail segment is presidential election in early 2018. Figure 35 also expected to be largely driven by mortgages, given shows the sensitivity of poverty projections to a strong demand and declining mortgage interest the minus/plus 15-percent change in oil prices rates. Due to an anticipated flat oil production in (scenarios 2 and 3) compared to the baseline. 2018 and high base of gas production in 2017, Figure 34: Non-tradable sectors are expected to drive growth in the medium-term (Projected growth by sector, percent) (Contribution to GDP, pp) 2.5 1.8 2.2 1.6 1.9 1.4 1.2 1.6 1 1.3 0.8 1.0 0.6 0.7 0.4 0.4 0.2 0.1 0 2017 2018 2019 2017 2018 2019 Agriculture Industrial production Services Agriculture Industrial production Services Source: World Bank staff calculations. 30 Russia Economic Report | Edition No. 38 II. Outlook and Risks Figure 35: The poverty headcount is likely to decline in Weak growth in Total Factor Productivity (TFP) 2017 and beyond and a shrinking labor force constrain GDP (Percent) growth in the medium to long term. As noted in 14 Russian Economic Report #37 “From Recession to Recovery,” TFP growth in Russia has been 13 declining over time. Addressing this constraint will 12 require deeper and speedier structural reforms. While Russia continues its progress in improving 11 its regulatory environment (Box 6), priority policy objectives remaining include limiting the role of 10 the state in the economy, improving institutional 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Poverty rate, % Scenario 1 (baseline) and regulatory frameworks, and promoting Scenario 2 (lower -bound) Scenario 3 (upper -bound) Gini (rhs) fair competition (See “Russian Federation– Source: Rosstat, World Bank staff calculations. Systematic Country Diagnostic: Pathways to Inclusive Growth”). Box 6 Russia is 35th out of 190 in the Doing Business 2018 Doing Business (DB) is a flagship World Bank project that provides an objective measure of business regulations and their enforcement across 190 economies around the world (Figure B6-1). The report tracks the business regulations across ten indicators23 that apply to firms throughout their lifecycle–from entering the market to operating the business and, when necessary, enforcing contracts and exiting. Figure B6-1: Top 10 economies, Russia and BRICS in Doing Business 2018 ranking 140 125 120 100 100 82 78 80 60 35 40 20 0 New Singapore Denmark Korea, Hong USA United Norway Georgia Sweden Russia China South India Brazil Zealand Rep. Kong SAR, Kingdom Africa China Source: Doing Business database. This year, Russia ranked 35th in the Doing Business 2018 report out of 190 economies–an improvement of 5 points over last year.24 Russia ranks in the top 20 globally in three indicators–Getting Electricity (10th), Registering Property (12th) and Enforcing Contracts (18th). It is in the top 30 in two more–Starting a Business (28th) and Getting Credit (29th) (Figure B6-2). Russia gained recognition in the Doing Business ranking thanks to three positive reforms in 2016/17. In Registering Property, Russia made it easier to transfer property by reducing the time needed to obtain state registration of title transfers. Russia also improved in Getting Credit by adopting a law that improved the collateral registry. Finally, Russia’s performance on Trading Across Borders also improved significantly, moving from 140th to 100th position between DB 2017 and DB 2018 as a result of opening a new deep-water port on the Gulf of Finland, which increased competition and reduced the cost of border compliance at the Port of St. Petersburg. Another factor that led to improved DB performance was the continuing 23 The Doing Business indicators: starting a business, dealing with construction permits, getting electricity, registering property, getting credit, protecting minority investors, paying taxes, trading across borders, enforcing contracts and resolving insolvency. 24 Beginning with Doing Business 2018, previous year country ranks are no longer being adjusted. The DTF (Distance to frontier) for the immediate prior year is still adjusted to reflect data corrections Russia Economic Report | Edition No. 38 31 II. Outlook and Risks improvement in implementation of reforms. It is important to highlight that the Doing Business report is based on feedback from firms, so for most indicators, improvements in legislation are not enough–they must be enforced so that firms see improvements on the ground. Figure B6-2: Russia ranks in top 20 globally on three indicators 140 120 115 100 100 80 60 51 52 54 40 29 28 18 20 10 12 0 Getting Registering Enforcing Starting A Getting Protecting Paying Resolving Trading Dealing With Electricity Property Contracts Business Credit Minority Taxes Insolvency Across Construction Investors Borders Permits Source: Doing Business database. Over the past years, Russia has made great strides in Doing Business, but there are still a number of important areas where more work must be done. Of the ten indicators, Russia’s worst performers are Dealing with Construction Permits25 (115th) and Trading Across Borders26 (100th). Both these areas have seen major improvement over the past six years, but they continue to lag OECD averages for the number of procedures, time, and cost involved with compliance for firms. Risks and challenges: The outlook is subject to oil prices would reduce growth to 1.4 percent in both downside and upside risks. The upside risk 2018 and 1.5 percent in 2019. A simulated rise comes from a possible stronger-than-expected of 15 percent in oil prices would increase growth growth in large advanced economies and hence to 2.0 percent for 2018 and 2.1 percent in 2019 higher Russian exports other than crude oil, (Figure 36). The introduction of the fiscal rule which is limited by the OPEC+ agreement on helps shield the federal budget from oil price production cuts. External downside risks stem volatility, and that suggests reduced sensitivity of from a significant drop in oil prices, a sudden the economy to oil price variations. tightening of global financial conditions and Figure 36: Government policy made the GDP growth possible negative impacts from the expansion of rate less sensitive to oil price volatility sanctions. Domestic downside risks stem primarily (GDP growth, percent) from a growing discrepancy between real wages 106 and disposable incomes (as discussed in Box 2), and a vulnerable banking sector (as discussed 104 in Box 3). Though it should be emphasized the banking sector risk is not deemed systemic, given the recent failures of some large banks, 102 preserving its stability and maintaining public confidence will be a key challenge. 