95697 The World Bank in the Russian Federation 33 | April 2015 The Dawn of a New Economic Era? Russia Economic Report The Dawn of a New Economic Era? I. Recent Economic Developments II. Economic Outlook III. In Focus: The Economic Impact of Sanctions This report is produced twice a year by World Bank economists of the Macroeconomics and Fiscal Management Global Practice. The team for this issue, led by Birgit Hansl (Lead Economist and Program Leader for Macroeconomics and Fiscal Management, Governance and Social Policy in Russia, bhansl@worldbank.org), consisted of Sergei Ulatov (Senior Economist), Stepan Titov (Senior Economist), Olga Emelyanova (Research Analyst), Mikhail Matytsin (Consultant), John Pollner (Lead Financial Officer), Mizuho Kida (Economist), Ekaterine Vashkmadze (Senior Economist), Damir Cosic (Economist), John Baffes (Senior Economist), Hanspeter Wyss (Senior Economist), Seyed Reza Yousefi (Consultant) and Irina Rostovtseva (Team Assistant). Birgit Hansl, Nancy Benjamin (Senior Economist), and Julie Saty Lohi (Consultant) produced the focus note on the economic impact of sanctions with contributions from Michael Ferrantino (Lead Economist) and Karlygash Dairabayeva (Consultant). Peer reviewers were Vinaya Swaroop (Lead Economist), Souleymane Coulibaly (Lead Economist), Fritzi Koehler-Geib (Senior Economist) and Karlis Smits (Senior Economist). The report was edited by Anne Grant (Сonsultant), and the graphic designer was Robert Waiharo (Сonsultant). The team is grateful for advice received from Laura Tuck (Vice President of the Europe and Central Asia Region), Hans Timmer (Chief Economist of the Europe and Central Asia Region), Michal Rutkowski (Country Director for Russia), Miria Pigato (Practice Manager, Macroeconomics and Fiscal Management Global Practice), Peter Tabak from the European Bank for Development and Reconstruction, and the IMF team for Russia, led by mission chief Ernesto Rigo Ramirez. TABLE OF CONTENT Abbreviations and Acronyms ............................................................................................................................ i Executive Summary ............................................................................................................................................... iii I. Recent Economic Developments .................................................................................................................... 1 1.1 Growth - A Lost Year ........................................................................................................................................... 2 1.2 Labor Market - Adjustment of Wages and Incomes ............................................................................................ 6 1.3 Monetary Policy and The Financial Sector - Navigating a Currency Adjustment ................................................ 9 1.4 Balance of Payments Deteriorates as Capital Flees .......................................................................................... 12 1.5 The Government Budget - The Calm Before the Storm? .................................................................................. 16 II. Outlook ................................................................................................................................................................. 20 2.1 Outlook for Russia – Protracted Recession ........................................................................................................ 22 Baseline Scenario ............................................................................................................................................... 24 Alternative Upper-bound Oil Price Scenario ...................................................................................................... 26 Alternative Lower-bound Oil Price Scenario ...................................................................................................... 27 2.2 Risks to the Growth Outlook .............................................................................................................................. 28 2.3 Risks to the Poverty and Shared Prosperity Outlook ......................................................................................... 30 III. The Economic Impact of Sanctions ............................................................................................................ 33 3.1 Introduction ........................................................................................................................................................ 34 3.2 The Economic Impact of Sanctions ..................................................................................................................... 34 3.3 Lessons From International Experience with Sanctions ..................................................................................... 35 South Africa ........................................................................................................................................................ 35 3.4 The Economic Impact of Sanctions on Russia .................................................................................................... 36 References ........................................................................................................................................................ 43 ANNEX: Main indicators ............................................................................................................................................... 44 List of Figures Figure 1: GDP growth, 2003-2014, percent .................................................................................................................. 2 Figure 2: Composition of GDP growth, percent ........................................................................................................... 2 Figure 3: Global industrial production and trade growth ............................................................................................. 3 Figure 4: Gross capital flows to developing countries, US$ billions ............................................................................. 3 Figure 5: Quarterly GDP Growth, y-o-y, and q-o-q, sa ................................................................................................. 3 Figure 6: Global energy prices ..................................................................................................................................... 4 Figure 7: Growth in the crude oil supply, U.S. and elsewhere ..................................................................................... 4 Figure 8: GDP reactions to external shocks, 2008 and 2014 ........................................................................................ 5 Figure 9: Growth in tradables, y-o-y, percent ............................................................................................................... 6 Figure 10: Contribution to GDP by sector, percent of GDP ............................................................................................ 6 Figure 11: Beveridge curve ............................................................................................................................................ 7 Figure 12: Employment and economic activity, million workers .................................................................................... 7 Figure 13: Unemployment dynamics, 2008 and 2014 ................................................................................................... 8 Figure 14: Real wage growth, 2008 and 2014 ................................................................................................................ 8 Figure 15: Real wage growth by sector, y-o-y, percentage points .................................................................................. 9 Figure 16: Contribution to real income growth, entire population, y-o-y, percent ........................................................ 9 Figure 17: Oil prices and the ruble exchange rate, 2014 ............................................................................................... 9 Figure 18: CPI inflation by component, y-o-y ................................................................................................................. 11 Figure 19: CBR policy rate hikes ..................................................................................................................................... 11 Figure 20: Current account balance, percent of GDP .................................................................................................... 12 Figure 21: Trade and services balances and oil prices ................................................................................................... 12 Figure 22: Top 10 countries sending workers to Russia, 2013 .................................................................................... 13 Figure 23: Top 10 countries to which Russians migrate, 2013 ....................................................................................... 13 Figure 24: Remittance outflows, 2014 ........................................................................................................................... 14 Figure 25: Remittance inflows, 2014 ............................................................................................................................. 14 Figure 26: Russia CDS spreads for 5-year bonds, basis points ....................................................................................... 14 Figure 27: Reserve fund and National Welfare Fund, percent of GDP ........................................................................... 17 Figure 28: Real GDP growth, y-o-y, percent ................................................................................................................... 22 Figure 29: Real GDP, percent, 2012=100 ........................................................................................................................ 22 Figure 30: Global oil spare capacity and inventories ..................................................................................................... 23 Figure 31: Growth in global oil demand ......................................................................................................................... 23 Figure 32: Poverty rate projections, percent of population ........................................................................................... 31 Figure 33: Share of the population with per capita income in US$ ppp/day ................................................................. 32 Figure 34: Stock market prices and trade volumes ........................................................................................................ 37 Figure 35: Exchange rate dynamics, Euro-dollar basket (axis in reverse order) ............................................................. 37 Figure 36: Bond issuance in US$ billion, US$ denominated .......................................................................................... 39 Figure 37: Russia corporate emerging market bond index for Russia ............................................................................ 39 Figure 38: Russia’s food and beverage imports: Q3-2013 and 2014 (US$ billion) ......................................................... 40 Figure 39: Russia’s dairy product imports: Q3-2013 and 2014 (US$ billion) .................................................................. 40 Figure 40: Russia’s food and beverage imports by country: Q3-2013 and 2014 (US$ billion) ....................................... 41 Figure 41: Russia’s cereal imports by country: Q3-2013 and 2014 (US$ billion) ........................................................... 41 Figure 42: Russia’s coal exports,Q3-2013 and 2014 (US$ billion) .................................................................................. 41 Figure 43: Russia’s fuel exports: Q3-2013 and 2014 (US$ billion) .................................................................................. 41 List of tables Table 1: Contribution to growth by demand components, percentage points .............................................................. 5 Table 2: Balance of payments, 2008-2014, US$ billions ................................................................................................ 15 Table 3: Net capital flows, 2008-2014, US$ billions ...................................................................................................... 15 Table 2: Russia’s external debt, 2011-2014, US$ billions .............................................................................................. 15 Table 5: Federal budget 2012-2014, percent of GDP ..................................................................................................... 16 Table 6: Consolidated budget, consolidated subnational budget, consolidated federal EBFs, 2011-2014, percent of GDP 17 Table 7: Economic indicators for the baseline scenario ................................................................................................. 24 Table 8: Global GDP growth, percent ............................................................................................................................. 25 Table 9: Economic indicators for the upper-bound oil price scenario ........................................................................... 27 Table 10: Economic indicators for the lower-bound oil price scenario .......................................................................... 28 Table 11: Poverty rates, percent .................................................................................................................................... 31 List of boxes Box 1: Global economic trends in 2014 ....................................................................................................................... 3 Box 2: Energy price trends .......................................................................................................................................... 4 Box 3: How does this adjustment compare to the crisis in 2008-2009? ...................................................................... 5 Box 4: How the labor market adjusted in previous crises ............................................................................................ 8 Box 5: December 2014: Policy moves to enhance financial stability ........................................................................... 10 Box 6: Migration and remittance trends ...................................................................................................................... 13 Box 7: The government anti-crisis plan ....................................................................................................................... 18 Box 8: Oil price outlook ................................................................................................................................................ 23 Box 9: Global outlook .................................................................................................................................................. 25 Box 10: The 2015-2017 budget projections ................................................................................................................ 26 Box 11: Methodologies of economic sanctions evaluation ........................................................................................... 35 Box 12: Russia’s food import ban .................................................................................................................................. 37 ABBREVIATIONS AND ACRONYMS BoP Balance of Payments CA Current Account CBR Central Bank of Russia CDS Credit Default Swap CIS Commonwealth of Independent States CPI Consumer Price Index EBF Extra-Budgetary Fund EU European Union FDI Foreign Direct Investment GDP Gross Domestic Product IMF International Monetary Fund NPL Non-Performing Loan NWF National Welfare Fund OECD Organization for Economic Cooperation and Development OPEC Organization of the Petroleum Exporting Countries PPP Purchasing Power Parity RDIF Russian Direct Investment Fund REER Real Effective Exchange Rate USITC United States International Trade Commission VAT Value-added Tax VTB Vneshtorgbank WTO World Trade Organization Russia Economic Report | Edition No. 33 i EXECUTIVE SUMMARY R ussia’s economy experienced two shocks in 2014. On top of the structural crisis that began in 2012, Russia had to deal with cyclical sanctions came late in 2014, so that their impact began to affect the economy only in the final quarter of 2014—the effects are likely to be more and idiosyncratic challenges to the economy. One profound this year and in 2016. Other supportive of the new shocks illustrates Russia’s integration circumstances relate to the balancing effect that into the world economy through its natural imports, lowered by the geopolitical tensions resource exports—and thus its dependence on and sanctions, had in softening the impact of the global commodity cycle: oil prices more than the oil terms-of-trade shock. Finally, the much halved between July and December 2014, giving weaker ruble and trade restrictions gave a slight Russia a terms-of-trade shock. The ruble lost 46 positive boost to the manufacturing sector. percent of its value against the US dollar, which worsened already eroded business and consumer Growth prospects for 2015-2016 are negative. confidence. The monetary tightening in response It is likely that when the full effects of the two made credit expensive, further dampening shocks become evident in 2015, they will push domestic demand. The other, more idiosyncratic, the Russian economy into recession. The World shock was related to the geopolitical tensions Bank baseline scenario sees a contraction of 3.8 that began in March 2014 and led to economic percent in 2015 and a modest decline of 0.3 sanctions. The tensions not only heightened percent in 2016. The growth spectrum presented perceptions that Russian investments had has two alternative scenarios that largely reflect become riskier, they also dramatically increased differences in how oil prices are expected to the costs of external borrowing for Russian affect the main macro variables. A lower-bound banks and firms. Spreads on Russian credit oil price scenario projects a larger contraction default swaps peaked in December at 578 basis of 4.6 percent in 2015 and a second recession points, compared to 159 a year ago. Together year in 2016 with a 1.0 percent contraction. with the financial sanctions imposed on Russia The upper-bound oil price scenario projects a in late July, which have restricted the access of contraction in real GDP of 2.9 percent in 2015 Russia’s largest state-connected banks and firms followed by recovery to 0.1 percent growth in to Western international finance markets, this all 2016. The main assumptions of the baseline but extinguished investment. growth outlook for both years are that consumer demand is likely to be eroded by weak confidence, Despite the economic turmoil, Russia has so still-high household debt, and slowing income far avoided recession. In 2014, growth was growth. In 2015, high inflation resulting from moderate at 0.6 percent, due to the carry- the recent steep devaluation of the ruble would over effect from 2013 growth of 1.3 percent. further depress incomes and wages. Investment Two reasons contributed to this result: (i) The is projected to contract in 2015, though with government and the Central Bank moved swiftly; external and credit conditions expected to policy responses to both shocks were adequate. improve somewhat in 2016, it should recover The economy was stabilized successfully: The marginally. The only bright spot is that the weak planned switch to a free float of the ruble was ruble could create incentives for expansion in advanced to November and other measures some tradable industries. However, high level of to support financial stability were introduced capacity utilization, structural rigidities, and the promptly, including the recapitalization of banks surging cost of imported investment goods and in December; (ii) The oil price slump and stricter credit may dampen these benefits. Russia Economic Report | Edition No. 33 iii Executive Summary A major medium-term risk for the economy Russia will continue to depend on natural lies in the continued dearth of investment. resource exports. Here a serious challenge will Low investment demand hints at the deeper be to assure progress in adopting technology that structural problems of the Russian economy and can support exploration of less accessible oil and has already initiated a new era of potentially gas fields; (ii) Future growth in productivity may small growth. Presently, higher interest rates well be threatened if natural resource revenues are exerting pressure on Russian banks as their are not invested to improve long-run growth costs of funding rise, credit levels decline, and prospects, particularly given restricted access to more loans default. Given the slowdown of the external financing. Specifically, less foreign direct economy, the result could be a vicious cycle of investment could limit the transfer of innovation a shortage of project credit, rising lending rates, and technology that is critical to heighten and a tightening of access to credit. But there Russia’s growth potential; and (iii) Finally, as are more fundamental factors that could limit long as access to external finance continues to investment demand: The uncertainty related to be a constraint, a policy of careful management geopolitical tensions and sanctions is still holding of financial sector risks and buffers will be vital. investors back and it is likely to take some time Adhering to inflation targeting within a flexible until their confidence is restored. The economy exchange rate regime will help keep international continues to grapple with serious inefficiencies reserves adequate. A greater focus on the in factor allocation, reflected, e.g., in limited efficiency of spending and prudent management labor mobility, and also with the weakness of of fiscal buffers is necessary to ensure continued the institutions that regulate markets, which fiscal sustainability at all administrative levels. leads to significant variation in how the rules of law are applied. Private investment would Achievements in shared prosperity are being need to be assured of a level playing field, with threatened. The past decade witnessed a more opportunities for competition and fewer dramatic drop in poverty as large numbers of for corruption. Systematically lower investment Russians were able to enter the middleclass. rates will ultimately lower Russia’s prospects for Poverty plunged from about 40 percent of higher growth in the next few years and limit the the population in 2001 to about 10 percent in already modest potential for growth. 