100 2016 2017 2018 2019 The fiscal rule and the lead-up to it suggest future GDP growth (baseline) GDP growth low (-15%) GDP growth high (+15%) reduced sensitivity of GDP growth to oil price volatility. A simulated decrease of 15 percent in Source: World Bank staff calculations. 25 Dealing with Construction Permits evaluates procedures, time and cost to complete all formalities to build a warehouse and the quality control and safety mechanisms in the construction permitting system. 26 Trading Across Borders considers time and cost to export the product of comparative advantage and import auto parts. 32 Russia Economic Report | Edition No. 38 PART III RUSSIA’S AGRICULTURE SECTOR: PROFITS, PERFORMANCE, AND PRODUCTIVITY III. Russia’s Agriculture Sector: Profits, Performance, and Productivity 3. Russia’s Agriculture Sector: Profits, Performance, and Productivity Agricultural support policies have helped transform Russian agriculture. In the past five years, not only has Russia become the world’s largest exporter of wheat, but it has reached self-sufficiency in pork and poultry. However, policies to further broaden productivity, market infrastructure and research and development could lead to stronger competitiveness of the sector in the long-term. R ussia is a major producer of agricultural commodities and plays an important role in global grain markets.27 It has the largest expanse largest producer of sunflower seeds; the third- largest producer of potatoes and milk, and the fifth-largest producer of eggs and chicken meat. of agricultural land in the world. Russia is ranked Domestically, the share of the agriculture value fifth in the world by agriculture value-added added is 4.3 percent of GDP. Agriculture and food and seventh by total foreign direct investment manufacturing value-added together comprise 6.3 (FDI) inflows in the agriculture sector (see Box percent of GDP. The agri-food processing sector 7). The country is the world’s largest producer of contributes 13.5 percent of the value-added of the barley; the fourth-largest producer of wheat, and country’s total manufacturing, but less than 2.0 most recently its largest exporter; the second- percent of its GDP.28 Box 7 Foreign Direct Investment in the agri-food sector The Russian agri-food sector has attracted considerable investment in the recent decade (Figure B7-1). The food manufacturing sector, including beverages and tobacco, received around 4.0 percent of all FDI, and the agriculture sector received around 0.4 percent of FDI. Such FDI performance compared positively with other countries, and Russia has been consistently in the top 10 countries with the most FDI in its agriculture sector (Figure B7-2). However, experts suggest that a considerable part of agri-food sector FDI was due to round-tripping—that is, Russian investments undertaken by Russian investors from foreign jurisdictions. Given the large market size, the majority of FDI in the food manufacturing sector has been market-seeking, therefore limiting potentially larger scale trickle-down effects for technology transfer and productivity gains (Kuznetsov 2012). Figure B7-2: Top 10 countries with FDI inflows in Figure B7-1: FDI and Fixed Capital Investment agriculture, 2000–13 (US$, millions) (US$, millions) 10,192 1,200 9,417 9,423 8,770 1,000 6,959 800 600 400 200 548 667 656 934 598 496 0 a y il a t a Ur ia sia nd n yp ua az tin an al tio s a ne ay em Eg Br ug Gh nl en ra 2010 2011 2012 2013 2014 I-IIIQ2015 al do ai de at g M ,m Ar In Gu Fe FDI: Agriculture, forestry and fisheries na n sia i Ch Fixed Capital Investment: Agriculture, hunting, forestry and fisheries s Ru Source: Bank of Russia and ROSSTAT database. Source: FAOSTAT database. 27 The data presented are from the FAOSTAT database. 28 ROSSTAT database. 34 Russia Economic Report | Edition No. 38 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity The agriculture sector has shown resilience to Export performance and overall sector the recent economic crisis. The sector had a gross competitiveness are among the most important value-added (GVA) growth rate of 3 percent in challenges for the agri-food sector’s long-term 2015 and 3.6 percent in 2016, and an expected performance. For long-term growth performance, growth rate of 1.7 to 2 percent in 2017, against a the sector needs to boost its competitiveness general decline of the economy of 2.8 percent and and access to new markets, including with value- 0.2 percent in 2015 and 2016 respectively (Figure added production. Two central facts characterize 37). The food and beverage manufacturing sector the Russian agri-food trade. recorded an impressive 4.7 percent growth in 2016, albeit after two consecutive years of decline First, despite recent positive export trends, agri- (Figure 38). food exports have remained mainly concentrated in the grain sector. Exports have picked up overall Since 2015, Russia has had bumper harvests of since 2007. The annual rate of growth in agri-food grains, becoming the largest exporter of wheat exports since 2007 is impressive, at 7.7 percent, in the world. The devaluation of the ruble, the compared to agri-food imports at 0.2 percent Russian response to Western sanctions—the so- during these years. However, moving beyond called countersanctions, and restrictive trade grains, exports of poultry meat products and some measures—through sanitary and phytosanitary processed food products (mainly confectionary border controls, boosted production and and condiments) are relatively limited, even broadened domestic market access (Box 8). The though domestic production surpasses domestic key policy challenges faced by the authorities will demand. It is important to highlight the fact be how to boost export performance and how to that net agri-food trade flows have always been ensure that the agri-food industry is competitive negative. The trade patterns depicted from 1998 in the long run. To achieve this, the sector requires to 2015 in Figure 39 show the trade balance to a different approach to government support have narrowed in 2014 and 2015. programs, such as policies that broaden the gains beyond the large corporate farming sector; policies Second, the country is a net food importer. that attract FDI, which brings new technologies The average share of agri-food exports in total and market access; and policies that boost exports has remained close to 2 percent in investments in market infrastructure, research 2007-15, whereas agri-food imports continue to and development. hold a sizeable share in total imports (averaged Figure 38: However, growth rate in value-added of Figure 37: Overall continuous growth in food and food manufacturing sector is mixed, 2012-16 agriculture sector value-added, 2003-16 (Percent) 6,000.0 6.00 5.00 5,000.0 4.00 4,000.0 3.00 3,000.0 2.00 1.00 2,000.0 0.00 1,000.0 -1.00 2012 2013 2014 2015 2016 -2.00 0.0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Tobacco manufacturing