2010, and in 10 years the middleclass doubled from 30 percent of the total population to over The impact of sanctions is likely to linger for 60 percent. The current World Bank baseline a long time. As lessons from international outlook, however, sees the national poverty rate experience demonstrate, sanctions could well increasing from 10.8 percent in 2013 to 14.2 alter the structure of the Russian economy and percent in 2015 and 2016. Poverty is expected the ways in which Russia integrates with the to increase because real disposable income and rest of the world. Early glimpses of changes in consumption will decline. This would be the first the Russian economy are already visible, notably significant increase in poverty rates since the a shift in orientation away from Europe and 1998-1999 crisis. Russia weathered the 2008- the West and efforts at closer integration with 2009 crisis well as disposable incomes continued East Asia, Latin America, and former Soviet to grow slightly. Given the current limited fiscal Union republics. Other changes take a more space, additional support for the poor and protectionist direction, with a growing footprint vulnerable is likely to be less generous than it was of the state on the economy. But no matter what during the 2008-2009 crisis. Although people at shape the new economic era for Russia takes, the bottom of the income distribution are the risks related to how to successfully adjust to the most vulnerable, there will be less opportunity new oil price and sanctions environment will for an increase in shared prosperity in 2015- need to be managed: (i) Despite the path to more 2016, and there is a worrisome possibility that selective integration into the world economy, recent achievements might be reversed. iv Russia Economic Report | Edition No. 33 PART I Recent Economic Developments R ussia avoided a recession in 2014. The modest growth of 0.6 percent lacked momentum, with seasonally adjusted quarterly growth persistently near zero. In addition to the structural slowdown that began in 2012, Russia had to internalize two major events. The first was a terms- of-trade shock when oil prices more than halved between July and December 2014. The ensuing ruble depreciation and monetary tightening made credit scarce and expensive, further dampening domestic demand. The second shock was related to the geopolitical tensions that began in March 2014 and led to economic sanctions. A heightened perception of risk and the financial sanctions imposed on Russia in late Julyall but extinguished investment. Nevertheless, the economy was stabilized successfully. The full impact of the oil price slump and stricter sanctions, however, will be realized this year and into 2016. I. Recent Economic Developments 1.1 Growth - A Lost Year In 2014 Russia’s economy barely grew at all. A steep drop in oil prices, together with uncertainty related to geopolitical tensions and sanctions, shocked the economy, where investment was already anemic and there were lingering structural problems. Domestic demand plummeted to rates not seen since 2008–2009. I n 2014 Russia’s growth trajectory diverged considerably from that of other high-income and emerging economies (Figure 1). In the first low oil prices had already led investors to reassess the growth prospects of oil-exporting countries. This contributed to capital outflows, reserve quarter of 2014, growth sank to 0.9 percent losses, abrupt depreciations, and rising from 2.0 percent in the last quarter of 2013 and spreads on sovereign credit default swaps stayed there for the rest of the year. However, (CDS) for many oil-exporting countries, while the global economy was slowly gathering among them Russia, Venezuela, Colombia, momentum, Russia’s economy was slowing Nigeria, and Angola. Real sector and financial (Box 1). The U.S. saw growth pick up most, but strains could entail adverse spillover effects there were weaknesses in Brazil, the Euro area, for partner economies through trade and and Japan. Overall, OECD countries held on to a financial linkages, such as remittance flows. small but expanding recovery. China was dealing with a managed slowdown, while other emerging Throughout 2014, Russia’s economy was void of economies were seeing a modest growth pick-up. growth momentum, with seasonally adjusted But the oil price declines began to put economic quarterly growth persistently near zero (Figure and financial strains on oil exporters. 5). Real GDP slowed from 1.3 percent in 2013 to 0.6 percent in 2014—about half of what the During the second half of 2014, external World Bank had projected in January 2014. demand for Russia’s exports lackened and oil Recognizing the negative impact on investor and prices retreated (Box 2), and throughout the consumer confidence of heightened geopolitical year geopolitical tensions and policy uncertainty tension, increased uncertainty about policy, and markedly reduced domestic demand. Investment the weaker ruble, the World Bank in June revised growth was negative and consumption grew its growth projection down to 0.5 percent. In more slowly than it had been (Figure 2). Globally, the second half of 2014, Western sanctions and Figure 1: GDP growth, 2003–2014, percent Figure 2: Composition of GDP growth, percent 12 17 12 8 7 4 2 0 -3 -4 -8 -8 -13 -18 -12 4 -23 3 4 5 6 7 8 3 9 0 1 2 Q1 3 -1 -0 -0 -0 -0 -0 -0 -0 -0 -1 -1 -1 -1 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1 OECD Oil-exporters Russia Other Emerging Consumption Gross fixed capital formation Import GDP growth OECD EU Emerging Change in stock Export Discrepancy Source: OECD. Source: Rosstat. Note: OECD oil exporters are Australia, Canada, Chile, the Netherlands, Norway, and the United States. 2 Russia Economic Report | Edition No. 33 I. Recent Economic Developments Box 1 Global economic trends in 2014 Global growth once again remained tepid in 2014. The global economy struggled to gain momentum as growth patterns in high-income economies increasingly diverged and in developing countries growth on average slowed. Overall, global growth is estimated to have averaged 2.6 percent in 2014, almost unchanged from 2012 and 2013. Growth was particularly disappointing in the Euro area and Japan and in emerging markets in Russia and Brazil. The growth of high-income countries increasingly diverged. While overall growth in high-income countries picked up marginally, from 1.4 percent in 2013 to an estimated 1.8 percent in 2014, there was a growing gap between countries. However, in the United States growth has been above potential since mid-2013 and in 2014 reached 2.4 percent, supported by easing fiscal consolidation, robust private investment, and a surge in consumption. In the euro area, real GDP growth continued to be subdued, reaching only an estimated 0.9 percent. Confidence stabilized at the end of 2014 even as the euro weakened and oil prices fell. In Japan, at zero percent a technical recession ended in the fourth quarter as both consumption and exports recovered. Growth in emerging and developing countries slipped. The slowdown in several large middle-income countries was mainly caused by cyclical factors, domestic policy tightening, and political tensions. India and Mexico grew well in 2014. China is undergoing a managed slowdown but growth was a still-robust 7.4 percent. In contrast to middle- income countries, economic activity in low-income countries picked up in 2014 as public investment rose, service sectors expanded significantly, and there were solid harvests and substantial capital inflows (Figure 3). For this group growth reached 4.4 percent in 2014, down only slightly from 4.9 percent in 2013. Global trade was surprisingly flaccid again, even though financing conditions were benign (Figure 4). Since the financial crisis began, global trade has slowed significantly, growing by less than 4 percent in 2013 and 2014—well below the pre- crisis average of 7 percent a year. The slowdown is due partly to a drop in demand and partly because world trade seems to be less sensitive to changes in global activity. Changes in global value chains and shifting composition of import demand may have contributed to the decline in the responsiveness of trade to growth. Benign financing conditions throughout much of 2014 allowed developing countries to tap international bond markets at a record pace. With major central banks committed to keeping their policies exceptionally accommodative to support activity, markets have tended to expect further accommodation when there is negative news. Figure 4: Gross capital flows to developing Figure 3: Global industrial production and trade growth countries, US$ billions % change, 3m/3m saar 80 25 70 20 60 15 50 10 5 40 0 30 -5 20 -10 10 -15 0 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jan-12 Jul-12 Jan-13 Ju13 Jan-14 Jul-14 Jan-15 Developing industrial production Developing country exports High income industrial production High income imports New equity issuance Syndicated bank lending Bond issuance Source: Datastream and World Bank prospects. Source: Dealogic and World Bank prospects. Figure 5: Quarterly GDP Growth, y-o-y, and q-o-q, sa plunging oil prices further depressed economic activity and consumer demand. As a result, 2014 6 was another lost year for the Russian economy: 5 real GDP edged up to just 6 percent above its 4 2008 level. Yet the 2014 adjustment to oil prices 3 that were about half of what they had been in 2013 seems to be playing out quite differently 2 1.1 1.2 0.4 (0.0) than the drop experienced in 2008, when a 1 1.5 0.8 0.1 0.4 0.0 similar oil-price cut immediately pushed the 0 0.9 0.6 0.1 economy into a deep recession (Box 3). So far, -1 0.3 0.3 0.4 0.0 Russia has not entered a recession, despite the Q2 1 Q3 1 Q4 1 Q1 1 Q2 2 Q3 2 Q4 2 Q1 2 Q2 3 Q3 3 Q4 3 Q1 3 Q2 4 Q3 4 Q4 4 4 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 economy’s structural weaknesses. This time, Q1 GDP growth, y-o-y GDP growth, q-o-q, sa Source: Rosstat. Russia Economic Report | Edition No. 33 3 I. Recent Economic Developments Box 2 Energy price trends During 2014, energy markets reached a historic turning point. After having fluctuated within a tight band around US$105 a barrel between 2011 and 2013—making it one of the least volatile three-year periods in recent history—in the second half of 2014 oil prices began to drop. They fell further on OPEC’s November decision to abandon targeting of prices. For 2014, crude oil prices ended 2014 at below US$60 per barrel, down from an average US$104 in 2013 (Figure 6). In recent years, the rapid expansion of unconventional oil production in North America was offset almost barrel for barrel by supply disruptions in the Middle East (Figure 6). These developments kept the global oil market fairly balanced and prices in the US$100-110 per barrel range. However, in the second half of 2014 some oil supply from the Middle East began returning to the market, while the U.S. continued its steady production of 1 million barrels per year. Previously in such situations Saudi Arabia—the producer with the highest spare capacity—would normally lead OPEC in production cuts to stabilize prices. However, OPEC decided to maintain its current quota, in effect ceasing to manage the global supply in order to protect its market share. This decision led to the largest supply-driven correction in prices since 1986. Figure 7: Growth in the crude oil supply, U.S. Figure 6: Global energy prices and elsewhere US$ per millions of British thermal units mb/d, changes since Q4-2010 25 4,000 3,000 Crude Oil 20 2,000 15 1,000 - 10 Natural Gas (US) (1,000) 5 (2,000) Coal (3,000) 2010-Q4 2011-Q4 2012-Q4 2013-Q4 2014-Q4 - Jan '00 Jan '02 Jan '04 Jan '06 Jan '08 Jan '10 Jan '12 Jan '14 Iran Libya Syria Yemen United States Net Changes Source: World Bank. Source: World Bank and International Energy Agency. Note: These are relative prices of different fuels in terms of energy units to ensure comparability. the impact of the shocks seems to have been Low domestic demand and the higher borrowing less severe and more gradual: external demand costs caused by financial sanctions further limited did not drop as much and the adjustment was investment. Consumption was again the main more gradual because imports in the first half growth engine but expansion of both household of 2014 had already been lowered as a result and public consumption slowed. Depreciation of restrained growth and a weaker ruble, of the ruble, high household indebtedness, which helped the domestic manufacturing and accelerating inflation eroded incomes and sector. Limited fiscal space will restrain the put the brakes on household consumption. government’s response this time. Unexpectedly high inflation also discouraged public consumption. As a result, the contribution In 2014 investment remained depressed for of aggregate consumption to GDP dropped to the second year in a row and the contribution 1.1 percent in 2014 after reaching 2.7 percent in of consumption to growth was less than half 2013 and 4.3 percent in 2012 (Table 1). what it had been in 2013. Since there were no major public investment projects, fixed A brisk contraction in imports more than investment contracted by 2.5 percent because compensated for weakened external demand, private businesses were reluctant to expand. heightening the contribution to growth of net In fact, heightened uncertainty about policies exports. External demand slackened in 2014 and persistent structural problems meant that because expansion of the global economy business sentiment continued to deteriorate. was below trend. Demand for Russian exports 4 Russia Economic Report | Edition No. 33 I. Recent Economic Developments Table 1: Contribution to growth by demand components, percentage points 2007 2008 2009 2010 2011 2012 2013 2014 GDP growth, percent 8.5 5.2 -7.8 4.5 4.3 3.4 1.3 0.6 Consumption 7.4 5.7 -2.6 2.6 3.7 4.3 2.7 1.1 Households 6.9 5.1 -2.5 3.0 3.5 3.8 2.5 1.0 Government 0.5 0.6 -0.1 -0.3 0.3 0.5 0.2 0.1 Gross capital formation 4.7 2.5 -10.5 5.4 4.7 0.7 -1.6 -1.3 Fixed capital investment 3.9 2.2 -3.2 1.3 2.0 1.4 0.3 -0.5 Change in stocks 0.8 0.3 -7.2 4.1 2.8 -0.7 -1.9 -0.8 Exports 2.1 0.2 -1.5 2.0 0.1 0.3 1.4 -0.6 Imports -5.5 -3.2 6.7 -5.3 -4.3 -1.9 -0.8 1.5 Source: Rosstat and World Bank staff calculations. Box 2 How does this adjustment compare to the crisis in 2008-2009? In 2008 the economy fell into a deep recession in the fourth quarter while in 2014 the economy suffered a gradual slowdown. In 2008, the oil price dropped from US$90 per barrel in September to US$35 in December. Similarly, in 2014 they dropped from US$115 per barrel in July to US$57 in December. In addition to the ebb in global trade flows, in 2008–2009 financial flows also ceased, which severely restricted access to external financing. In 2014 economic sanctions targeting the financial sector restricted access to external capital markets or made external borrowing essentially unaffordable. In both cases domestic demand, specifically consumption, sank swiftly. Though the external shocks that hit the Russian economy in 2008-2009 and 2014 were similar, their impact differed. By the end of 2008, oil and non-oil exports had suffered much more than they did in 2014. Imports adjusted in both cases, but they did so earlier in 2014, even before the terms-of-trade shock, starting in quarter one due to low growth and a weakening ruble (Figure 8). In 2014, Russia’s ban of food imports in August helped to counterbalance the export drop and prevented a widening trade deficit. In 2008-2009, imports started to adjust in quarter four with the external shock. Russia’s recovery after 2008-2009 was swift, but its growth path in 2015-2016 is expected to be a protracted recession. In 2010, led by a fast revival in external demand based on an upward adjustment in oil prices, accompanied by a quick restoration in access to external capital markets and a sizable counter cyclical fiscal program (implemented in the second half of 2009), the economy exited recession. Fiscal savings over the preceding decade that accumulated in the Reserve Fund allowed the government to finance the fiscal deficit of 6.8 percent of GDP without a significant deterioration in its debt-to-GDP ratio. In 2015, Russia’s external environment is expected to remain somewhat hostile, given low oil prices and export demand. As sanctions stay in place, access to external borrowing will remain restricted. Most importantly, the government’s fiscal space for countercyclical measures is more limited because the Reserve Fund is half the size it was in 2008-2009. Even though proposed amendments to the 2015 federal budget imply some consolidation of expenditures, the expected fiscal gap of 3.8 percent of GDP could severely deplete the Reserve Fund (currently equal to 4.7 percent of GDP). The anti-crisis plan for 2015 (Box 7) amounts to less than 2 percent of GDP and most funds are earmarked for recapitalization of banks. Figure 8: GDP reactions to external shocks, 2008 and 2014 a. 2008-2009 b. 2014 17 5 12 4 7 3 2 2 1 -3 0 -8 -1 -13 -2 -18 -3 -23 -4 Q1 08 Q2 08 Q3 08 Q4 08 Q1 09 Q2 09 Q3 09 Q4 09 Q1-13 Q2-13 Q3-13 Q4-13 Q1-14 Q2-14 Q3-14 Consumption Gross Fixed Capital Formation Import GDP growth Consumption Gross Fixed Capital Formation Import GDP growth Change in stock Export Discrepancy Change in stock Export Discrepancy Source:RosstatSource:Rosstat Russia Economic Report | Edition No. 33 5 I. Recent Economic Developments deteriorated dramatically: the contribution of with spare capacity (Figure 9). Some industries exports to GDP growth turned negative, to–0.6 also benefited from a surge in military-related percent, after making a positive contribution of production. While there might be some natural 1.4 percent in 2013. Yet even though external substitution as resources are shifted from demand was disappearing, the contribution of nontradable to tradable sectors, persistent net exports to GDP went up from 0.6 percent in structural rigidities and high uncertainty in 2015 2013 to 0.9 percent. The improvement occurred are expected to limit such a shift of resources because imports also contracted acutely; the and capacity expansion. In 2014, as activity in ruble had begun to depreciate at the onset of nontradable sectors slowed, the tradable sector the geopolitical tensions in the first half of 2014 became the main growth engine. The aggregate and the depreciation accelerated in the second contribution of the tradable sector to growth half. This depressed domestic demand, and the in 2014 increased to 0.4 percentage points problem was compounded by Russia’s ban on despite the depressed demand (Figure 10). As the import of food items on August 7, 2014. consumption slowed further in 2014, demand for nontradable services fell, and their aggregate The weaker ruble and trade restrictions contribution to growth sank to 0.3 percent, from supported economic activities in the tradable 1.0 percent in 2013 and 2.9 percent in 2012. sector, mainly in a few manufacturing industries Figure 9: Growth in tradables, y-o-y, percent Figure 10: Contribution to GDP by sector, percent of GDP 20 5.0 0.2 15 2.2 0.1 3.0 5.0 2.8 2.9 0.3 10 1.3 1.8 1.0 1.0 0.4 0.3 0.0 0.0 0.2 0.5 0.0 0.1 5 -1.0 -2.7 0 -3.0 -3.6 -5 -0.4 -5.0 -10 -7.0 -15 2008 2009 2010 2011 2012 2013 2014 2008 2009 2010 2011 2012 2013 2014 Agriculture Mineral Extraction Manufacturing Tradable Non-Tradable Public Sector Source: Rosstat. Source: Rosstat. 