Food and beverage manufacturing -3.00 Fisheries Forestry Agriculture and hunting Agriculture value added growth Food and beverage manufacturing value added growth Source: ROSSTAT database. Source: ROSSTAT database. Russia Economic Report | Edition No. 38 35 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Box 8 How the Russian agri-food sector responded to recent economic shocks A recent combination of economic shocks resulted in a deterioration of terms of trade for the Russian agri-food sector over the course of the past three years. The first shock was the depreciation of the ruble exchange rate resulting from the drop in global oil prices. The Russian ruble lost 46 percent of its value between July and December 2014. The decline boosted the price competitiveness of commodity exports (Shagaida and Uzun 2016), which registered a record volume in the 2015-16 export seasons, pushing Russia to the top place in grain exports. At the same time, major agri-food producers and exporters complained that their costs of production suffered because their inputs and technology investments became more expensive. According to the Bank of Russia’s survey in May 2016, more than 80 percent of agri-food producers interviewed would have preferred a stronger ruble in order to reduce the costs of imported technology and other inputs for their production (Bank of Russia 2016). The second shock was the decline in consumer incomes, which led to reduced consumption. Food purchases constitute significant share of average household expenditures, and the average share of food expenditures in total expenditures rose to 38 percent for the whole population in 2014. Consumers switched to less expensive food products. The net effect from consumption decline has been difficult to measure, but recent research suggests that food retail trade declined considerably.[a] The third shock was the decision by the government to embargo imports from countries that imposed sanctions on Russia as a result of the political crisis around Ukraine. According to some experts, the effects of these measures were significant in that they reduced the availability of certain food items (fresh fruits and vegetables, cheeses and other dairy products, and so on). Russian suppliers shifted to alternative markets in the search for substitute channels for food products. The domestic sector response has been relatively quick, expanding production, but with a time lag required to substitute domestic supply in absence of investment growth (World Bank 2017b). This is probably the biggest shock, which created market imbalances and significantly reduced the availability of key food products. Domestic prices responded. As a result, food prices increased; they are still above international levels for several key food products. Such imbalance created a favorable environment for key domestic subsectors (dairy, pork and poultry, beef), which in turn benefited from more directed government support programs. Note: [a] Based on the data from the Analytical Center for the Government of Russian Federation. 2015 “Results of Food Embargo”. World Bank Group. 2017b. Russia Economic Report, No. 37, May 2017: From Recession to Recovery. World Bank, Washington, DC Figure 39: The agri-food trade balance average has 16 percent in the same period), indicating the been negative but Narrowing, 1998–2015 country’s high level of demand for food imports (Percent share in total value of agriculture exports) (Figure 40). This demand remains high even though Bln Rubles Percent 800,000 25.0 there has been a consistent decline in the share 700,000 of agri-food imports in total imports—from a high 20.0 600,000 of 24 percent to almost 14 percent since 2009. 500,000 15.0 Moreover, the composition of the agri-food trade 400,000 10.0 has not shown any significant change over time. 300,000 200,000 Commodities have a relatively higher share in total 5.0 100,000 agri-food exports; they include cereals (43 percent) 0 0.0 and edible oils (12 percent) (Figure 41). However, 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Russian commodities are priced lower, due to their Agri exports Agri imports Share agri exports in total exports Share agri imports in total imports low grades and the lower quality of the commodity products supplied (e.g. wheat). On the other hand, Source: Authors’ estimates, based on COMTRADE data. the agri-food import basket is shifted towards 36 Russia Economic Report | Edition No. 38 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Figure 40: Agri-food imports: High-value food products Figure 41: Agri-food exports: commodities Tobacco, cigarettes & cigars Tobacco, cigarettes & cigars Water, wine & vinegar Flour, brans & oilcake Extracts & preparations of coffee, soups & icecreams Water, wine & vinegar Vegetables preserved & fruits juices Extracts & preparations of coffee, soups & icecreams Sugar & molasses Food prepration & bakery Edible oil, fats & glycerine Cocoa beans, butter & chocolate Sunflower and other oilseeds Banana, grapes & other fruits Edible oils, fats & glycerine Potatoes, tomatoes & other vegetables Sunflower & other oilseeds Milk, cream, butter & bird's eggs Cereals: rice, barley, wheat etc. Meat of bovine animals & poultry Milk, cream, butter & bird's eggs 0 5 10 15 20 25 0 5 10 15 20 25 30 35 40 45 Percent Percent 2007-2015 1998-2006 2007-2015 1998-2006 Source: Authors’ estimates, based on COMTRADE data. Source: Authors’ estimates, based on COMTRADE data. higher value products, such as beef, fruits, and In the short term, market-protection measures vegetables, whose combined share in total agri- may deter investments in the agri-food processing food imports has varied from 5 to 20 percent. industry. This is because high domestic farm prices (Figures 42 and 43) incentivize investing in primary To boost export performance, and to ensure that agriculture, making it more attractive than the industry is competitive both domestically and investing in food manufacturing (all other factors internationally, structural reforms are needed. held constant). However, as experience in other The Russian agri-food sector needs to continue to countries shows, in the long term, demand for improve productivity, to expand food processing processed food will continue to increase, primarily and manufacturing with much stronger linkages because of dietary transitions and the increasing to agricultural production, and to substantially incomes of the urban middle class (Minten, increase value addition in agricultural production. Reardon, and Chen 2017). Public policy may Policies to further broaden productivity, market consider gradual steps for promoting investments infrastructure and research and development in the food manufacturing industry with a view to could lead to stronger competitiveness of the improving the competitiveness of both primary sector in the long term. and processed food sectors. Progressively raising the quality and targeting of public expenditure The agri-food sector is faced with several in agricultural services (extension, research, challenges, when looking at the long-term education, and food safety and quality) and performance opportunities: supporting infrastructure development to the levels like those of Russia’s closest comparators Competitiveness: The overly protective market (The EU, the BRICs, and the G-20) would do much environment results in high domestic prices for food to increase the competitive edge of the sector. commodities. In the short-term, high prices may attract investments only in primary agriculture, The key distinguishing characteristic of where the length of the project payoff period is government support policies has been that public lower than in downstream sectors. In the long- term, agricultural sector growth would increasingly expenditure has been heavily directed at private depend on how downstream sectors would goods to the possible detriment of public goods generate domestic demand by creating value- (Box 9). Concessional credit has been the major addition opportunities. support instrument in the form of subsidies on Russia Economic Report | Edition No. 38 37 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Figure 42: Pork prices in Russia are higher than in Figure 43: Milk prices in Russia are higher than the Germany world prices (Slaughter weights, USD per kg CW) (Ruble per 100 kg ECM) 4.5 nat. C / 100 kg ECM 4.0 2,500 3.5 2,000 3.0 2.5 1,500 2.0 1.5 1,000 1.0 500 0.5 0.0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Year Price in Russia Prices in Germany IFCN milk price indicator National milk price Source: Agribenchmark. Source: International Farm Comparison Network. interest-rate payments. Starting in 2005, support and OECD countries (Figure 44b) reveals that measures also included direct capital grants (from Russia is consistently underperforming OECD 25 percent to 35 percent of investment, depending comparators in the types of public investments on the activity) for funding investments in priority in agriculture that normally generate productivity sectors, to some extent supporting some value- gains throughout the industry. Investment levels in adding productions, such as slaughterhouses and extension, education, research and development, milk processing. and other public goods are persistently low. Another interesting characteristic of public investments in Overall, the level of investment in public goods agriculture is that they are heavily skewed toward has been consistently low compared to OECD so-called miscellaneous categories—that is, those and BRIC comparators. A comparison of general categories that do not fit the general description services support estimates of Russia (Figure 44a) of public investments. Box 9 Types of agriculture support measures in the Russian Federation Interest-rate subsidies. There are two types of interest-rate subsidies: (1) working capital, and (2) investment loans. These subsidies comprise the largest share of funding of agricultural support measures. Area payments. Area payments were introduced in 2012. They are provided by the federal government via regional administrations to all commercial agricultural producers as a decoupled subsidy. This procedure was triggered by Russia’s World Trade Organization (WTO) accession as an attempt to repackage direct WTO amber box production subsidies into the green box. However, it seems that many regional governments began to incorporate various additional conditions to eliminate “negligent” farmers. Direct subsidies to agricultural machinery manufacturers for selling machinery to domestic farmers. These subsidies were introduced in 2012. They include a discount of 15 to 30 percent for farmers if they acquire domestically manufactured agricultural machinery. This is an indirect subsidy to domestic agricultural producers and is provided as a support measure to domestic manufacturers. If agricultural machinery is produced abroad but assembled in Russia, under this scheme it qualifies as “domestically” manufactured. There are also less-sizable, indirect farm support programs. They involve melioration and soil conservation, rural development, breeding activities, and so on. These programs, however, make up only a small portion of government support to agriculture. 38 Russia Economic Report | Edition No. 38 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Figure 44: General services support estimates, 2009-14 (a. Russia) (b. OECD) Miscellaneous Miscellaneous Cost of public stockholding Cost of public stockholding Promotion of agricultural products Promotion of agricultural products Collective investments for marketing or processing Collective investments for marketing Farm restructuring or processing Farm restructuring Institutional infrastructure Storage, marketing and other physical infrastructure Institutional infrastructure Hydrological infrastructure Storage, marketing and other physical infrastructure Input control Hydrological infrastructure Pest and disease inspection and control Pest and disease inspection and control Agricultural product safety and inspection Agricultural product safety and inspection Extension Education Extension Agricultural knowledge generation Education 0 2,000 4.000 6.000 8,000 10,000 Agricultural knowledge generation US$ millions Average (2009 -2014) Average (2003 -2008) Average(1995 -2002) 0 200 400 600 800 1,000 1,200 US$ millions Source: OECD (2009 - 2014) Support Production Average Database, Average (2003 - 2008) http://www.oecd. Average (1995 - 2002) Source: OECD Production Support Database, http://www.oecd. org/tad/agriculturalpolicies/producerandconsumersupportes- org/tad/agriculturalpolicies/producerandconsumersupportes- timatesdatabase.htm timatesdatabase.htm Most countries that achieved significant results Despite trends showing that the Russian agri- in agriculture and agri-food sector productivity enterprises are catching up with those of boosted their agriculture and food industries competitors in terms of productivity, overall by investing considerably in public goods, such agricultural productivity continues to remain as agricultural advisory services and education, below international benchmarks. Considerable veterinary and animal health, research and investments have been made in new technologies development, and so on. The literature has that have replaced old and obsolete ones as more many empirical examples that demonstrate financial resources became available, both from such successes in China (Jin, Huang, and Rozelle public and private investments. However, these 2010), Australia and New Zealand (Mullen 