1.2 Labor Market – Adjustment of Wages and Incomes Despite a continuing slowdown in the real sector, the labor market stayed tight, with unemployment barely moving from its historically low levels as the demographics of aging continue to pressure the labor supply. However, in the second half of 2014, as inflation accelerated real wages contracted abruptly; if that continues, it will mean the labor market is adjusting to lower demand. L abor demand did not change much in the second half of 2014: The seasonally adjusted vacancy rate (ratio of vacancies to total jobs) 2.9, from 3.0 in the second quarter. There was no corresponding growth in unemployment (Figure 11). Total employment was high throughout decreased only slightly, in the fourth quarter, to 2014, though the seasonally adjusted indicator 6 Russia Economic Report | Edition No. 33 I. Recent Economic Developments Figure 12: Employment and economic activity, Figure 11: Beveridge curve million workers 77 76 3.10 3Q 13 4Q 13 2Q 14 75 3.05 2Q 13 1Q 14 74 3.00 1Q 13 4Q 12 73 3.2 2.95 2.90 72 [CELLR Vacancy rate, % 2.85 EF] 71 2Q 12 2.7 5.1 5.2 5.3 5.4 5.5 5.6 4Q 11 70 69 2.2 4Q 104Q 09 68 67 1.7 2010 2011 2012 2013 2014 2015 5.0 6.0 7.0 8.0 9.0 Employment Activity Unemployment rate, % Activity, SA Employment, SA Source: Rosstat and World Bank staff estimates. Source: Rosstat and World Bank staff estimates. dropped slightly at mid-year and ended the year at working for individual entrepreneurs, migrant 71.7 million, compared to 71.2 million at the end workers, and other forms of employment that of 2013 (Figure 12). More women (5.2 percent) official statistics do not capture well), and the than men (4.8 percent) were unemployed in the accompanying switch from formal wages to second half of 2014, but that was slightly below shadow forms of remuneration. In times of crisis, the 6.0 percent in the second half of 2013. In this factor is likely to have more effect. Because the second half of 2014 urban unemployment labor market rigidities are reflected in the limited was just 4.2 percent, compared to 7.6 percent in geographic mobility of labor, unemployment rural areas. With the Russian population aging, continues to vary widely by region: There are the slow decline in the working-age population more unemployed in the poorest regions—the that began in 2008 continues to put pressure Northern Caucasus Federal District of Ingushetia on labor supply and partly explains the very low (23.6 percent), Chechnya (19.7 percent) and the unemployment rates. However, for the second Tuva Republic (16.7 percent)—while in the large half of 2014, with both demand for and supply metropolitan areas almost everyone in the labor of labor easing slightly, it is difficult to explain market is employed; unemployment in Moscow the further decrease in the seasonally adjusted city is 1.4 percent, St. Petersburg 1.3 percent, unemployment rate, from 5.3 percent in 2013 to and the Moscow region 2.7 percent. 5.1 percent. Real disposable income contracted in 2014 for Despite the slowing economy, employment and the first time since 1999. For the year as a whole activity levels remained near their maximum the decline was 1 percent, but in the fourth quarter historical levels, and unemployment was the drop was 3.5 percent. Income dynamics were at a record low. A combination of factors volatile throughout the year, but the negative may explain this phenomenon: Traditionally outcome was driven by a contraction in both Russia’s labor market adjusts to lower demand of the main income components, pensions and primarily through wage contraction rather wages. Real wages and pensions both decelerated than an immediate increase in unemployment gradually during the year until the sudden (Box 4). Also contributing is the trend toward contraction in December. Up to September, the more informal employment (self-employment, wage deceleration was uniform across sectors Russia Economic Report | Edition No. 33 7 I. Recent Economic Developments Box 4 How the labor market adjusted in previous crises Keeping unemployment stable by adjusting wages is a feature of Russia’s labor market. A traditional high share of public employment performs the functions social security nets play elsewhere. For this reason social protection programs are not well-developed in Russia. In the transition period of the early 1990s, when GDP declined by about 40 percent, the labor markets of Russia and other former Soviet Union republics saw a relatively low increase in unemployment (up to 15 percent) and a much higher contraction of real wages (more than 50 percent). Similarly, in 2009, although unemployment went up by 3 percentage points, wage growth contracted by 5 percent after growing 15 percent year-on-year before the crisis (Figure 13 and Figure 14). The labor market reacted similarly this time: Real wages contracted by 4 percent year-on- year in December and averaged 9 percent in January and February 2015. Continued wage adjustment is likely to contain unemployment. More labor market arrangements are informal during crisis periods because: (i) relatively low unemployment benefits induce people to find new jobs quickly, which, given the softer labor market, are more likely to be informal; and (ii) high variation in salaries leaves room for employers to adjust wages in different ways. Among them are an increase in informal earnings (“envelope salaries”), which allows employers to lower social insurance and other contributions. Usually, this tends more to characterize small enterprises and the self-employed, but during crises even medium and large enterprises switch in part to informal salary payments. Finally, the widespread use of migrants in some sectors of the economy, especially services and construction, is more easily adjusted during crises and the statistics on this are not fully captured. Figure 13: Unemployment dynamics, 2008 and 2014 Figure 14: Real wage growth, 2008 and 2014 9 20 8.5 15 8 10 7.5 7 5 6.5 0 6 5.5 -5 5 -10 t+12 t+16 t+20 t+24 t+28 t+32 t+36 t+40 t+44 t-24 t-20 t-16 t-12 t+4 t+8 t-8 t-4 t 4.5 t+45 t+12 t+15 t+18 t+21 t+24 t+27 t+30 t+33 t+36 t+39 t+42 t+3 t+6 t+9 t-24 t-21 t-18 t-15 t-12 t-9 t-6 t-3 t Real wage growth, y-o-y (t=Jan -2008) Real wage growth, y-o-y (t=Jan -2014) Unemployment rate (t=Jan-2008) Unemployment rate (t=Jan-2014) Source: Rosstat and World Bank staff estimates. Source: Rosstat and World Bank staff estimates. (Figure 15). According to preliminary data the factors, such as wages in small and informal November-December contraction was mainly enterprises and currency operations (Figure 16). driven by public wages and wages in the tradable Meanwhile household disposable income came sector. Wages in nontradable sectors were more under pressure from higher borrowing costs and resistant, though in December they declined as limited opportunities for rolling over short-term well. In 2014, second and third quarter income consumer debt, which made debt servicing and growth was significantly impacted by other debt repayment more expensive. 8 Russia Economic Report | Edition No. 33 I. Recent Economic Developments Figure 15: Real wage growth by sector, Figure 16: Contribution to real income growth, y-o-y, percentage entire population, y-o-y, percent 15 12 10 10 8 6 5 4 2 0 0 -2 -5 -4 -6 -10 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 2009 2010 2011 2012 2013 2014 2009 2010 2011 2012 2013 2014 Nonmarket Nontradables Others Business and property Total Tradables Total Public wages and transfers Market wages Source: Rosstat and World Bank staff estimates. Source: Rosstat and World Bank staff estimates. Note: Data for Q4 2014 are preliminary. 1.3 Monetary Policy and the Financial Sector - Navigating a Currency Adjustment The steep drop in oil prices and the sanctions led to massive devaluation of the ruble. This required a shift in exchange rate policy and coordinated measures to stabilize the financial system. Significant monetary tightening failed to anchor the inflation expectations that were generated by the weakening ruble and Russia’s ban on food imports. T he Russian currency was extremely volatile in 2014, and massive depreciation in the second half of the year motivated the Central Figure 17: Oil prices and the ruble exchange rate, 2014 (right hand axis in reverse order) 120 30 Bank of Russia (CBR) to advance its switch 110 35 to a free-float exchange rate system. In 2014 100 40 the ruble lost 46 percent of its value against 90 45 the U.S. dollar (in 2008 the loss had only been 80 50 17.7 percent). During the second half of 20141 70 55 exchange rate dynamics reflected the abrupt 60 60 downward adjustment in oil prices, but the 50 65 sanctions and speculations about CBR plans for a 40 70 shift in exchange rate policy also had a significant 14 4 31-De 4 ec 4 4 t-1 17 v-1 -D c-1 -1 p- impact (Figure 17). The second half of 2014 saw Oc o Se -N 1- 2- 27 three discrete periods of ruble exchange rate Oil price Rub/USD (right hand axis) dynamics. In the first, from July to October 2014, Source: Haver database; the Central Bank of Russia. the exchange rate mainly tracked the gradual oil price decline of 14.7 percent, showing a loss in to November 10, 2014, pressure on the ruble the ruble’s value against the dollar of 14 percent. intensified as oil prices slid dramatically and Pressure on the ruble and exchange rate volatility foreign exchange liquidity limitations surfaced as were still moderate and the CBR had to intervene a result of the sanctions. During that period the only marginally.2 However, from early in October CBR introduced several emergency measures3 to 1 See RER 32 for the evolution of the exchange rate in the first half of 2014. 2 In response to rising inflation pressures,on July 29 the CBR increased policy rates by 50 basis points, to 8 percent. 3 To increase foreign exchange (forex) liquidity the CBR on October 29 introduced 7- and 28-day repo facilities in foreign currency. The day before it had hiked policy rates by another 150 basis points, to 9.5 percent, in response to of rising depreciation pressures and accelerating inflation. Russia Economic Report | Edition No. 33 9 I. Recent Economic Developments guarantee foreign exchange liquidity; in October In December, the Consumer Price Index (CPI) alone it spent US$30 billion to support the reached 11.4 percent (Figure 18). Despite all currency. However, on November 10 the central the CBR’s efforts to tighten, inflation had nearly bank switched to the free float to try to end the doubled from the 6.5 percent at the end of 2013, drain on reserves.4 soaring past the initial CBR target of 5.0 percent by 6.4 percentage points to 11.4 percent. Russia The currency crisis at the end of 2014 prompted had not seen double-digit inflation since 2008. the CBR and the government to put in place In the first half of 2014 inflation was already coordinated measures to ensure financial higher than expected because of the weakness stability. After November 27, when OPEC of the ruble induced by the geopolitical tensions. decided not to cut oil production, the ruble went In the second half, the situation worsened: Core into free fall, which required the CBR to resume inflation, which had been 7.5 percent in June, its interventions; it spent another US$10.3 year-on-year, hit 11.2 percent in December. billion in the first half of December. Massive Russia’s ban on major food imports in early capital outflows, hoarding of foreign exchange August was another non-monetary factor that proceeds by exporters because access to external continued to push up food inflation, and thus the finances was restricted for sanctioned banks and CPI,in the second half of 2014.5 Food inflation corporations, and dollarization of the savings of shot up from 9.2 percent in June to 15.4 percent Russians had added to pressure on the ruble. in December, year-on-year, especially for meats In response to the unprecedented volatility, on (20.1 percent), milk products (14.4), and fresh December 16 the CBR hiked its policy rate by fruit and vegetables (22.0 percent). In January 650 basis points. The initial response was deeply 2015, inflation gained another 3 percent, negative: the very next day the exchange rate hitting 15.0 percent, year-on-year, again driven plummeted by 11 percent, prompting the CBR by high food inflation (20.7 percent) and the and the government to work urgently to keep the pass-through effect of the ruble devaluations financial system stable (Box 5). These measures, in December and January. The result was core together with the massive rate hike, helped inflation of 14.7 percent, year-on-year—a level to stabilize the exchange rate, but because of not seen since 2002. concerns about the continued bleak outlook for oil prices, a looming recession, and waning chances that sanctions would be removed, the pressure on the ruble did not abate. Box 5 December 2014: Policy moves to enhance financial stability The ruble collapse in December prompted the Russian authorities to implement coordinated measures to stabilize the exchange rate and ensure financial stability. In addition to the new foreign exchange repo facilities introduced in November, the following measures were introduced: • The Ministry of Finance sold foreign exchange in the amount of US$1.5 billion. • The CBR introduced 28- and 365-day foreign currency loans to the 11 banks with capital of over RUB100 billion. • Five major state-owned exporters were given a deadline of March 1, 2015, to cut their net foreign assets back to the level of October 1, 2014. • On December 30, a RUB1 trillion bank recapitalization program was launched by issuing Treasury bonds. • The State Duma approved a bill allowing the government to invest up to 10 percent of the National Wealth Fund in subordinate deposits and subordinate bonds of Russian banks. 4 The CBR spent US$86.5 billion of foreign currency reserves in 2014, leaving it with a balance of US$390 billion (10.7 months of imports) at year end. 5 Imports of both food and non-food items constitute about 15-20 percent of Russia’s consumer basket items. Yet some imports (e.g., meats, fruit, and vegetables) account for a significantly higher share in total consumptions. Thus how the ban affected inflation differed for food items. 10 Russia Economic Report | Edition No. 33 I. Recent Economic Developments Figure 18: CPI inflation by component, y-o-y Figure 19: CBR policy rate hikes 18 18 16 16 14 14 12 12 10 10 8 8 6 4 6 2 4 0 3 4 4 4 -D 4 -F -14 16 -15 5 -1 -1 -1 -1 12 ov-1 -1 2011 2012 2013 2014 2015 ep eb pr l 02 ec eb ar -Ju -M -A N -S -F 22 5- 22 13 25 Food Non-Food Services CPI Source: CBR. Source: Rosstat. To anchor inflation expectations the CBR Russia’s larger banks to low-cost medium-term continued to tighten throughout 2014, hiking financing have put considerable stress on the the policy rate to 17 percent in six steps, for a banking system. Several banks with non-ruble total of 1,150 basis points (Figure 19). As a result, debt to external creditors now have higher debt growth in money supply (M2) slowed from 15.2 servicing costs and thus lower net cash flows and percent in 2013 to 8.5 percent in 2014, and for profits. Meanwhile, the currency depreciation the first time since 2009 monetization of the and the ensuing tighter monetary policy have economy (M2/GDP) decreased. Since the inflation caused a severe increase in bank funding costs. pressures and expectations were largely inflicted As a result, growth of credit has declined and by nonmonetary factors, tighter monetary policy interest rates are higher—for example, interest was only partially effective. On January 30, 2015, rates on 1–3-year loans to small and medium the CBR cut its key policy rates by 200 basis enterprises are averaging more than 14 percent, points, back to 15 percent, citing as reasons and interbank loans to maintain banking system stabilization of devaluation and inflationary liquidity have been averaging 11-12 percent. expectations. Unfortunately, the market reaction was so negative that the CBR once again had to It is likely that the current health of the financial intervene with US$700 million to stabilize the sector is overstated, given the regulatory ruble. In February, the 12-month CPI surged to forbearance the CBR has been exercising to over 16 percent, largely driven by food inflation, carry banks through this volatile period. As which soared to over 20 percent. However, a of 2014, banking system return on assets was slowing of monthly inflation in February suggests 1.5 percent, return on equity was 12.1, and some moderation of inflationary pressure, likely nonperforming loans (NPLs), taking into account as a result of the tapering-off pass-through regulatory forbearance, were under 7 percent. effect of the ruble devaluation and constraints The capital adequacy ratio for the system was on consumer demand. On March 13 the CBR 11.9 percent. The CBR has allowed banks some lowered its policy rates by another 100 basis flexibility in classifying overdue loans and in their points, citing downside risks to growth as the provisioning during this crisis. This means in reason for its decision. effect that NPLs are much higher than reported and banks would have larger capital shortfalls if The tighter monetary policy brought on by the they were to classify and provision their credit weakness of the ruble and the international portfolios accurately. The CBR has allowed sanctions that limit the access of many of forbearance by not requiring banks to mark all Russia Economic Report | Edition No. 33 11 I. Recent Economic Developments their assets to market value (letting them use through the budget and the National Welfare original book value) so that they can avoid having Fund (see the fiscal section, Box 7). For example, to recapitalize their balance sheets immediately. in December 2014, the CBR gave the medium- The policy is based on expectations that the sized Trust bank the equivalent of US$1.9 losses in value will be temporary. billion to help it avoid insolvency. An additional US$538 million was given to FC Otkrytie, which To assure financial stability, the CBR and the had acquired Trust. Though these and other government have injected liquidity and capital measures are giving banks some relief, they into the banking system (Box 5), though these may also be heightening systemic risks because injections have gone only to specific banks, not the they mean that bank liabilities are increasing in entire system. In early January, the government relation to their liquid assets or the real earning unveiled an anti-crisis program that incorporates potential of those assets (see Section 2.2). measures to support bank recapitalization 1.4 Balance of Payments Deteriorates as Capital Flees As imports tumbled, the current account surplus doubled from 1.6 percent of GDP in 2013 to 3.0 percent, but this could not outbalance massive net capital outflows. These reached US$130.5 billion (7 percent of GDP)—close to the net capital outflows of 8 percent of GDP in the crisis of 1998. In the fourth quarter of 2014, Russia’s balance of payments (BoP) suffered a severe terms-of- trade shock due to falling oil prices, which was first three quarters, the trade balance remained positive (Figure 21). Import demand slackened as the economy grew more slowly and the ruble accommodated by a significant drop in imports. depreciated. The restrictions Russia imposed in The current account (CA) strengthened from August on the import of food products from a US$34.1 billion in 2013 to US$56.7 billion in 2014 number of Western countries likely contributed (Figure 20), with the non-oil CA deficit narrowing to a decrease in imported goods of US$15.3 to US$265.5 billion (equivalent to 14.2 percent billion, year-on-year. Imports of services also fell, of GDP) compared to a deficit of US$316.1 billion mainly because transport services declined. In (15.2 percent of GDP) in 2013 (Table 1.2). The the fourth quarter, falling oil prices produced a CA surplus nearly doubled back to 2012 levels terms-of-trade shock but it was mostly absorbed for the following reasons: despite a reduction by a drop in imports. In the fourth quarter of of US$2.2 billion in the value of exports in the 2014, oil and gas export proceeds dropped by Figure 20: Current account balance, percent of GDP Figure 21: Trade and services balances and oil prices 12 140 60 50 120 5 40 100 30 20 80 10 2 0 60 -10 9 40 -20 2008 2009 2010 2011 2012 2013 2014 Q1-08 Q1-09 Q1-10 Q1-11 Q1-12 Q1-13 Q1-14 Q4-14 Crude oil, Brent, $/b (left axis) Trade balance, bln USD (right axis) Goods Services Investment income Services balance, bln USD (right axis) Compensation of employees Transfers Current account balance Source: CBR and World Bank staff estimates. Source: CBR, Bloomberg and World Bank staff estimates. 12 Russia Economic Report | Edition No. 33 I. Recent Economic Developments US$25.1 billion (27.3 percent, year-on-year) The real crisis for the BoP in 2014 was the while imports dropped by US$24.3 billion (19.3 massive capital outflow caused mainly by percent, year-on-year). the geopolitical uncertainties and related sanctions. Russia’s capital and financial accounts A second factor that helped to increase the CA balance quadrupled to a deficit of US$146.6 balance was the increase in the investment billion (7.8 percent of GDP) in 2014, compared income balance, especially in the second half of to a deficit of US$45.4 billion (2.2 percent of 2014, when external liabilities decreased due to GDP) in 2013. High geopolitical uncertainty and the lack of opportunities for Russian banks and the second-round effect of the drop in oil prices companies to roll over debt, given their restricted led net capital outflows from the private sector access to international markets. However, the to more than double, from US$60.7 billion in steep ruble depreciation in 2014, which pushed 2013 to US$130.5 billion (adjusted for currency the real effective exchange rate (REER) down swaps and correspondent accounts of resident by 8.1 percent, did not help to promote non- banks in the CBR; Table 3).6 For all of 2014, net oil exports, which dropped by 1.5 percent in purchases of foreign currency constituted 26.1 nominal terms. The CA was also supported by the percent of net capital outflows and amounted improved balance of employee compensation as to US$33.9 billion.7 Massive capital outflows the depreciation caused outward remittances to created pressure on the ruble and led to plunge at the end of 2014 (Box 6). CBR interventions of US$86.5 billion in 2014, compared to US$21.8 billion in 2013 and to Box 6 Migration and remittance trends Russia is the second largest host of immigrants worldwide. In 2013, nearly half of the 11 million immigrants in Russia came from Ukraine (2.9 million) and Kazakhstan (2.5 million). Other major countries of origin were Azerbaijan (0.7 million), Belarus (0.7 million), the Kyrgyz Republic (0.6 million), Armenia (0.5 million), Tajikistan (0.5 million), and Georgia (0.4 million) (Figure 22). Of the 10.8 million Russians living abroad, most were in Ukraine (3.5 million) and Kazakhstan (2.4 million), followed by Germany (1 million), Belarus (0.7 million), Uzbekistan (0.6 million), and the U.S.(0.4 million) (Figure 23). After the U.S. (46 million), Russia hosts the second largest number of migrants worldwide (11 million), followed by Germany (10 million) and Saudi Arabia (9 million). However, this number fell from 11.9 million in 2000 to 11.0 million in 2013; the number of Russians living abroad held steady at about 10.8 million. Figure 22: Top 10 countries sending workers to Figure 23: Top 10 countries to which Russians Russia, 2013 migrate, 2013 7% 14% 2% 2% 32% 4% 2% 27% Ukraine Ukraine 4% 2% Kazakhstan Kazakhstan Germany Uzbekistan 2% 5% Azerbaijan Belarus Belarus Uzbekistan 4% United States Kyrgyz Republic 5% Tajikistan Armenia Moldova Tajikistan Azerbaijan Georgia 5% Estonia Moldova Others 7% Others 6% 7% 22% 9% 22% 10% Source: UN population division. Source: UN population division. 6 Net capital outflows had several components: private firms and banks increasing their net asset positions abroad, net purchases of foreign currency by private companies and households, and FDI. In addition, the restricted access to capital markets resulted in firms and banks deleveraging their external debt, paying it rather than rolling it over. FDI flows are a small part of capital outflows and include in part repatriated offshore money from Russian firms. 7 In 2013 there had been US$0.3 billion in net sales of foreign currency. Russia Economic Report | Edition No. 33 13 I. Recent Economic Developments Outward remittances in 2014 were impacted by the ruble depreciation. Of a total of US$20.2 billion remittances from Russia, more than 88 percent went to: Uzbekistan (US$5.6 billion), Tajikistan (US$3.7 billion), Ukraine (US$2.2 billion), Kyrgyzstan (US$1.9 billion), and Armenia (US$1.2 billion) (Figure 24). Remittances to these countries have been going up steadily since 2009 and most noticeably in 2009-13. However, in 2014, the currency depreciation meant that the value of remittances to these countries was 14 percent less than in 2013. The cost for sending remittances from Russia (2.4 percent) is the lowest among all G20 countries—only a third of the G20 average (8.1 percent).1 Remittance inflows into Russia (US$4.2 billion) are about a fifth of outflows. Some 43 percent of all remittance inflows come from three countries: Uzbekistan, Kazakhstan, and Tajikistan (US$0.6 billion each) (Figure 25). Inflows to Russia have been growing in recent years. Figure 24: Remittance outflows, 2014 Figure 25: Remittance inflows, 2014 6% 15% 4% 21% 6% 27% Uzbekistan Uzbekistan Kazakhstan 6% Tajikistan Tajikistan Ukraine 3% Kyrgyzstan Kyrgyzstan 14% Ukraine Armenia Armenia 7% Moldova 4% Azerbaijan Azerbaijan China Moldova Other Countries Other Countries 5% 9% 18% 8% 14% 11% 9% Source: Central Bank of Russia. Source: Central Bank of Russia. 1 Cost of sending US$200 / local currency equivalent. the US$155.3 billion of international reserves quarter. Early in January 2015, Fitch downgraded spent during the 2008-2009 crisis. At the end Russia’s sovereign debt rating to one notch above of 2014, the ratio of international reserves to noninvestment; later in January and February, months of imports remained at a comfortable S&P and Moody’s both downgraded Russia’s 10.7 months. However, if the National Welfare sovereign rating to below investment grade. The Fund and Reserve Fund are subtracted, this increased risk is reflected in Russia’s CDS spreads ratio falls to 6.1 months of imports. on 5-year bonds, which reached close to 600 basis points in February 2015, compared to 160 External borrowing had virtually vanished basis points a year previously (Figure 26). by the end of 2014 as the cost of borrowing skyrocketed due to sinking oil prices and Figure 26: Russia CDS spreads for 5-year bonds, basis points sanctions restricting access to international 640 financial markets. Sanctions that targeted big state companies and banks, introduced in July, 540 together with heightened geopolitical risk, limited external borrowing for Russians in the 440 third quarter of 2014. As of October 1, 2014 external debt8 was down to US$524.7 billion, 340 from US$539.9 billion on July 1, 2014 (Table 4). In the fourth quarter, as oil prices continued 240 to slip, for all Russian firms and banks the cost of external borrowing soared to a prohibitive 140 level, in essence closing most external financing 1-Jan-14 1-Jul-14 20-Mar-15 options. The rollover ratio fell from 100 percent Source: Bloomberg. in the first half of 2014 to 62 percent in the third 8 Debt to nonresidents in foreign currency. 14 Russia Economic Report | Edition No. 33 15 Table 2: Balance of payments, 2008-2014, US$ billions Russia Economic Report | Edition No. 33 2008 2009 2010 2011 2012 2013 2014 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Current account balance 103.9 50.4 67.5 97.3 71.3 34.1 56.7 26.8 12.9 6.4 10.5 Trade balance 177.6 113.2 147.0 196.9 191.7 181.9 185.6 50.9 51.9 45.4 37.5 Non-oil current account balance -206.2 -140.3 -186.6 -244.5 -275.5 -316.1 -265.5 -57.3 -76.3 -75.6 -56.3 Capital and financial account -139.8 -40.6 -21.6 -76.0 -30.9 -45.4 -146.6 -64.0 -16.5 -7.8 -58.2 Errors and omissions -3.1 -6.4 -9.1 -8.7 -10.4 -10.8 3.4 -3.3 6.8 3.0 -3.1 Change in reserves (- = increase) 38.9 -3.4 -36.8 -12.6 -30.0 22.1 86.5 40.5 -3.2 -1.6 50.8 Memo: average oil price (Brent, US$/barrel) 96.9 61.5 79.7 111.1 112.0 108.9 98.8 107.9 109.8 102.1 76.0 Source: CBR.Note: *Preliminary estimates. Table 3: Net capital flows, 2008-2014, US$ billions 2008 2009 2010 2011 2012 2013 2014 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Total net capital inflows to the private sector -133.6 -57.5 -30.8 -81.4 -53.9 -61.0 -130.5 -61.7 -8.9 -0.4 -59.5 Net capital inflows to the banking sector -55.2 -32.2 15.9 -23.9 18.5 -7.5 -28.8 -34.3 -2.2 25.0 -17.3 Net capital inflows to the non-banking sector -78.3 -25.3 -46.7 -57.4 -72.4 -53.5 -101.7 -27.4 -6.7 -25.4 -42.2 Source: CBR. Note: *Preliminary estimates. Table 4: Russia’s external debt, 2011-2014, US$ billions Mar- Mar- Mar- Dec-11 Jun-12 Sep-12 Dec-12 Jun-13 Sep-13 Dec-13 Jun-14 Sep-14 Dec-14 12 13 14 Total debt 538.9 557.5 570.6 598.9 636.4 691.7 707.8 716.3 728.9 715.8 732.4 679.4 599.5 I. Recent Economic Developments Corporate 492.6 509.1 517.1 538.8 566.4 614.6 632.9 636.0 651.2 646.9 650.2 614.5 547.6 Banks 162.8 169.2 175.4 189.9 201.6 205.9 211.9 207.1 214.4 211.9 208.8 192.1 171.1 of which Private Banks 89.5 90.6 78.7 84.1 86.2 81.1 82.4 79.4 81.4 76.3 74.9 68.9 Non-financial corporations 329.8 339.8 341.7 348.9 364.8 408.8 420.9 428.9 436.8 432.8 450.6 422.4 376.5 of which Private Non-fin. Corporations 227.8 236.0 234.2 237.7 251.3 255.5 259.5 265.3 271.6 263.9 279.7 259.3 Source: CBR. Note: End-of-month data. I. Recent Economic Developments 1.5 The Government Budget - The Calm before the Storm? The federal fiscal balance continued to register a deficit of 0.5 percent, but the non-oil deficit went up to 11 percent of GDP. Compared to 2013, subnational debt rose by 0.8 percent of GDP, to 3.4 percent. Many of Russia’s fiscal buffers are committed to supporting investment demand and ensuring financial stability. T he Ministry of Finance estimates that the 2014 federal budget was executed at a deficit of 0.5 percent of GDP, the same as in as imports fell steeply. The federal non-oil deficit reached 11.0 percent of GDP, up by 0.6 percent of GDP since 2013. 2013. The June 2014 budget revision projected a slight surplus, but that turned to a deficit The consolidated budget deficit was 1.2 with the issuance of Treasury bonds in the percent of GDP in 2014, compared to a 1.3 amount of RUB1 trillion (1.4 percent of GDP) on percent deficit in 2013. The budget saw a large December 30, 2014, to recapitalize the Russian drop in the revenues and spending of federal banking system (Table 5). As a result of the bond extra-budgetary funds (EBFs).For the first time, issue and transfer of the bonds to the Deposit consolidated federal EBFs were executed at Insurance Agency, spending in the budget a small deficit (less than 0.1 percent of GDP), category of support to the national economy driven by a decrease in federal transfers by 1.0 went up by 1.5 percent of GDP. Together with percent of GDP compared to 2013 (Table 6). spending on defense that was higher by 0.2 Simultaneously there were significant cuts in percent of GDP and higher federal transfers Pension Fund spending on social benefits (by of 0.1 percent of GDP, federal spending rose RUB370 billion) and other social policy items by 0.7 percent to 20.9 percent of GDP. Federal (by RUB420 billion). Year-on-year, however, budget spending year-on-year went down by consolidated budget revenue and spending 1.0 percent of GDP for social policy and 0.1 did not change much. That was also true of percent each for education, health, and housing subnational budgets. However, subnational debt and utilities. Government revenue rose to 20.4 rose from 2.6 percent of GDP in 2013 to 3.4 percent of GDP from 19.7 percent in 2013 as oil percent because of the higher borrowing costs revenues grew from 9.9 percent of GDP to 10.5 seen across the economy that are making debt percent of GDP due to the ruble depreciation. rollover more expensive. The heavy dependence Federal non-oil revenue saw a moderate increase of federal EBFs, especially the Pension Fund, on of 0.1 percent of GDP from 2013 to 9.9 percent federal transfers and the rising indebtedness of in 2014 due to higher VAT proceeds. However, subnational entities are becoming worrisome import tariffs fell by 3 percent in nominal terms fiscal risks. Table 5: Federal budget 2012-2014, percent of GDP 2012 2013 2014 2014 2014 Execution Execution Budget Law 2014 June Execution Amendment Expenditures 20.6 20.2 19.0 19.5 20.9 Revenues 20.5 19.7 18.5 19.9 20.4 Balance -0.1 -0.5 -0.5 0.4 -0.5 Oil revenues 10.3 9.9 8.9 10.5 10.5 Non-oil balance -10.4 -10.4 -9.4 -10.1 -11.0 Urals oil price, US$/barrel 110.4 107.9 101.0 97.0 97.6 Source: Ministry of Finance, Economic Expert Group, and World Bank staff calculations. 16 Russia Economic Report | Edition No. 33 I. Recent Economic Developments Table 6: Consolidated budget, consolidated subnational budget, consolidated federal EBFs, 2011-2014, percent of GDP 2011 2012 2013 2014 Execution Execution Execution Execution Consolidated Budget Expenditures 35.9 36.6 38.2 38.3 Revenues 37.5 37.0 36.9 37.2 Balance 1.6 0.4 -1.3 -1.2 Consolidated Subnational Budget Expenditures 13.8 13.3 13.3 13.2 Revenues 13.7 12.9 12.3 12.5 Balance -0.1 -0.4 -1.0 -0.6 Subnational Debt 2.1 2.1 2.6 3.4 Consolidated Federal EBFs* Expenditures 9.6 11.1 12.1 10.7 Revenues 10.4 12.0 12.2 10.7 Balance 0.8 0.9 0.1 0.0 Source: Ministry of Finance, World Bank staff calculations. Note: *Main federal EBFs are the Pension Fund, the Social Security Fund, and the Mandatory Medical Insurance Fund. Russia’s main fiscal buffer, the Reserve Fund, The second buffer, the National Welfare Fund was replenished during 2014. In August, US$6 (NWF) was increasingly committed to boosting billion was deposited in the Reserve Fund, investment demand. The NWF was down to bringing the total to US$87.9 billion (4.7 percent US$78 billion by the end of 2014 (4.2 percent of of GDP) by the end of 2014, compared to US$87.4 GDP) compared to US$88.6 billion (4.3 percent) billion (4.2 percent) last year (Figure 27). The at the end of 2013. However, in ruble terms, it replenishment represented oil revenue accrued went up to RUB4,338 billion, having gained about to the federal budget in 2013 that was more than RUB1,500 billion from the depreciation. In June, originally budgeted. the government changed the NWF investment Figure 27: Reserve fund and National Welfare Fund, rules, raising the limit on resources that could be percent of GDP used to finance domestic infrastructure projects 16 to 60 percent; previously no more than 40 14 percent (not to exceed RUB1.16 trillion) could be invested in debt securities and stocks of Russian 12 companies to finance infrastructure projects 10 approved by the government. After June, an 8 additional 10 percent (not to exceed RUB290 6 billion) was released for purchase of debt securities and stock of companies implementing 4 projects in which the Russian Direct Investment 2 Fund (RDIF) is participating.9 Another 10 percent 0 2008 2009 2010 2011 2012 2013 2014 (not to exceed RUB290 billion) could be used to National Welfare Fund Reserve Fund purchase debt securities and stock of companies Source: Ministry of Finance, World Bank staff calculations. 