2010), investments have not yet resulted in broad-based Canada (Veeman and Gray 2009), and many productivity gains for the whole industry, although other countries. In the case of Russia, however, as some enterprises have successfully outperformed evidenced by the analyses of factors that impact their peers. Going forward, more broad-based TFP in food manufacturing29, the amount of public productivity gains could be achieved and growth spending and expenditure on agriculture support maintained by introducing policies that support the services does not seem to significantly impact spread of innovation and technology throughout productivity in the food manufacturing sector. the entire industry. Going forward, more in-depth analysis of impact of public investments in agriculture and food industry productivity may be required. Productivity: Russian farms are less productive and less profitable than their foreign comparators. In the short-term, they are benefiting from government support, high market prices and low land costs and wages. But they face low labor and capital productivity, even with the same technologies as their comparators in other countries. With increasing labor costs and scarce labor, a growing economy can put pressure on competitiveness of agri-food enterprises and farms. Policies that support agricultural education, research and development and public-private advisory services could help improve labor skills and access to better technologies (such as seeds and machinery). 29 See World Bank. Russia: Policies for Agri-Food Sector Competitiveness and Investment. Washington, DC: World Bank, 2017. Russia Economic Report | Edition No. 38 39 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Agricultural enterprises (especially those in the through improved management and improved livestock sector) are profitable in the short term mechanization. On the other side, the capital mostly because of two factors: low-cost feed input of Russian farms is almost twice as high as production and high domestic prices for meat and it is in comparable farms in Europe and the United milk. A closer look at the cost structure of meat States; clearly such high capital investments and milk production suggests that around 50 to 60 are not needed for the optimal combination percent of costs go to buying feed, where Russia of labor intensity and capital intensity. When has a comparative advantage; these costs reduce typical farms in Russia are compared with similar the overall costs compared with benchmarked countries (using a methodology developed by farms in North America and Europe. Typical Agribenchmark and the International Farm Russian farms have quite high labor costs, even Comparison Network), Russian farms normally though farm wages are much lower than wages lag behind in key physical productivity indicators in other comparator countries (see Box 10 for the such as land, labor, and capital productivity description of the Russian farming sector). indicators (Figures 45a, b, and c). For dairy farms, labor productivity levels in Russia are about 30- There is potentially scope to improve labor 40 kilograms of energy-corrected milk (ECM) per productivity by a factor of three to five hour. The labor productivity levels in Germany are Box 10 Russian farming sector Russia’s agrarian structure may help explain some of the successes of recent agricultural sector performance and the challenges it faces. The agrarian structure in Russia is based on three types of farms: (1) agri-enterprises—large industrial farms with large land and livestock holdings; (2) emerging family farms—individual farms operated by family famers and limited hired labor; and (3) household plots—small land plots adjacent to rural homes. Around half of agricultural output is produced by agri-enterprises. Although many agri-enterprises are nearly the same in terms of the area farmed and in management and technology used as the collective farms of Soviet times, since 2000 more-advanced agri-enterprises have emerged. These enterprises can mobilize investments, utilize advanced technology, and import better management practices in the agriculture sector. They are sometimes called agro-holdings and are perceived to be the driving force behind productivity (Davydova and Franks 2015) and production growth. They also dominate the export of commodities. In many respects, these large agro-holdings are extremely concentrated vertical businesses that own the most-advanced technology. The value chains are limited to each individual agri-holding, and spillovers of technology beyond the borders of the holding are rare. Agri-enterprises and family farms tend to specialize in the production of grain, oilseeds, and other industrial crops that require high levels of mechanization, while household plots generally produce potatoes, vegetables, fruit, and milk for self-consumption and sale in local markets.30 The largest share of household plots (78 percent) specializes in the production of potatoes, but these farms sell only 17 percent of their production. The share of household plots in vegetable production was 68 percent in 2015, of which 16 percent was sold. By contrast, agri-enterprises sold 83 percent of their production and family farms 77 percent.31 In livestock, specialization has also emerged. Poultry is produced mainly by agricultural enterprises. Pork production is gradually specializing in agri-enterprises by pushing household pig farming out of business as a result of animal health and bio-safety concerns. Nevertheless, households were responsible for 39 percent of all livestock production, of which 46 percent was commercialized. They were also responsible for 46 percent of total milk production, of which 31 percent was commercialized. In general, the share of output of agri-enterprises has increased in total production. For example, in 2013 agri-enterprises contributed 47.6 percent of gross agricultural output. Their contribution increased to more than 52 percent in 2016. 30 This discussion is based on Grosclaude 2016. 31 Agri-enterprises and family farms are fully commercial. The statistics show only the share of primary production sold. If the primary production is processed on farm, it is not reflected in the statistics. Most agri-enterprises are integrating up in the value chain and are acquiring processing facilities, which allows them to process their own production. 40 Russia Economic Report | Edition No. 38 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity 210 kilograms of ECM per hour; in New Zealand productivity rates, at least for the time being. it is 355 kilograms of ECM per hour. The high Going forward, there is great scope to improve levels of labor productivity in Germany and New land use for dairy development, but because land Zealand are explained by good management and is not yet a constraining factor, such potential may the efficient use of mechanization by highly skilled not be fully realized. farm labor. But when total costs are compared with However, when it comes to costs, Russian farms benchmarked farms in advanced European tend to have a more favorable position than their and North American comparator countries, the foreign comparators. Land costs in Russia are the combination of low physical productivity and lowest among the countries compared, leading to low costs results in total costs that are still higher extensive land-use practices as reflected in a very than those of foreign comparators on a per-unit low stocking rate. This makes milk productivity per basis (Figure 46). In the short-term, there is little unit of land use low, at around 1,000 kilograms of incentive to reduce costs by improving productivity milk per hectare. Land productivity levels in other as market protection yields favorable prices, and countries are 5 to 12 times higher. However, with demand continues to grow. The only limiting factor low costs of production, farms can sustain low in the short-term for Russian agri-food enterprises Figure 45: Dairy farm productivity a. Capital Productivity (Excluding Land) b. Land Productivity c. Labor Productivity 3.5 14,000 400 kg ECM/ha arable & pasture land for dairy 12,000 350 3.0 300 10,000 kg milk (ECM )/ hour kg milk (ECM) / USD 2.5 250 8,000 2.0 200 6,000 1.5 150 1.0 4,000 100 0.5 2,000 50 0 0 0 Denmark Farm US Farm Russian Farm 1 Russian Farm 2 Ireland Farm New Zealand Farm Ireland Farm Denmark Farm US Farm New Zealand Farm Russian Farm 1 Russian Farm 2 Ireland Farm New Zealand Farm Denmark Farm US Farm Russian Farm 1 Russian Farm 2 Source: IFCN International Farm Result Database 2016 Comparison Network (IFCN), http://ifcndairy.org/ Note: ECM = Energy-corrected milk; ha = hectare. Figure 46: Cost comparison of typical dairy farms, barns Russian farms – free stall barns Typical farms - free stall barns Free grazing systems 60.00 40.00 20.00 0.00 Russian Farm 1 Russian Farm 2 Denmark Farm US Farm Ireland Farm New Zealand Farm Vet & medicine, insemination Machinery + buildings Costs for purchased feed, seeds, fertiliser + pesticides Total capital costs Source: IFCN International Farm Result Database 2016 Comparison Network (IFCN), http://ifcndairy.org/ Note: ECM = Energy-corrected milk. Russia Economic Report | Edition No. 38 41 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity seems to be capital. Capital investments in Russian dairy enterprises are almost twice as Food processing and manufacturing: The food-processing sector is relatively small for an high as they are in comparators due to several economy the size of Russia’s, and it has weak factors, including low-quality infrastructure, linkages with agricultural production. While the high financial-market risks, geography and size and backward linkages of food processing distance. For this reason, the greatest scope for and agriculture sectors vary from one region improvement is in achieving capital efficiency in to another and depend on the structure of the Russian agri-food sector, overall the agri-food the short-term, including through public support processing sector has the potential for higher policies that can help eliminate or reduce some growth if it can attract more investments. of the external costs that put pressure on capital However, the sector has demonstrated good investments. In this situation, capital seems to be productivity growth. Improving value chains, the only constraining factor. boosting quality, helping access to markets and expanding exports, could help further grow the food processing industry. Such growth can have In the short term, incentives to improve labor positive effects on the whole economy in terms of productivity might not exist, but they would be jobs and general economic growth. required for long-term competitiveness. The favorable configuration of relative price factors far below that share in countries at similar income poses medium- to long-term risks. Wages are levels, indicating that there are still opportunities likely to rise over time, as they have elsewhere for developing value-addition in the agri-food (for example, in East Asian markets). Market- sector. Furthermore, the so-called depth of the protection measures do not benefit the economy food manufacturing sector—an indicator that overall, are harmful to the consumers, and may not measures the extent to which agri-food processing be enduring. Therefore, policies should gradually is developed in a country compared to primary shift toward spreading innovation and technology agriculture—is also quite low in Russia (Figure 47). throughout the agriculture sector and helping Relative to comparators, Russia’s indicator is closer farms to stay profitable in the long term. to that of commodity producer and exporter countries rather than to technologically advanced Russia’s food manufacturing industry has grown food manufacturers. Russia’s food, beverage, over the past decade at a higher rate than and tobacco industry (farming and agribusiness primary agricultural production. However, the taken together) constitutes a smaller share of the share of food manufacturing in the economy is still economy than in other OECD countries. Figure 47: Depth of food manufacturing sector: Food manufacturing value-added/agriculture value-added, 2005–14 average 4 3.5 3 2.5 2 1.5 1 0.5 0 Kyrgyzstan Egypt Turkey Senegal Georgia Greece Ethiopia Uruguay Norway Iran (Islamic Republic of) Tunisia Philippines Slovakia Serbia (exc Kosovo) Bulgaria Republic of Korea Latvia Sweden Poland Netherlands France Russian Federation Jordan Switzerland Ireland Sources: FAOSTAT data and authors’ calculations. 42 Russia Economic Report | Edition No. 38 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity In general, Russia’s food-sector employment in the economy (Figure 49). This indicates that (employment generated by the agriculture, the food manufacturing industry may be losing food manufacturing, and food-service sectors) its appeal. It also indicates that, as the industry is skewed toward agriculture (Figure 48). A more becomes more technologically advanced, it is not desirable structure in food-sector employment attracting enough higher-skilled (and therefore would include more jobs in value-added sectors higher-paid) workers. such as food processing and food services. In high-income countries, within the food system, Production and output-per-factory in the food- agriculture accounts for a smaller share of jobs, processing sector have grown quite rapidly in while food services accounts for most jobs. recent years, primarily because of an increase in For example, in the United States, agriculture the scale of