9 The RDIF was established in June 2011 on the initiative of the President and Prime Minister to attract foreign investment into leading sectors of the Russian economy. Russia Economic Report | Edition No. 33 17 I. Recent Economic Developments implementing projects in cooperation with state 2014 only RUB5.13 billion (US$80 million) had corporation Rosatom.10 The government also been invested in bonds of Russian companies approved for financing a long list of projects cooperating with the RDIF on IT projects and amounting to about RUB900 billion, including a improving Internet connectivity. The likely reason new Central Ring Road in Moscow, upgrades to is that those projects are required to mobilize 60 the Trans-Siberian and Baikal-Amursk railways, percent in co-financing from sources other than and other projects to improve energy efficiency the NWF, which in the current high-interest rate and Internet connectivity. Yet by the end of environment is difficult. Box 7 The government anti-crisis plan On January 27, 2014, the government adopted an anti-crisis plan with the goal to ensure sustainable economic development and social stability in an unfavorable global economic and political environment. It announced that in 2015–2016 it will take steps to advance structural changes in the Russian economy, provide support to systemic entities and the labor market, lower inflation, and help vulnerable households adjust to price increases. To achieve the objectives of positive growth and sustainable medium-term macroeconomic development the following measures are planned: • Provide support for import substitution and non-mineral exports; • Support small and medium enterprises by lowering financing and administrative costs; • Create opportunities for raising financial resources at reasonable cost in key economic sectors; • Compensate vulnerable households (e.g., pensioners) for the costs of inflation; • Cushion the impact on the labor market (e.g. provide training and increase public works); • Optimize budget expenditures; and • Enhance banking sector stability and create a mechanism for reorganizing systemic companies. The government aims to achieve a balanced budget in the medium term and intends to cut budget expenditures by 5 percent in real terms in the next three years. In 2015, the plan is to cut 10 percent of spending across all categories except military, agriculture, and external debt-servicing. The Ministry of Finance currently plans to use the Reserve Fund to optimize federal budget spending. It is expected that about RUB1.4 trillion of the anti-crisis plan will be financed this year, of which up to RUB972 billion will be financed from the federal budget and RUB550 billion with the NWF. It is estimated that the plan will cost RUB2.4 trillion, of which 67 percent is earmarked for bank recapitalization, which will operate through three channels: (i) Treasury bonds worth RUB1 trillion had already been transferred to the Deposit Insurance Agency in December 2014. In February the government approved a list of 27 banks eligible for recapitalization. Banks to be recapitalized are expected to increase mortgage loans, loans to small and medium enterprises, and loans to key economy sectors by 1 percent a month and increase their own capital by at least half of the amount received from the Deposit Insurance Agency; (ii) The NWF will finance a second channel, investing RUB250 billion in subordinated deposits and bonds of the systemic banks that have capital of RUB100 billion (US$1.6 billion). The interest rate should at least cover the CPI inflation rate. On October 1, 2014, nine banks met the criteria. Banks that receive these deposits are expected to finance government-approved investment projects; and (iii) Another RUB300 billion will be channeled through the NWF to Vnesheconom bank to provide credit to the real sector. About 13.9 percent of the anti-crisis plan (RUB320 billion) will go to direct support of the real sector: RUB200 billion in state guarantees for systemic companies, RUB50 billion for support of agricultural enterprises, and RUB10 billion for the transport utilization program. The government has approved a list of 199 systemic enterprises eligible for state guarantees, among them all major Russian companies. Companies on the list produce 70 percent of GDP of Russia. These steps mainly address the development of sustainable enterprises given lower domestic demand, an unfavorable global environment, and high credit costs. Some administrative measures are expected to smooth state procurement, which was hit by the exchange rate crisis. Another 12.9 percent (RUB296 billion) is earmarked for social support, including pension indexation higher than the federal budget law envisaged, RUB52.2 billion for easing the labor market, RUB30 billion for payments for registered unemployed, and RUB16 billion for additional medical support. About 7.0 percent (RUB160 billion) will be transferred to the regions through budget loans. 10 Rosatom is the state corporation established to develop a variety of civil and military nuclear energy projects, including production, research, design and construction of power stations, and uranium enrichment. 18 Russia Economic Report | Edition No. 33 I. Recent Economic Developments As sanctions were imposed, the government approved real sector projects. With this, the allowed further discretionary use of NWF upper limit of NWF ruble investments reached resources, this time to help stabilize the about 50 percent. In December RUB100 billion financial system. In December, to recapitalize had already been deposited with VTB in 30- them and to heighten the stability of the year accounts at an interest rate exceeding financial system, the government allowed the the inflation rate by 1 percentage point; NWF to invest in the stocks of Vneshtorgbank the goal was recapitalization and lending to (VTB),11 Rosselkhozbank,12 and Gazprombank13 government-approved investment projects. In to a ceiling of RUB279 billion. That month the January, the government announced an anti- government also allowed the NWF to invest up crisis plan that also envisions some financing to 10 percent of its resources in subordinated from the NWF (Box 7). bank deposits for financing government- 11 Venshtorgbank is a state-owned bank which works primary with corporate clients. 12 Rosselkhozbank is a state owned bank which was created to service agricultural companies. 13 Gazprombank is the third largest Russian bank (with over fifty percent state-ownership) which services corporate clients and households. Russia Economic Report | Edition No. 33 19 PART II Economic Outlook R ussia’s medium-term growth prospects are threatened by the recent slide in oil prices and the continued impact of sanctions. The World Bank growth outlook for Russia projects that in 2015 these two shocks will push the economy into recession. The baseline scenario sees contractions over the next two years of 3.8 percent in 2015 and 0.3 percent in 2016. There are upside and downside risks to the oil price projections as the global oil market continues searching for a new equilibrium price. To account for this risk, the World Bank Russia outlook has two alternative scenarios for Russia straddling the baseline scenario, one reflecting an upper-bound oil price and the second a lower- bound price. In the medium term, the economy will need to adjust to both the new oil prices and continued uncertainty related to geopolitical tensions and sanctions. Both new realities have the potential to alter the structure of the Russian economy and the ways Russia integrates with the rest of the world. II. Economic Outlook 2.1 Outlook for Russia – Protracted Recession The World Bank has set out three scenarios: the baseline, an upper-bound oil price scenario and a lower-bound oil price scenario. The baseline projects recession, given the most likely oil price prospects and the assumption that economic sanctions will be in effect throughout 2015 and 2016. M edium-term growth prospects for Russia are dim. The World Bank growth outlook projects that the continued impact of sanctions incomes much faster than anticipated, but credit costs have become prohibitively high for both consumers and investors. Continued geopolitical and lower oil prices will push the Russian tensions led to the revised assumption that economy into a protracted recession. With sanctions will carry over through 2016. This continuing low oil prices at an average US$53 is likely to keep external borrowing costs high per barrel in the baseline scenario, the economy and access to international capital markets is projected to contract by 3.8 percent in 2015, limited, so that investment demand would pushing real GDP down below what it was in continue to be depressed. Those factors, which 2012 (Figure 28 and Figure 29). With oil prices are undermining Russia’s medium-term growth expected to recover only marginally, to US$57 prospects, require that the economy adjust not per barrel, in 2016, growth is likely to continue only to new oil prices but to a fundamentally to be below zero. The two alternative scenarios altered economic environment. presented in the growth spectrum largely reflect differences in how oil prices are expected to Russia’s medium-term growth outlook again affect the main macro variables. depends heavily on the trajectory of oil prices. The World Bank oil price assumptions have The assumptions underlying the outlook have changed significantly; the September projections changed since previous growth forecasts. The assumed stable oil prices of about US$100 per steep drop in oil prices and the negative effect of barrel in both 2015 and 2016. The new baseline sanctions in the second half of 2014 have already parameters reflect revised World Bank global impacted the Russian economy. Not only did growth and oil price projections (Box 8). The abrupt devaluation and high inflation erode real average oil price now projected for 2015 is US$53 Figure 28: Real GDP growth, y-o-y, percent Figure 29: Real GDP, percent, 2012=100 102 101.9 3.4 3 101.3 101 2 1 100.0 1.3 100 0.1 99.0 99.1 0.6 0 -0.3 99 -1 98.0 -1.0 97.7 -2 98 -2.9 97.2 -3 -3.8 97 -4 96.2 -4.6 96 -5 2012 2013 2014 2015 2016 95 2011 2012 2013 2014 2015 Lower-bound scenario Baseline scenario Upper-bound scenario Lower-bound scenario Baseline scenario Upper-bound scenario Source: World Bank staff estimates. Source: World Bank staff estimates. 22 Russia Economic Report | Edition No. 33 II. Economic Outlook Box 8 Oil price outlook With supplies surging and demand diminishing, oil inventories have been building up. OECD stocks recovered to about 2.7 billion barrels at yearend 2014 and now exceed their 5-year average. The build-up in stocks was nearly continuous after they reached 9-year lows in 2013. Inversely, OPEC’s spare production capacity eased back to 3.7 million barrels per day in the fourth quarter of 2014 on increased output, after peaking at almost 5 million barrels per day at the end of 2013 (Figure 30). The World Bank projects that oil prices will average US$53 per barrel in 2015, 45 percent less than in 2014. It is assumed that OPEC will abstain from any form of supply management and that there will be no deterioration in the global economic environment. This forecast reflects the shift in OPEC policy, easing of geopolitical tensions, ample supplies, and moderating demand (Figure 31). The production capacity already in place suggests that low prices will continue for some time, with prices expected to recover only modestly, by US$4 a barrel, in 2016. The weakness in crude oil prices will extend to other energy markets, especially European and Asian markets for natural gas. In 2015 prices for European natural gas are expected to decline by 15 percent. Figure 30: Global oil spare capacity and inventories Figure 31: Growth in global oil demand mb/d million bbl mb/d, year over year growth 7 OPEC Spare Capacity (left axis) 2,900 4.00 3.00 6 2,800 2.00 5 1.00 - 4 2,700 (1.00) 3 (2.00) 2,600 OECD Crude Oil Inventories (right axis) (3.00) 2 (4.00) 2008-Q2 2009-Q4 2011-Q2 2012-Q4 2014-Q2 1 2,500 Jan '07 Jan '09 Jan '11 Jan '13 Jan '15 Non-OECD, ex China China OECD Source: International Energy Agency. Source: World Bank and International Energy Agency. per barrel and for 2016 US$57. At present, the The second core assumption of the new oil market is searching for a new equilibrium forecast relates to the impact and duration of price as OPEC and non-OPEC producers compete economic sanctions. Previous baseline forecasts for market share―especially since OPEC’s assumed that the impact would be limited to November decision not to cut production―so 2015 and that 2016 would see geopolitical there are both upside and downside risks to this tensions resolved and sanctions terminated. projection. That is why there are two alternative The current forecast assumes that economic scenarios: the lower-bound scenario assumes sanctions will be in effect throughout 2015 and average oil prices of US$45 per barrel in 2015 and 2016. The inference is that the access of major US$50 in 2016, the upper-bound US$65 in 2015 Russian state-owned banks and corporations and US$69 in 2016. Not anticipated are shifts in to external funding will stay restricted, limiting government policy over the projection period their ability to roll over debt and thus impacting that could significantly affect how changes in the capital account and investment in both oil prices are transmitted to the economy. The years. Nevertheless, the assumption is that projections also assume that the government geopolitical tensions will gradually subside will follow its new anti-crisis plan no matter what toward the end of the projection period, making the oil price may be in 2015. new economic sanctions less likely. The assumed Russia Economic Report | Edition No. 33 23 II. Economic Outlook effect of sanctions is similar in all three scenarios. credit activities, and stagnating incomes would Uncertainty about their protracted impact will lead consumption to contract further by 1.9 continue to depress business and consumer percent. In 2015, the government is scaling down sentiments in both years, postponing recovery in and delaying some large infrastructure projects domestic demand. due to revenue shortfalls, price pressures, and the high cost of borrowing. It is expected Baseline Scenario that private investors are also cutting back on T he World Bank baseline scenario for Russia investment programs as restricted access to projects contractions of 3.8 percent in 2015 external funding and increased credit costs put and a minimal 0.3 percent in 2016. Consumer pressure on profit margins. Policy uncertainty demand would be undermined by deteriorated and geopolitical tensions will continue to weigh confidence, still-high household debt, and on business sentiments and investment activities. slowing growth in incomes. The recent steep devaluation of the ruble is expected to bring It is projected that investment demand will about much higher inflation than initially continue to be deeply depressed in 2015, with anticipated, which will further depress incomes an estimated decline in gross capital formation and wages. Since the government has cancelled of 15.3 percent. In 2016, with external and credit a planned indexation of public wages, growth in conditions somewhat improved, investment public wages will be negative. Unemployment would see a marginal recovery. The weaker would grow moderately to an average of 6.5 ruble could create incentives for small-scale percent for this year; the labor market will adjust expansions in some tradable industries, financed mainly through wage cuts. With average inflation by profits. However, with imported investment for 2015 assumed to be 16.5 percent, credit costs goods and credit much more expensive, such are likely to stay high, causing consumer credit natural substitution would be realized primarily activity to stagnate. through better utilization of capacity. Thus its potential effect is likely to be limited. Consumption is projected to contract by 5.3 percent in 2015 after a negligible expansion in Low oil prices and sanctions will continue 2014 (Table 7). In 2016 a negative carry-over to exert moderate pressure on the external effect of the 2015 recession, a slow recovery in accounts. Projections of external demand for Table 7: Economic indicators for the baseline scenario 2012 2013 2014 2015 2016 Oil price (US$ per barrel, WB average) 105.0 104.0 97.6 53.2 56.9 GDP growth, percent 3.4 1.3 0.6 -3.8 -0.3 Consumption growth, percent 6.4 3.9 1.5 -5.3 -1.9 Gross capital formation growth, percent 3.0 -6.6 -5.7 -15.3 1.1 General government balance, percent of GDP 0.4 -1.3 -1.2 -3.6 -3.1 Current account (US$ billions) 71.3 34.1 56.7 73.7 62.9 Percent of GDP 3.6 1.6 3.0 6.0 4.4 Capital and financial account (US$ billions) -32.3 -56.2 -143.2 -122.1 -60.0 Percent of GDP -1.6 -3.0 -7.7 -10.0 -4.2 CPI inflation (average) 5.1 6.8 7.7 16.5 8.0 Source: Rosstat, Ministry of Finance, CBR, and World Bank staff estimates. 24 Russia Economic Report | Edition No. 33 II. Economic Outlook Russia’s exports are aligned with the recent World oil prices begin to stabilize so that the CBR will Bank global outlook (Box 9). Though exports will not have to intervene. drop further due to low demand and low oil and commodity prices, the resultant pressure on the The baseline scenario makes the following current account will be more than offset by an monetary and fiscal policy assumption: The expected sharp contraction of imports caused CBR will continue inflation targeting, although by the weaker ruble and depressed domestic political pressure might materialize to relax demand. Thus, the 2015 current account monetary conditions sooner to support growth. balance will rise to US$73.7 billion, 6.0 percent The CBR is also likely to continue lowering its of GDP (Table 7). Economic sanctions will policy rates from the current 14 percent. The continue to limit both access to external funding scenario assumes, however, that inflationary for major Russian banks and corporations and expectations will stay high through the first half of their rollover capacity. However, since in 2015 2015 and projects that CPI inflation will average the debt payment profile is easier than it was 16.5 percent in 2015 (Table 7). With the ruble in 2014, and devaluation expectations are stabilizing, in 2016 inflationary expectations subsiding, pressure on the capital account is will subside further,so the 2016 CPI average is expected to moderate: The capital account estimated at 8.0 percent. The fiscal projections, deficit will drop from US$143 billion in 2014 to based on 2015-2017 budget proposals, are US$122.1 billion in 2015. Exchange rate volatility summarized in Box 10. Low oil prices and an will abate as the geopolitical environment and eroded non-oil tax base are expected to put Box 9 Global outlook Global growth is expected to rise moderately in 2015 (Table 8). At present, recovery is relying heavily on robust growth in the U.S.: above-trend growth (with job creation)is expected to carry over into 2015 and to outpace global growth for the first time since 1999. In the Euro area, conditions are in place for improvement in the first quarter of 2015 despite rising uncertainty about the Greek bailout plan and unresolved tensions related to Russia. High-income countries are likely to see growth slightly up from the 1.7 percent posted in 2014 as labor markets gradually recover, fiscal consolidation ebbs, and financing costs stay low. Meanwhile, activity indicators in China continue to signal a gradual deceleration. As the domestic headwinds that held back growth in developing countries in 2014 abate and recovery in high-income countries slowly firms up, growth is projected to gradually accelerate. Table 8: Global GDP growth, percent 2009 2010 2011 2012 2013 2014e 2015f 2016f 2017f World -1.8 4.3 3.1 2.4 2.5 2.6 2.9 3.2 3.2 High-income countries -3.6 3 1.9 1.4 1.4 1.7 2.1 2.4 2.2 Developing countries 3.0 7.8 6.3 4.7 5.0 4.5 4.5 5.1 5.3 Euro area -4.5 2 1.7 -0.7 -0.4 0.9 1.4 1.7 1.6 Russia -7.8 4.5 4.3 3.4 1.3 0.6 -3.8 -0.3 2.2 Source: World Bank Global Economic Prospects and World Bank Russia team. Global activity over the medium term should be supported by declining oil prices, but the positive effect will be offset in 2015 by tough adjustments in oil-exporting economies (e.g., Russia and Venezuela) and persistent headwinds among larger net importers, such as the Euro area and Japan. Overall, lower oil prices mean that prospects for oil- exporting and oil-importing countries will diverge. Empirical estimates suggest that growth in some oil-exporting countries could contract by 0.8–2.5 percentage points in the year after a 10 percent decline in the annual average oil price. The slowdown would compound revenue losses in these countries as fiscal break-even prices exceed current oil prices for most oil exporters. However, such fiscal pressures can partly be mitigated by sovereign wealth funds or reserves. In Brazil, Indonesia, South Africa, and Turkey, falling oil prices will help suppress inflation and reduce current account deficits—a major source of vulnerability for many emerging economies. Growth in low-income countries is expected to stay strong, but the moderation in oil and other commodity prices will hold back growth in those low-income countries that export commodities. Russia Economic Report | Edition No. 33 25 II. Economic Outlook heavy pressure on the fiscal accounts. Despite Alternative Upper-bound Oil Price Scenario T the positive effect of depreciation, revenues he upper-bound oil price scenario projects are projected to be severely compressed due a contraction in real GDP of 2.9 percent in to lower oil export receipts, reduced import 2015 followed by recovery to 0.1 percent growth duties, and the contraction in GDP. Because the in 2016. Better growth outcomes than in the 5 percent projected decline in real government baseline are largely explained by