operations, i.e the output per factory accounts for about 20 percent of overall food (Figure 50). However, the number of enterprises system jobs and food manufacturing accounts grew at a much slower pace and employment per for 14 percent of jobs, while food services factory has barely increased. The sector has not accounts for about two-thirds of the jobs in the demonstrated notable employment generation, food system. Such transformation is achieved despite the relatively low exit rate of enterprises by upgrading the skillsets of rural labor, both in in recent years. Although the average number of primary agriculture and in other food sectors. workers is much higher in food processing than Modern agricultural production demands highly in beverage and tobacco, labor productivity per skilled labor, with workers who have knowledge of employee is significantly lower in food processing, modern practices and tools, such as information at 1,475,000 rubles compared to 1,946,000 and communication technologies. In addition, and 7,875,000 rubles in beverage and tobacco skills beyond agricultural production—including in respectively. This shows that the food processing food storage, grading, processing, and alternative sector has a diverse technological base: there are energy—also need to be developed to facilitate some advanced manufacturing enterprises with food systems transformations and investments, new technologies and some old, Soviet-era legacy including FDI, in response to changing consumer enterprises. In contrast, the beverage and tobacco demand (Townsend et al. 2017). subsectors enjoy higher-level technological advancement because FDI in these sectors has Salaries in the food-manufacturing sector (as well been rapid and comprehensive—the beverage and as in other food sectors) have been declining in tobacco segments have aimed to quickly establish the last 15 years, compared with average salaries themselves in the domestic market. Figure 48: Composition of food-sector employment, Figure 49: Ratio of the average wage in the industry to 2010-2015 average the country’s average wage, 2000-2015 1.1 Food processing Agriculture and 1 14% hunting 77% 0.9 0.8 Food Services, 0.7 9% 0.6 0.5 0.4 0.3 0.2 0.1 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 Agriculture and hunting Hotels and restaurants Food processing Source: ROSSTAT database. Source: ROSSTAT database. Russia Economic Report | Edition No. 38 43 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Figure 50: Output and gross value-added per 51 depicts changes in employment and labor enterprise in food enterprises, millions of rubles at productivity in each sector at two points in time: 2005 prices 40 2005 and 2015. 35 30 As Figure 52 shows, the fall in labor intensity 25 in food enterprises was less steep than that 20 in total manufacturing until 2007, after which 15 the two moved at the same rate. Such a fall in labor intensity is consistent with the investments 10 made in technology; after 2013, some signs of 5 improvement are visible in both. 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Output per enterprise GVA per enterprise Consistent with this trend, labor productivity Source: Authors’ calculations based on ROSSTAT database. has risen, as have the levels of wages—albeit at Note: GVA = gross value-added. a declining rate compared with the rest of the economy—while capital intensity declined and From 2005 through 2015, employment in each capital productivity increased. It is important to of these three subsectors fell at an annual rate mention that labor productivity has risen faster of 2.27, 5.25, and 6.15 percent respectively in the food processing, but wages have increased (Figure 51). However, labor productivity grew at more rapidly in the overall manufacturing sector. 3.67 percent per annum only in the food sector, Like labor productivity, capital intensity32 is much which has been able to upgrade technology. Labor higher in food—1.5 to 2 times more than in total productivity increased more rapidly in food only manufacturing. Capital productivity and the wage after 2012. The key subsectors within food include rate have almost converged, but significant gaps meat and dairy processing, bakery, fish preserving, remain in labor productivity and capital intensity and the vegetable oil industry. Both the beverage in favor of food enterprises, thereby suggesting its and tobacco segments have declined at the rate high growth potential in the country. of 4.36 and 0.59 percent respectively. Figure Figure 51: Changes in employment and labor Figure 52: Trends in labor intensity in total productivity in food enterprises, 2005 and 2015 manufacturing and food enterprises, 2005 Prices Employment Labor Productivity Labor Intensity 53 1,000 1,600 50 900 47 1,400 44 800 41 1,200 38 700 35 1,000 32 600 29 500 800 26 23 400 600 20 17 300 14 400 11 200 8 100 200 5 2 0 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 1998 1999 2000 2005 2015 2005 2015 2005 2015 Food Beverage Tobacco Year Employment (000') Labour Productivity (000' Rubles at 2005 Price) Labour intensity - Food Labour intensity - Mfg Source: Authors’ calculations based on ROSSTAT database. Source: Authors’ calculations based on ROSSTAT database. 31 Capital intensity is the amount of fixed or real capital present in relation to other factors of production, especially labor. At the level of a production process or the aggregate economy, it may be estimated by the capital to labor ratio. Labor intensity is the relative proportion of labor (compared to capital) used in a process. Its inverse is capital intensity. 44 Russia Economic Report | Edition No. 38 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity Like partial productivity measures, TFP tends to be worker training and retraining, and on improving much higher in food than in total manufacturing. the availability of a skilled labor force in the food The TFP index in the food sector was 97.98 during processing industry. 1998-2006; it jumped to 112.6 during 2007-15, growing significantly at an average rate of 1.51 Policies to unleash the potential of the agri- percent per annum. A higher rate of growth food sector in TFP is identified only in the second period. With the caveat that further analysis would be This contrasts with total manufacturing, which merited to identify such policy and programmatic witnessed a higher rate of growth in the first interventions, public policy in three areas could period at 2.43 percent and a decline at 1.08 in the improve the performance of Russia’s agri-food period that follows (Figure 53). sector: Figure 53: TFP index in food enterprises and total manufacturing, 1998-2015, 2005 prices First, investing in broadening productivity gains TFP Index in priority sectors. Russian agricultural subsectors 140 are catching up with those of competitors in 120 terms of productivity and are close to achieving 100 competitiveness with international comparators. 80 Considerable investments have been made in new technologies, which replaced obsolete 60 technologies as more financial resources became 40 available both from public and private investments. 20 However, these investments have not yet resulted 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 in broad-based productivity gains for the whole TFPI -Food TFPI -Manufacturing industry, although selected individual enterprises Source: Authors’ calculations based on ROSSTAT database. have successfully outperformed their peers. More broad-based productivity gains could be achieved These results show that the food-processing and growth maintained by introducing policies that sector is undergoing technological modernization support the spread of innovation and technology and improving labor productivity. However, throughout the entire industry. lower wages and stagnation in the movement of workers from one sector to another may indicate In addition, profitability in priority subsectors that labor is not moving from agriculture or other (pork, poultry, dairy, grains) is largely a result lower productivity sectors to food manufacturing. of low labor costs, and the cost structure of key There could be constraints to the movement of priority commodities shows that physical labor labor as a result of infrastructure, geography or productivity is low compared with comparators major skill gaps. The lack of skilled labor could in North America and Europe. Farms also benefit be one of the main impediments to further labor from favorable market conditions because market productivity growth in food manufacturing. As prices for most agricultural products are high in firms improve their technologies, they drive out Russia thanks to market protection measures. unskilled labor and demand a more skilled labor In this situation, capital seems to be the only force. Training and re-training would be costly for constraining factor: capital costs are high and these firms, putting pressure on their profitability investments depend on many externalities. and competitiveness. Government policies should In the short term, incentives to improve labor focus on promoting vocational education and productivity might not exist, but labor productivity Russia Economic Report | Edition No. 38 45 III. Russia’s Agriculture Sector: Profits, Performance, and Productivity would be required for long-term competitiveness. experience in other countries shows, in the long The favorable configuration of relative price term, demand for processed food will increase, factors poses medium- to long-term risks. Wages primarily because of dietary transitions and the are likely to rise over time, as they have elsewhere increasing incomes of the urban middle class (for example, in East Asian markets). Market (Minten, Reardon, and Chen 2017). Public policy protection measures do not benefit the economy may therefore consider gradual steps for promoting overall; are harmful to the consumers, and may not investments in food manufacturing industry with be enduring. Therefore, policies should gradually a view to improving the competitiveness of both shift toward spreading innovation and technology primary and processed food sectors. throughout agriculture industry, and in helping farms to stay profitable in the long term. Third, support small and medium farms by reducing the bias of public support towards Second, strengthening value chains and larger farms. There is considerable literature that value-addition in the food industry. The food underscores the benefits of supporting small- and manufacturing industry is small compared to the medium-size farms (see for example Hazel et al[1]; agriculture sector and to the rest of the economy. Reardon et al[2]). Apart from key benefits such as But it is productive, with productivity growth poverty reduction, job growth, and social inclusion, showing some good prospects for sector expansion. there are two major public goods that warrant However, the sector is not expanding. One reason public support to small and medium farms. First is is that backward linkages of food manufacturing to technology transfer. Large agribusinesses possess the agriculture sector are not as strong. Adequate critical mass of technologies that are largely import- infrastructure and effective modern public policies dependent. Import dependence tends to benefit that support food manufacturing-agriculture large firms, limiting technological spillovers to small linkages and stronger value chains could therefore and medium farms. Public programs can therefore strengthen its performance, as that of agriculture support diffusion of advanced technologies to and the rural economy in general. The key question reach small and medium ones. Second, public is whether the food manufacturing sector has programs could support the inclusion of small the potential to grow, or is it unique to Russia to and medium farms in value chains, when small have a relatively small food manufacturing sector and medium farms dominate the production sub- compared with other competitors? There are both sector. Currently, federal and regional government short-term and long-term factors. In the short agricultural support programs and efforts are term, market protection measures may deter mostly directed to supporting large agribusiness— investments in the agri-food processing industry even in sectors where production is dominated because high domestic farm prices incentivize by small and medium farms (e.g. dairy, fruits, and investing in primary agriculture, making it more vegetables). Redressing this bias in public support attractive than investing in food manufacturing programs towards larger firms would be helpful. (all other factors held constant). However, as the [1] Hazell, Peter BR, Colin Poulton, Steve Wiggins, and Andrew Dorward. “The future of small farms for poverty reduction and growth.” Vol. 42. Intl Food Policy Res Inst, 2007. [2] Reardon, Thomas, Christopher B. Barrett, Julio A. Berdegué, and Johan FM Swinnen. “Agrifood industry transformation and small farmers in developing countries.” World development 37, no. 11 (2009): 1717-1727 46 Russia Economic Report | Edition No. 38 References World Bank. 2017b. Russia Economic Report No. 37: From Recession to Recovery. Moscow: World Bank Group. http://pubdocs.worldbank.org/en/383241495487103815/RER-37-May26-FINAL-with- summary.pdf Minten, Bart, Thomas Reardon, and Kevin Z. Chen. 2017. “Agricultural Value Chains: How Cities Reshape Food Systems.” Global Food Policy Report. Washington, DC: International Food Policy Research Institute (IFPRI). 42–49. 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