higher oil prices spending will not be enough to compensate and their spillover effect onto other economic for the revenue shortfall, additional domestic activity. For 2015 the oil price is projected at borrowing or drawdowns from the Reserve US$65 a barrel and for 2016 at US$69. External Fund will be necessary. Parliamentary elections conditions and the impact of sanctions would be in 2016 are likely to induce increased spending, similar to the baseline. As oil prices adjust upward especially by indexing public wages and pensions. over the year, the ruble is expected to strengthen, The government deficit is therefore projected to which would lessen inflation expectations and go up from 1.2 percent of GDP in 2014 to 3.6 the pass-through effect on inflation. Consumer percent in 2015 and 3.1 percent in 2016. price inflation would average 14 percent in 2015—2.5 percentage points lower than in the Box 10 The 2015-2017 budget projections The amendments to the budget law apply to 2015, with the Ministry of Finance planning to introduce changes related to 2016 and 2017 by September 2015. This temporary lack of medium- term perspective leaves all budget entities deeply uncertain. It is however, similar to what happened during the 2008–2009 crisis when there was no medium-term budget projection in 2009. The new macroeconomic assumptions for the 2015 amendments to the federal budget law project an average oil price of US$50 per barrel (down from US$100 per barrel) and a GDP contraction of 3.0 percent. In 2015, federal budget revenue is projected to decrease by 3.3 percent of GDP (13.5 percent in nominal terms) with oil and gas revenues falling by 12.1 percentage points (2.7 percent of GDP). The oil price used to calculate the oil extraction tax and customs duties, has a tax-exempted part (US$25 per barrel), and with oil prices low its share becomes proportionally higher. As for non-oil revenues, VAT is projected to decrease most, due to shrinking domestic demand and the REER depreciation. Federal budget expenditures will decrease marginally, from 20.9 percent of GDP in 2014 to 20.8 percent in 2015. The main challenges for the spending side are the weaker ruble and high inflation, which put upward pressure on expenditures through indexed social payments and the cost of procuring imported goods. In 2015, government priorities favored social policy and national defense. In 2015, social policy expenditures will increase by 0.9 percent of GDP (a nominal 22.1 percent increase) with the majority of the increase devoted to pensions and social provisioning of households. National defense spending will increase by 0.7 percent of GDP (a nominal 25.7 percent increase) compared to 2014 as the government adheres to its long-term program of modernizing the army. Spending on the national economy is planned to decrease by 1.4 percent of GDP. Intergovernmental transfers will decrease by 0.3 percent of GDP, but this will be partly compensated by budget loans to the regions in the amount of RUB160 billion (0.2 percent of GDP). Expenditures for health will decrease by 0.2 percent of GDP and for education 0.1 percent. The federal budget projects a deficit of 3.7 percent of GDP in 2015, compared to a 0.5 percent deficit in 2014. The primary budget deficit will increase to 2.9 percent of GDP from the surplus of 0.1 percent in 2014. The non-oil deficit will reach 11.5 percent of GDP compared to the 10.9 deficit in 2014. With access to international financial markets restricted and credit costs high, the Reserve Fund will be the main source for deficit financing. By the end of the year, it is projected to decrease from RUB3.1 billion to RUB2.6 billion. The amendments suggest that an additional RUB 500 billion could be used for deficit financing in 2015—a possible downside risk. The anti-crisis plan will have limited effect on federal budget spending in 2015. Budget financing of RUB713.8 billion (1 percent of GDP) will be required in addition to RUB260 billion already earmarked in the anti-crisis fund in the law on federal budget. RUB230 billion will be recorded as below the line operations for state guarantees. Government has reduced the number of projects it plans to finance with the NWF from 10 to 6: (i) the Central Ring Road in Moscow; (ii) upgrades to the Baikal-Amursk railway; (ii) the Hanhikivi nuclear station in Finland; (iv) improving Internet connectivity; (v) gas extraction infrastructure at the Yamal peninsula; and (vi) locomotives for the Russian Railway. Their total cost in 2015 is about RUB500 billion. In February 2015, the government placed RUB75 billion (US$1.16 billion) from the NWF in bonds of OAO Yamal SPG for financing gas extraction at the Yamal peninsula. The total of NWF resources placed into securities of companies conducting government-approved infrastructure projects reached RUB80 billion (US$1.3 billion). 26 Russia Economic Report | Edition No. 33 II. Economic Outlook baseline. This would improve the dynamics of deficit to 2.8 percent of GDP in 2015 and 2.1 real incomes and wages. In response to faster percent in 2016; it would largely be financed deceleration of inflation the CBR is likely to cut from the Reserve Fund and domestic borrowing. the policy rate more aggressively, which should BoP outcomes for both 2015 and 2016 are support credit growth. As a result, in the upper- similar to the baseline. Given the same effect bound scenario, in 2016 consumption would as in the baseline of sanctions on bank and contract by 3.0 percent, or 2.3 percentage points corporate capacity to roll over debt, the size of less than in the baseline, and recover faster in capital outflows and the impact on the capital 2016 (Table 9). In 2015, gross capital formation account will be comparable. The current account would contract by 10.8 percent (15.3 in the is expected to be somewhat weaker than in the baseline). A slow recovery in investment in 2016 baseline in both 2015 and 2016 because higher would be compensated for by faster action on imports will more than offset the positive impact infrastructure projects by the government and of higher oil prices on trade balances. companies in the oil sector. Investment demand would also benefit from lower interest rates and Alternative Lower-bound Oil Price Scenario T higher oil prices. he lower-bound oil price scenario projects a larger contraction of 4.6 percent in 2015, In the upper-bound scenario Russia’s fiscal and in 2016 a second recession year with a 1 position will firm up and external balances percent contraction. It assumes a further drop will stay virtually the same as in the baseline. Higher oil prices and a larger non-oil tax base in oil prices, to an average of US$45 per barrel in would bring in more revenue. No major changes 2015 and US$50 in 2016. A sharper contraction in spending are expected in 2015 because the of both consumption and investment than in government would continue adjusting its fiscal the baseline explains the difference in growth policy to lower oil prices. The same 5 percent cut outcomes. First, the ruble would continue to in real expenditures is assumed for 2015, but in depreciate moderately in response to lower oil 2016, with oil prices higher and parliamentary prices. This would keep inflationary expectations elections imminent, the government is likely to higher than in the baseline, so the CBR is likely spend more. Large infrastructure projects are to keep monetary policy tight. Higher average expected to accelerate relative to the baseline, inflation of 18.0 percent in 2015 and 9.0 percent which would increase the general government in 2016 would depress real incomes more than Table 9: Economic indicators for the upper-bound oil price scenario 2012 2013 2014 2015 2016 Oil price (US$ per barrel, WB average) 105.0 104.0 97.6 65.5 68.7 GDP growth, percent 3.4 1.3 0.6 -2.9 0.1 Consumption growth, percent 7.0 3.5 0.9 -3.0 -0.6 Gross capital formation growth, percent 1.5 -5.6 -8.2 -10.8 1.8 General government balance, percent of GDP 0.4 -1.3 -1.2 -2.8 -2.1 Current account (US$ billions) 71.3 34.1 56.7 61.7 54.0 Percent of GDP 3.6 1.6 3.0 4.5 3.5 Capital and financial account (US$ billions) -32.3 -62.2 -143.2 -105.5 -48.6 Percent of GDP -1.6 -3.0 -7.6 -7.7 -3.1 CPI inflation (average) 5.1 6.8 7.7 14.0 7.0 Source: Rosstat, MinFin, CBR and World Bank staff estimates. Russia Economic Report | Edition No. 33 27 II. Economic Outlook projected in the baseline, and higher interest more expensive imported investment goods, rates would slow credit activities more. Together higher credit costs, and lower consumer demand. with higher unemployment these factors would Public and quasi-public infrastructure projects cause consumption to contract by 6.6 percent would be scaled down and delayed more than in 2015 and 2.7 percent in 2016 (Table 10). In in the baseline, keeping investment demand 2015 both private and public investment would depressed in 2016. contract more than in the baseline because of Table 10: Economic indicators for the lower-bound oil price scenario 2012 2013 2014 2015 2016 Oil price (US$ per barrel, WB average) 105.0 104.0 97.6 45.0 50.0 GDP growth, percent 3.4 1.3 0.6 -4.6 -1.0 Consumption growth, percent 6.4 3.9 1.5 -6.6 -2.7 Gross capital formation growth, percent 3.0 -6.6 -5.7 -17.1 -0.4 General government balance, percent of GDP 0.4 -1.3 -1.2 -4.5 -2.6 Current account (US$ billions) 71.3 34.1 56.7 83.1 79.7 Percent of GDP 3.6 1.6 3.0 7.1 5.8 Capital and financial account (US$ billions) -32.3 -62.2 -143.2 -130.2 -79.7 Percent of GDP -1.6 -3.0 -7.6 -11.1 -5.8 CPI inflation (average) 5.1 6.8 7.7 18.0 9.0 Source: Rosstat, MoF, CBR and World Bank staff estimates. 2.2 Risks to the Growth Outlook Risks to Russia’s external environment, the global outlook, and especially oil price trends are prominent. Russia’s medium-term growth outlook will also depend on how Russia will master the adjustment to the oil price and the sanctions shocks, taking into account the risks to financial stability and fiscal sustainability. R isks to Russia’s growth outlook stem partly from what may happen in the global outlook: Global recovery may continue to quite active in the capital markets for several years. Intensifying geopolitical tensions, bouts of volatility in commodity markets, or financial move slowly. If the Euro area or Japan slips stress in major emerging markets could make it into prolonged stagnation or deflation, global necessary to reassess risk. trade could decline even more. Although this is a low-probability event given China’s There are significant risks to the global energy substantial policy buffers, a worse decline in its price forecast. On the supply side, while the growth could trigger a disorderly unwinding of costs of extracting unconventional oil may be financial vulnerabilities that would have severe above current oil prices, it will take at least a implications for the global economy. Financial year before supply moderates, probably through market volatility, compounded by the risk of a cancellation of new projects. Furthermore, most sudden deterioration in liquidity, could heighten energy companies have been busy reducing the borrowing costs of emerging and developing their costs so that they can continue with most countries—an unwelcome development projects. On the demand side, the January 2015 considering that these countries have been assessment of the International Energy Agency 28 Russia Economic Report | Edition No. 33 II. Economic Outlook expects further softening, with oil consumption As long as access to external finance continues projected to average 93.3 million barrels per to be a problem, careful management of day in 2015, down from 94.1 million projected financial sector risks and buffers will be vital. in its July 2014 assessment. There are also risks Adhering to inflation targeting within a flexible related to uncertainty about future OPEC policy: exchange rate regime will help keep international a significant part of the drop in oil prices has reserves adequate. A tighter focus on the been driven by OPEC’s November decision to efficiency of spending and prudent management let markets determine the price rather than of fiscal buffers would ensure continued fiscal engaging in supply management. Before that sustainability at all administrative levels. The decision, Saudi Arabia—OPEC’s largest and vulnerability of Russia’s financial sector has most influential member—had offered a series heightened. Government and central bank of discounts to Asian oil importers, signaling measures are providing some relief to banks but its intention to abandon price targeting. Since could also be pushing up systemic risks. Parts of November OPEC officials have repeatedly stated the January government anti-crisis plan relate that the cartel will not act even if prices fall to to measures to support financial stability (Box US$20 per barrel. 7). Bank liabilities keep increasing in relation to liquid assets and the real earnings potential A second set of risks relates to how successfully of those assets. Deteriorating asset values will Russia will manage adjustments to the oil price require injections of capital (which may not and sanctions shocks. Specifically, sanctions are be possible) and will thus make banks more likely to linger for longer and could well alter the vulnerable to funding shortfalls and possible structure of the Russian economy and how Russia deposit runs. Thus, the financial condition of integrates with the rest of the world. A notable banks, especially smaller ones that are not shift is its reorientation to new trade partners and considered systemically important, is likely to to markets other than Europe and the West. This worsen during 2015. Liquidity support from the includes efforts at closer integration with former central bank is likely to rise, and the collateral Soviet Union republics, East Asia, and Latin requirements for CBR loans could expose the America. It also appears that Russia is already declining market value of assets on bank balance adapting the structure of its economy, through sheets—to the point that more of the 800 or so more protectionism and other promotion of banks might close. domestic industries and a footprint of the state in the economy that is once again growing. The financial authorities need to continue Despite the path to more selective integration earmarking financial resources to support into the world economy, Russia will continue to Russia’s systemically important banks and depend on its natural resource exports. Here it prevent a financial crisis. Many such banks are will be important to assure progress in adopting state-owned or state-controlled, so that the technology that can support exploration of less government is the main shareholder and equity easily accessible oil and gas fields. Future growth provider. However, support would need to be in productivity may well be threatened if natural selective; the government would not be able resource revenues are not invested effectively to cover the entire financial system, given the so as to counterbalance restricted access to amounts in government reserve funds and the external financing. Specifically, less foreign direct potential capitalization needs—not to mention investment (FDI) could limit the innovation and other emergency demands on the budget. One technology transfer that is critical to heighten advantage banks retain is that their net foreign Russia’s growth potential. asset holdings are still positive and thus currency- Russia Economic Report | Edition No. 33 29 II. Economic Outlook matching balance sheet pressures have not yet and the tightening of access to credit. Meanwhile, fully emerged. However, recapitalization needs despite CBR forbearance, NPL ratios are could quickly erode any advantages; because expected to rise. But other, more fundamental, banks are largely shut out of the international factors could limit investment demand. The capital markets, their local currency funding is uncertainty related to geopolitical tensions and increasing substantially. A further decline in the sanctions is still holding investors back and it is ruble would exacerbate the pressure. likely to take some time until the confidence of investors is restored. The economy still grapples The main medium-term risk for Russia’s growth with large inefficiencies in factor allocation, as lies in the continued dearth of affordable reflected, e.g., in limited labor mobility but also credit and the low investment demand. On in weak institutions to regulate markets, which one hand, high interest rates could continue to leads to significant variation in how the rule of exert pressure on Russian banks as their costs of law is applied. Private investment would need to funding rise (though supplemented by CBR loans be reassured by a level playing field, increased for some time), credit levels decline, and more competition, and less corruption. Systematically loans default. The result could be a vicious cycle lower investment rates will ultimately lower of a shortage of project credit caused by the Russia’s prospects for growth in the coming slowdown of the economy, higher lending rates, years and limit already modest growth potential. 2.3 Risks to the Poverty and Shared Prosperity Outlook Given the growth outlook, Russia’s achievements in the last decade with regard to poverty reduction and the upward mobility of a large part of the population might be under threat. The first significant increase in the poverty rate since the 1998-1999 crises is expected, since Russia has limited fiscal space to protect the most vulnerable. I n the past decade, Russia has witnessed unprecedented growth in household welfare, which has lifted many out of poverty and Russia became a middle-income society where growth was driven by consumer demand. By 2010, the middle class controlled 74 percent allowed many others to join the ranks of of total household income and 86 percent of a growing middle class. The poverty rate— total household consumption. When it came to the share of the population with per capita private consumption, in fact, the middle class consumption equal to or below US$5/day—fell became the only game in town. Positive and from 40 percent in 2001 to 10 percent in 2010. At sustained economic growth for most of the the same time, the middle class—those with per period translated into notable growth in per capita consumption equal to or above US$10/ capita consumption from US$9/day in 2001 to day—grew from 30 percent to 60 percent of almost US$17/day in 2010 (2005 PPP). There was the total population. And although the middle a significant decline in poverty, and to a lesser class in Russia and many other middle-income extent vulnerability. countries was disproportionately affected by the 2008-2009 global financial crisis, the Upward economic mobility was the result number of middle-class households recovered of both increases in average incomes and quickly and continued to grow after the crisis, changes in the distribution of income. Using an though more slowly. established decomposition technique (Dattand Ravallion 1992) to examine the impact on 30 Russia Economic Report | Edition No. 33 II. Economic Outlook economic mobility of changes in the distribution Based on the growth outlook, in all three of household per capita income between 2001 scenarios the World Bank projects that poverty and 2010, particularly the emergence of the will again rise in 2015 and 2016 (Figure 32). The middle class, it was found that over three-fourths baseline scenario projects that the poverty rate of the observed decline in poverty could be will rise to 14.2 percent in 2015 (equivalent to explained by changes in average income; the 20.3 million people) and remain there in 2016 remaining fourth was explained by changes in (equivalent to 20.5 million). This would be the the distribution of income. In contrast, growth in first significant increase in the poverty rate since average income levels accounted for only half of the 1998-1999 crises: poverty did not grow in the movements into the middle class; the other 2008-2009 because there was some growth in half was linked to changes in the distribution disposable income. The increase in poverty would of income. This differed from the experience of be driven by an expected decline in disposable other European and Central Asian countries, income and consumption and by an increase in where changes in the distribution of income the poverty line caused by high inflation. Because had a negative (though very small) impact on the share of food items in the subsistence basket the growth of the middle class during the same for the poor is higher than for the rest of the period, as well as the experience of countries in population, they would be more heavily affected Latin America and the Caribbean, where income if food prices outpace headline inflation. Recently growth explained almost all the growth in the announced measures, such as the agreement of middle class observed in 1995-2010. the biggest retail chains to control food prices, could partly offset the increase in the poverty The main platforms for the rise of the middle rate but will not fully compensate for it because class in Russia were access to good, productive controls could be applied to only part of the jobs and wage growth in both private and public subsistence basket. Such measures are not sectors. Significant increases in pensions also as effective as others, such as targeted social helped many escape poverty and vulnerability support for the poor. and join the middle class, particularly in 2006- Figure 32: Poverty rate projections, percent of population 2010. Today, with economic growth slowed and fiscal resources constrained, the sustainability of 16 15.7 0.424 those trends is increasingly threatened. 15 15.2 14.8 0.422 14.2 0.420 In 2014, though national poverty and shared 14 14.2 13.3 0.418 prosperity measures have been flat, the risks 13 13.0 12.6 12.7 for vulnerable groups have gone up. The 2014 12.5 12.7 0.416 12 poverty rate increased from 10.8 percent in 2013 0.414 to 11.2 percent in 2014. The increase was due to 11 11.2 0.412 10.7 10.8 poverty changes in the final quarter of 2014, but 10 0.410 through the third quarter inter-year dynamics 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Gini (rhs) were in line with 2013 (Table 11). Poverty rate, % Lower-bound scenario Baseline scenario Upper-bound scenario Source: Rosstat and World Bank staff estimates. Table 11: Poverty rates, percent 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 2010 2011 2012 2013 2013 2013 2013 2013 2014 2014 2014 2014 Poverty rate, cumulative 12.5 12.7 10.7 10.8 13.8 13.0 12.6 10.8 13.8 13.1 12.6 11.2 Source: Rosstat. 14 These estimates were done on RLMS data in an approach comparable to the Focus note of Russia Economic Report no. 31. However, all the estimates should be taken with caution because survey data is usually biased downward due to underreporting of incomes and expenditures and under-representation of people with high incomes. Russia Economic Report | Edition No. 33 31 II. Economic Outlook People at the bottom of the income distribution Figure 33: Share of the population with per capita income in US$ PPP/day are the most vulnerable. As fiscal space in 2015- 100 2016 is limited, additional support for the poor 90 and vulnerable is likely to be less generous than 80 in 2008-2009. Public wages will not be indexed 70 this year, and pensions, social benefits and other 60 transfers will decrease in real terms because their 50 40 indexation is based on 2014 inflation, which was 30 much lower than the price growth projected for 20 2015. Currently, pensioners, public employees, 10 and employees of state-owned enterprises 0 constitute a significant share of the bottom 40 01 02 03 04 05 06 07 08 09 10 11 12 13 20 20 20 20 20 20 20 20 20 20 20 20 20 Less than 5 USD/day 5 - 10 USD/day More than 50 USD/day percent income group; other vulnerable groups 10 - 25 USD/day 25 - 50 USD/day More than 10 USD/day are those employed in the informal sector and Source: Rosstat and World Bank staff estimates. families with children. As a result, 2015-2016 will see less opportunity for an increase in shared best-performing countries when this definition prosperity. of middleclass is applied. However, a closer look at how that growth was distributed shows that Russia’s share of the population belonging to it was driven by expansion of the share of the the middle class continued to grow in 2013. relatively richest people within the group. The In 2013, the share of Russians belonging to the share of population with a per capita income middle class, defined as people with per capita of more than US$50 per day in 2013 increased income exceeding US$10 PPP per day14 (Figure faster by 0.7 percentage points to reach 6.4 33) increased by 2 percentage points, reaching percent. The share of the population with a per 70 percent of the population as the trends of the capita income of US$10-25 and US$25-50 per previous decade continued. Within the Europe day grew more slowly. and Central Asia region, Russia is one of the 32 Russia Economic Report | Edition No. 33 PART III The Economic Impact of Sanctions 15 S ince the start of the geopolitical tensions, Russia has been subject to several rounds of sanctions by developed economies. First, sanctions directed at specific individuals, groups, and companies imposed restrictions on travel and business operations and froze their assets. Later, sanctions aimed at Russia’s military, energy, and financial sectors followed. In August, Russia introduced counter sanctions, banning food imports from sender countries. Sanctions and counter sanctions hit the economy through three channels: (i) Massive capital outflows made the foreign exchange market more volatile and caused a significant depreciation of the ruble; (ii) Financial sanctions restricted access to international financial markets for some Russian banks and firms and made external borrowing very expensive for others; and (iii) The already low confidence of domestic businesses and consumers in future growth prospects diminished further, reducing consumption and investment. Sanctions also started to impact trade flows. International experience shows that sanctions are likely to last for long periods. 18 15 Thisnote Thisnote based iswas on the recent produced World by Birgit Bank Europe Hansl, Nancyand Central Asia andRegional Benjamin, Flagship Julie Saty Report: Lohi with Diversified Development: contributions from Michael Making the Most Ferrantino andof Natural Resources Karlygash in Eurasia. Washington, DC 2014. The authors of the report are Indermit Gill, IvailoIzvorski, Willem van Eeghen, and Donato Dairabayeva. De Rosa. This note was produced by Donato De Rosa, Elena Bondarenko and Ekaterina Ushakova. III. The Economic Impact of Sanctions 3.1 Introduction I n 2014, Russia became subject to sanctions resulting from the Russia-Ukraine geopolitical tensions. These tensions and the related on output dynamics by economic sectors since the second quarter of 2014 (immediately after the geopolitical tensions arose) suggest sanctions affected investor and consumer a sluggish economy but with a small positive decisions and trade flows. First, they created impulse coming from the weaker ruble. much uncertainty: equity and currency markets entered a prolonged period of acute volatility as This note offers an early assessment of the they gradually internalized the uncertainty. They economic impact of sanctions on Russia. First, also exacerbated the crisis in confidence the it will assess impact through the main sanction economy had entered in 2012-2013, weighing channels, based on the data currently available. heavily on consumption and investment. As the In doing so, it will also suggest potential long- September 2013 edition of the Russia Economic term impacts and areas for future research. Report said,16 in the first half of 2014 the Second, it will review international experience impact of Western sanctions on Russia’s growth with economic sanctions in terms of their impact was channeled mainly through adjustments on the sanctioned country. In general terms, in financial flows. The gradual imposition of economic sanctions are pressures, such as financial sanctions and more limited trade trade restrictions, disinvestment campaigns, sanctions started in late July 2014, and those on and restrictions on credit from international the financial sector began to make an impact in banks, that are imposed, either unilaterally the second half of 2014. Other sanctions with or multilaterally, on a given country or group trade implications will likely make their full of countries. impact known only throughout 2015. Statistics 3.2 The Economic Impact of Sanctions T he methodologies that have been used to evaluate the economic impact of sanctions fall into two categories: statistical analysis of In addition to these methodologies, industrial surveys have been conducted to capture the indirect costs, which are notoriously hard to situations and game theory (Box 11). Many of quantify. Hufbauer (1990) and the EABC (1997) the evaluation exercises measured direct costs looked at indirect costs typically incurred by the incurred, such as losses in export sales and sender of a sanction, such as loss of reliability market shares, job losses, compliance costs, as a supplier, loss of opportunities for forming and losses incurred by suppliers of inputs to critical business relationships or participating sanctioned countries. Indirect costs have also in joint ventures, and loss of competitiveness been identified. The methodologies applied evaluate the impact of sanctions by measuring because of loss of market share. For example, in both the direct and indirect costs incurred by the 1998 the president of Caterpillar, Inc., reported target and compare them with different aspects that Russians still doubt the company’s reliability of past sanctions episodes, such as the size of the as a supplier following U.S. sanctions on the partners and the trade flow between them, the former Soviet Union gas pipeline to Western intensity and length of sanctions applied, and the Europe (see USITC 1998, p. 49). extent of international cooperation.17 Studies of how sanctions impact senders are rare. 16 See World Bank Russia Economic Report №32, Policy Uncertainty Clouds Medium-Term Prospects. 17 Hufbauer et al. 1983, 1990; Bergeijk 1994; Carter 1988; Eaton and Engers, 1992, and Miyagawa 1992 evaluate the impact of economic sanctions through factors such as trade costs incurred in various sanctions episodes. 34 Russia Economic Report | Edition No. 33 III. The Economic Impact of Sanctions Box 11 Methodologies of economic sanctions evaluation The statistical approach used in evaluating the impact of economic sanctions include gravity, partial equilibrium, and general equilibrium models. The gravity model of bilateral trade flows assesses bilateral trade patterns and what drives them. The basic gravity equation1 is often augmented with a sanctions variable to quantify the impact of sanctions on trade patterns (e.g., Hufbauer et al., 1997; Askariet et al., 2003; International Economics Policy Brief, 2003). The partial equilibrium model makes it possible to examine the welfare impacts of economic sanctions on the markets involved; the general equilibrium model links restricted markets and sectors to all other markets in the economy. Richardson (1993)2 pioneered sanctions evaluation using the partial equilibrium model. The model considers demand and supply disruptions in sender and target countries due to sanctions to assess the impact of each3 sanction under varying degrees of imperfect competition, cost structures, and number of firms and countries. A limitation of partial equilibrium models in general is their inability to distinguish between sectors, which mitigates substitution or input cost effects on other sectors due to sanctions in one sector—the second-order effects on goods or sectors not targeted as a result of sanctions on a targeted sector. The general equilibrium model fills the interaction gap left by partial equilibrium models. General equilibrium modeling allows for full interactions between flows of output, income, and consumption because it is based on the social account matrix, which is the complete data base of sectoral flows and the aggregate of an entire economy for a given period. Canes (1998) used general equilibrium modeling to evaluate the implications of economic sanctions for energy policy and Becker et al. (1990) used it in evaluating the costs of economic sanctions on South Africa. Unlike the empirical approaches, the game theory approach does not yield quantified estimates of the costs incurred by the countries involved. Applying game theory in the context of economic sanctions allows for qualitative analysis of their impact. In using the game theory approach to evaluate sanctions, the countries involved (sender and target) are treated as two opposed subjects where each country makes strategic policy decisions vis-à-vis the strategy adopted by the other.4 Costs, especially to the sender, are attributed to an overall sanction strategy (see, e.g., Eaton and Engers 1992; Bergeijk 1994; Bergeijk and Marrewijk 1994; Bonetti 1994; Barrett 1998; and the USITC 1998). It also considers the potential impact of a threat of sanctions, which can in itself negatively impact countries. Even if sanctions are not imposed, the threat can be an efficient strategy for the sender, one the target country could avoid by cooperating. 1 The basic determinants or explanatory variables of bilateral trade patterns in the gravity equation are geographical distance between the two partners, official language in common, colonial links, contiguity (whether they share a border), and the GDP of each partner. 2 See also Hufbauer et al. 1983, 1990. The application of the partial equilibrium model in these papers does not accommodate some features of the 1993 Richardson model, such as enlarged numbers of suppliers and demanders, and varying degrees of imperfect competition. 3 This refers to distinct impacts of a sanction, such as export embargoes or restrictions on export financing. 4 Game theory is based on a mathematical model of conflict and cooperation that is traditionally used in economics to study rational decision making by two players assuming a zero sum-game, such that the loss of one party equals the gain of the other party. Game theory applications today can diverge from the zero-sum equilibrium and allow a mixed-strategy equilibrium with even a cooperative game by multiple players (see Koller and Milch 2003). 3.3 Lessons from International Experience with Sanctions T his section builds on past international South Africa S experience with economic sanctions to outh Africa was subject to economic illustrate potential medium- and long-term sanctions starting in the 1960s which were impacts. It explores sanctions against South implemented on a more significant scale Africa in terms of their economic impact on after the mid-1980s. Many governments and the targeted country. This example was chosen institutions banned South African exports to for its possible relevance to Russia’s sanction their countries and advocated disinvestment experience because this country has some in corporations and banks doing business in or similar characteristics, being resource-rich and with South Africa. In the U.S. alone, by the late having also had to deal with sanctions that 1980s 26 states, 22 counties, and over 90 cities impacted the financial sector and investment had passed laws banning transactions with flows. However, each sanction set was unique, companies doing business in South Africa. The as was the country circumstances when the divestment movement pressured institutions, sanctions hit, which makes outright comparison including many universities, and public pension of impacts difficult. funds to divest holdings in companies doing Russia Economic Report | Edition No. 33 35 III. The Economic Impact of Sanctions business in South Africa. Governments also plunged. Fixed domestic investment fell from intensified the pressure by adopting selective 26 percent of GDP in 1980-1985 to 19 percent purchasing policies, whereby preference in in 1986-1990. The annual rate of growth in suppliers of goods and services was given to capital stock slowed from 4 percent in the early companies that did not do business in South 1980s to 1 percent after 1985, and capital stock Africa. Financial sanctions closed off access actually fell in agriculture, manufacturing, and to foreign savings. Trade restrictions targeted construction. imports of the South African Krugerrand (then the South African gold coin), certain steel and The main conclusion from past international iron products, and products of state-controlled experience is that the current economic enterprises dealing with uranium, coal, textiles, sanctions on Russia could have serious medium- agricultural products, food, and petroleum and long-term impacts. Indeed, the review found products. The campaign of disinvestment and that economic sanctions can cause significant the international trade restrictions continued deterioration in the target’s economy. The until 1994. sanctions have left target countries with negative economic impacts that took far longer to reverse During the sanctions South Africa continued to than the length of time they were imposed. Once mine and export minerals, diamonds, and gold. a target country becomes isolated from major The mineral exports allowed it to buy oil and economic and financial markets, foreigners and other necessities despite sanctions, although at even domestic investors become reluctant to higher cost. A variety of manufactures persisted, invest in the country, clouding its medium- and often based on local raw materials, agriculture, long-term economic prospects. This is especially livestock, and minerals. Agriculture diversified to clear from the experience of South Africa, which produce a few crops that had become difficult was cut off from international transactions to obtain from abroad. The share prices of during its sanctions period. The isolation from companies facing divestment by institutional international economic activities, such as investors changed little as other investors picked trade and bank transactions, that are pivotal up the shares that were shed. to a country’s growth, have proven to be very damaging for targeted economies even Sanctions eventually choked off investment if the sender also suffers to some extent (Bayoumi 1990; Gershenson 2001). Because of from missed trading opportunities with the the uncertainty related to the financial sanctions sanctioned country. that started in the mid-1980s, investment 3.4 The Economic Impact of Sanctions on Russia R ussia is currently subject to multilateral economic sanctions resulting from the Russia-Ukraine geopolitical tensions. First, in In July 2014, new sanctions were directed at Russia’s military, energy, and financial sectors. Access of the six major Russian state banks March-April 2014 sanctions introduced by the and of energy and defense firms to the EU and U.S., the EU, and other countries were directed U.S. financial markets was severely limited. As at specific individuals, groups, and companies. of September 2014, these companies can only They prohibit the entry of sanctioned individuals, apply for loans and issue debt not exceeding freeze their assets, and ban business operations 30 days maturity. In the defense sector, the U.S with the named individuals and companies. and the EU cut access to financing exceeding 36 Russia Economic Report | Edition No. 33 III. The Economic Impact of Sanctions 30 days maturity for Russia’s major companies In response to the sanctions, Russia on August and banned the export of dual-use goods and 7, 2014, banned the import of food items technology for 14 mixed-defense companies. from several Western countries for a year (Box Sanctions on cooperation with Russia in the 12). Among them were meat, fish, seafood, military sector were also introduced by the U.K., vegetables, fruit, milk, dairy products, and a Israel, Switzerland, and Sweden. In the energy wide range of processed foods from the U.S., the sector, the U.S. and the EU limited access to EU, Australia, Canada, and Norway. Later, other finance for major Russian oil and gas companies; countries were added. they also prohibited export of goods, services (not including financial), and technology in Sanctions and counter sanctions hit the support of exploration or production for Russian economy through three channels; first, they led deep-water, Arctic offshore, and shale projects. to increased volatility on the foreign exchange Norway, Canada, and Australia largely joined the market and a significant depreciation of the sanctions introduced by the EU. national currency (Figure 34 and Figure 35). Figure 35: Exchange rate dynamics, Euro-dollar basket Figure 34: Stock market prices and trade volumes (axis in reverse order) 1900 35 110 1800 40 90 45 1700 50 1600 70 55 1500 60 50 1400 65 30 70 1300 75 1200 10 80 6-Jan-14 14-Mar-14 1-Jul-14 1-Oct-14 25-Mar-15 Trade volume, bln Rub (right axis) MICEX index 1-Jan-14 18-Mar-14 1-Jul-14 18-Dec-14 25-Mar-15 Source: MICEX. Source: CBR. Box 12 Russia’s food import ban On August 7, 2014, Russia imposed a ban on specific food commodities imported from the U.S., the EU, Canada, Australia, and Norway in response to the economic sanctions those countries had imposed. The banned products include beef, poultry, fish, sausages and other meat products, vegetables, fruits and nuts, milk and dairy products, and cheese. Russia also banned fresh fruits, wine, and processed meat from Moldova, and potatoes, soy beans, sunflower, and corn grits from Ukraine. The total value of affected trade is estimated at US$9.5 billion; the banned products account for 9.5 percent of total food consumption in Russia and 22.5 percent of its total food imports. The ban heightened inflation pressures; prices have already risen for the targeted items, hurting Russian consumers but stimulating domestic food production (section 1.3). The food import ban is very broad and covers both staples and luxury items. Also, substitution by domestic products has increased the cost of food for the most vulnerable segments of the population in Russia. Russian food processing companies that rely on imported inputs that are on the banned list are experiencing increased costs. In an effort to control and prevent increases in food prices, the decree that introduced the import ban also included measures to prevent the growth of prices for related agricultural products. A list of 40 products (almost all goods of the approved in the Russian CPI food basket) was created by the Ministry of Industry and Trade of Russia, based on which the authorities monitor daily prices of traders, municipalities and regions. However, the food import ban created some incentive for domestic food production, which increased continuously in the past half year. Some short-term and medium-term risks are connected to the food import ban. In the short term, transaction costs are rising as new channels to source food imports are sought. In the mediumterm, the trade ban could result in retaliation by trading partners, and there is a risk that WTO disputes will escalate. The EU is considering WTO dispute settlement options in response to Russia’s import bans. Russia has also indicated that the U.S. (and implicitly EU) sanctions are in breach of WTO rules. Russia Economic Report | Edition No. 33 37 III. The Economic Impact of Sanctions Massive capital outflows triggered by the was consistent with the CBR’s goals of inflation tensions led to a deterioration of Russia’s capital targeting and financial stability, it increased and financial account balance and a decrease in domestic borrowing rates and further restricted net international reserves (Section 1.4). The flight access to domestic credit for both investors and from the ruble was compounded in the second consumers. half of 2014, when falling oil prices caused the ruble to lose nearly half of its value against the The second channel through which sanctions U.S. dollar in 2014 (Section 1.3). hit the economy was the restrictions on Russia’s access to international financial markets, which Despite the depreciation, non-oil exports did had already started when the geopolitical not increase. Although there is an impulse for tensions arose. Even before the financial sector substitution, given the persistent structural sanctions became effective, markets were pricing rigidities and little spare capacity to expand Russia’s higher risk into the cost of credit, which without further investment, its potential sent sovereign CDS spreads for Russia soaring. appears to be limited. In the short-term, New foreign borrowing decreased in the first the positive impulse for substitution might half of 2014 and all but vanished in the second increasingly be used to promote protectionist half of 2014 after the sanctions were introduced measures. Even before the current geopolitical (Section 1.4). The tighter domestic and external tensions started, government showed interest in credit conditions negatively affected investment supporting elected firms and sectors that would and consumption decisions, leading to a delay or benefit, one example being the ban on pork a scaling back of some plans. In fact, after the oil products at the beginning of 2014.18 There is a price drop in the final quarter of 2014, financial risk that the Russian government will continue sector sanctions seem to have had the most such protectionist measures. This could delay adverse impact on domestic demand. Since they structural reforms that could help the economy were imposed, very few international financial to become globally more competitive. institutions have provided Russia with financing, and most Western financial markets remain The ruble depreciation put pressure on inflation. closed to Russian banks and companies. Even The food import ban in August stimulated an for non-sanctioned firms and banks, external acceleration of food inflation. By February 2015, financing conditions have become more difficult. food inflation had reached 23.3 percent, adding For example, bond issues for Russian companies to the already high inflation pressure from the dropped dramatically in both halves of 2014, ruble depreciation pass-through. In response to year-on-year (Figure 36). At the same time the these pressures and in support of the ruble, in the costs of issuing bonds continued to be high latter half of 2014 the CBR significantly tightened during 2014, though they started to decrease as monetary conditions (Section 1.3). Although this 2015 began (Figure 37). 18 In January 2014, Russia excluded the import of live pigs, pork, and pork products from the EU based on its phy to sanitary standards (SPS) policy. These products amounted in 2013 to US$1.3 billion in imports. On April 18, 2014, the EU requested consultations with the WTO Dispute Settlement Body (DSB) with regard to the ban on pork products. The pork product ban followed the detection of four cases of African swine fever in wild boar in Lithuania and Poland. However, The ban applies to live pigs, pork, and pork products from throughout the EU. One issue in the dispute involves localization requirements, which refer to attempts by a country or customs territory (such as the EU) to impose measures for control of diseased animals on part of its territory―such as quarantines―and to have the rest of the territory certified as disease-free. On July 22, 2014, the DSB established a panel for the dispute. 38 Russia Economic Report | Edition No. 33 III. The Economic Impact of Sanctions Figure 37: Russia corporate emerging market bond Figure 36: Bond issuance in US$ billion, US$ denominated index for Russia 25 320 20 300 15 280 10 260 5 240 0 220 H1 2013 H1 2014 H2 2013 H2 2014 1-Jan-14 1-Jul-14 16-Dec-14 20-Mar-15 Source: CBonds. Source: JP Morgan. Finally, domestic business and consumer of 2014 to net outflows, enough to make the confidence, already low due to dim growth flow of FDI into Russia negative. In the third prospects, further depressed consumption quarter alone, net FDI inflows were US$1 billion, and investment. The lack of confidence in the compared to US$12.1 billion in the third quarter face of geopolitical tensions and sanctions was of 2013. Capital outflows from Russia into tax compounded by lingering policy uncertainty. havens like Cyprus was US$4.6 billion in the third Domestic demand slackened: fixed investment quarter of 2014 and US$900 million went to contracted by 2.5 percent in 2014 and the Bermuda and the British Virgin Islands. If foreign contribution of consumption to growth dropped and domestic capital continue to be averse to to less than half that of 2013. Investment investing, Russia’s medium- to long-term growth activities initiated abroad also declined as prospects will suffer. business and consumer confidence deteriorated. Sanctions have already impacted trade flows. Total FDI into Russia plunged in the first three Some of the impact seen so far is based on early quarters of 2014; it was 47 percent lower than trade outcomes that compare quarter three the average for the same quarters in 2011- 2014 and quarter three 2013: a plunge in imports 2013. The share of FDI from countries used due to the already weakening exchange rate as tax havens, such as Cyprus, Bermuda, the and Russia’s ban on food imports from Western Caribbean, and Jersey, traditionally constitutes countries. Imports of foods and beverages from repatriated capital outflows and at 48 percent the EU sank in the third quarter of 2014, year- was high by historical standards in 2014.19 In on-year (Figure 38), and dairy product imports the first three quarters, it was mainly FDI from from the U.S., Japan, and Australia also dropped non-tax havens that declined, resulting in a 59 (Figure 39). Although the main devaluation of the percent drop; FDI from tax havens decreased ruble did not happen until the fourth quarter of by only 3 percent. However, in quarter three of 2014, it would be misleading to attribute these 2014, the pattern of FDI from tax havens shifted changes entirely to the sanctions environment. from heavy inflows into Russia in the first half Even without sanctions, the Russian economy 19 FDI in Russia was in the past closely intertwined with capital outflows. Historically, investors sought to avoid adverse features of the Russian investment climate by relocating investments offshore and engaging in round-tripping (Fabry and Zeghini 2002), though off-shoring for tax reasons is also likely. Russia’s FDI contains a large share of inbound FDI reported as originating from Cyprus and other countries, which is likely to be round-tripping FDI of Russian origin—in other words, repatriated capital which was previously part of capital outflows from Russia. After removing FDI with a reported origin in likely tax havens, the ratio of Russia’s FDI inflows for 2007-2013 was about 1.8 percent, comparable to that for India and South Africa. This comparison may understate the amount of round-tripping in Russia’s inbound FDI since it may also involve other reported sources. Russia Economic Report | Edition No. 33 39 III. The Economic Impact of Sanctions Figure 38: Russia’s food and beverage imports: Q3-2013 Figure 39: Russia’s dairy product imports: and 2014 (US$ billion) Q3-2013 and 2014 (US$ billion) 4 500 3.5 450 400 3 350 2.5 300 2 250 1.5 200 150 1 100 0.5 50 0 - EU CIS ECA EA LAC NAM MENA SA SSA ЕС USA Аustralia Q3-2013 Q3-2014 Q3-2013 Q3-2014 Source: Federal Customs Services, World Bank staff calculations. Note: EU-European Union; CIS-Commonwealth of Independent States; ECA-Europe and Central Asia, EA-East Asia and the Pacific; LAC-Latin America and the Caribbean; NAM-North America; MENA-Middle East and North Africa; SA: South Asia; and SSA: Sub-Saharan Africa. would have barely expanded due to low growth companies are able to divert products to other potential. In the future it will be even more markets. Other non-EU member countries, difficult to attribute changes in trade patterns such as Turkey and some former Soviet Union purely to sanctions, since the steep oil price drop republics(except for Moldova and Ukraine), are in quarter four of 2014 likely had more profound likely to benefit from the trade ban. effects. In 2015 oil revenues are projected to be at most two-thirds of their previous values, Latin American countries and Belarus appear which implies that Russian imports would drop to have been able to expand production and even further. exports to Russia to fill the gap in targeted items. In the third quarter of 2014 shares of The economic sanctions on Russia and its Russian food and beverage imports increased counter sanctions will benefit some countries, for Brazil, Paraguay, and Belarus (Figure 40). This but traditional trade partners might lose their stems mainly from an increase in cereal imports markets. The impact of the ban on Eastern from Paraguay and meat imports from Brazil. European EU members (the Baltics, Poland, the For example, the value of cereal imports from Czech Republic, Bulgaria, Romania, Slovenia, Paraguay went up from about US$155 million in the Slovak Republic, and Croatia) is likely to be quarter three of 2013 to US$209 million in the negative but small because they do not export same quarter of 2014—a more than 35 percent much to Russia. In total, exports of the banned increase (Figure 41). items constituted only 0.001-0.5 percent of their GDP, though for Lithuania, they constituted The impact of sanctions on Russia’s energy 2.9 percent. However, some sectors in those exports is not yet evident. Coal exports declined countries have sizable exposure to Russia; for in quarter three of 2014, year-on-year, not only instance, 68 percent of Polish apple exports and to European destinations, but also to East Asia, 65 percent of Lithuanian cheese exports went traditionally Russia’s second largest coal market, to Russia before the countersanctions were and the former Soviet Union republics, the third imposed. The net impact on these food industry largest market (Figure 42). This might reflect segments will depend on whether the exporting changes in global coal prices. Oil and gas exports 40 Russia Economic Report | Edition No. 33 III. The Economic Impact of Sanctions Figure 40: Russia’s food and beverage imports by country: Figure 41: Russia’s cereal imports by country: Q3-2013 and 2014 (US$ billion) Q3-2013 and 2014 (US$ billion) 1.8 0.25 1.6 1.4 0.2 1.2 1 0.15 0.8 0.1 0.6 0.4 0.05 0.2 0 0 il us e ay y e s A nd a nd az an in in c US ay il li a y an nd A e s nd ar an gu ru la az an in US Ch ra Br rm la gu Ita st l la la Po la ra Fr Be Br ra Uk rm er kh Po ai Be Ge ra Uk Pa th Th Ge za Pa Ne Ka Q3-2013 Q3-2014 Q3-2013 Q3-2014 Source: Federal Customs Services, World Bank staff calculations. Source: Federal Customs Services, World Bank staff calculations. seem to have seen little change so far (Figure 43). It is too early to quantify the impacts of the Oil and gas contracts are usually for set periods economic sanctions on all the targeted sectors and any changes in the traded amount and price of the Russian economy. However, the sanctions are only expected in 2015-2016. The effects of will most likely be felt most in investment, sanctions, which might reduce production due especially in oil and gas. For example, restrictions to inability to tap international financing, have on the export of high-tech oil-drilling equipment yet to materialize; they thus constitute a longer- may delay some new drilling investments. term risk. Similarly, the impact of concerted However, such investments may slow down efforts by some major importers of Russia’s oil independently when global demand is weak and and gas, including the EU, to identify alternative international oil prices low. Restrictions on new energy supplies is likely to take a long time, with medium-and long-term borrowing will restrict no immediate impacts expected. external funding for all new investments. State- Figure 42: Russia’s coal exports, Q3-2013 and 2014 Figure 43: Russia’s fuel exports: Q3-2013 and 2014 (US$ billion) (US$ billion) 3 90 80 2.5 70 2 60 50 1.5 40 1 30 20 0.5 10 0 0 EU CIS ECA EA LAC NAM MENA SA SSA EU CIS ECA EA LAC NAM MENA SA SSA Q3-2013 Q3-2014 Q3-2013 Q3-2014 Source: Federal Customs Services, World Bank staff calculations. Note: EU-European Union; CIS-Commonwealth of Independent States; ECA-Europe and Central Asia, EA-East Asia and the Pacific; LAC-Latin America and the Caribbean; NAM-North America; MENA-Middle East and North Africa; SA: South Asia; and SSA: Sub-Saharan Africa. Russia Economic Report | Edition No. 33 41 III. The Economic Impact of Sanctions owned enterprises that have been sanctioned The economic impact of sanctions on Russia have their solvency guaranteed by state is expected to linger. As geopolitical tensions resources, but global uncertainty about the persist, international sanctions will continue to environment in which they function, reinforced influence the Russian economy, especially given by international sanctions, may cause potential lower oil prices. Growth of the Russian economy foreign financiers to hesitate. This uncertainty has slackened due to unresolved structural may compound the instability in the exchange constraints and the uncertainty created by rate brought on by both low oil prices and the geopolitical tensions and sanctions. The measures the CBR is taking to compensate economic effects of the sanctions are unfolding for them. Any decline in real investment will in the context of lower global oil demand and reinforce the economic slowdown. worsening oil prices and export earnings. These trends are expected to continue through 2015, when the impact of previous and new rounds of sanctions will be felt most, pushing the economy into recession. 42 Russia Economic Report | Edition No. 33 REFERENCES ▪ Askari, H., Forrer, J., Teegen, H., and Yang J. 2003. “US Economic Sanctions: An Empirical Analysis.” Occasional Paper Series. 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Russia Economic Report | Edition No. 33 43 Annex: Main indicators 44 2014 2015 Output Indicators 2007 2008 2009 2010 2011 2012 2013 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2014 Jan Feb GDP, % change, y-o-y 8.5 5.2 -7.8 4.5 4.3 3.4 1.3 - - 0.9 - - 0.8 - - 0.7 - - 0.6 - - Industrial production, % change, y-o-y 6.8 0.6 -10.7 7.3 5.0 3.4 0.4 -0.2 2.1 1.4 2.4 2.8 0.4 1.5 0.0 2.8 2.9 -0.4 3.9 1.7 0.9 -1.6 Manufacturing, % change, y-o-y 10.5 0.5 -15.2 10.6 8.0 5.1 0.5 0.0 3.4 3.5 3.9 4.4 0.3 2.4 -0.6 3.6 3.6 -3.0 4.1 2.1 -0.1 -2.8 Extraction of mineral resources, % change, y-o-y 3.3 0.4 -2.8 3.8 1.8 1.0 1.1 0.9 0.8 0.6 1.1 0.9 0.8 0.2 0.8 2.4 1.9 2.5 3.0 1.4 1.5 0.1 Fixed capital investment, % change, y-o-y 23.8 9.5 -13.5 6.3 10.8 6.8 0.8 -7.3 -4.5 -4.7 -2.6 -2.7 -0.7 -0.9 -1.6 -1.9 -0.8 -7.8 -1.1 -2.7 -6.3 -6.5 Fiscal and Monetary Indicators 1/ Federal government balance, % GDP 5.4 4.5 -5.9 -4.1 0.8 -0.1 -0.5 9.7 0.3 0.7 0.3 1.4 1.9 1.7 2.0 2.1 1.9 1.9 -0.5 -0.5 -4.2 -7.4 Russia Economic Report | Edition No. 33 2/ M2, % change, p-o-p 51.3 27.2 -3.5 30.6 23.3 17.9 15.4 -4.0 1.1 -2.2 1.2 0.3 0.6 0.3 0.5 -0.1 -1.2 1.2 4.8 7.3 -2.1 Inflation (CPI), % change, p-o-p 9.0 14.1 11.7 6.9 8.5 5.1 6.8 0.6 0.7 1.0 0.9 0.9 0.6 0.5 0.2 0.7 0.8 1.3 2.6 7.8 3.9 2.2 Producer price index (PPI), % change, p-o-p 25.1 -7.0 13.9 16.7 13.0 6.8 3.4 0.4 -0.4 2.3 0.7 0.4 0.8 1.6 0.0 -0.8 0.3 -0.5 0.8 6.1 1.3 2.1 Nominal exchange rate, average, Rb/USD 25.6 24.8 31.7 30.4 29.4 31.1 31.8 33.5 35.2 36.2 35.7 34.9 34.4 34.6 36.1 37.9 40.8 45.9 55.4 38.4 61.7 64.6 Reserve Fund, bln USD e-o-p 137.1 60.5 25.4 25.2 62.1 87.4 87.1 87.5 87.5 87.9 87.1 87.3 86.6 91.7 90.0 89.6 88.9 87.9 87.9 85.1 77.1 National Wealth Fund, bln USD, e-o-p 88.0 91.6 88.4 86.8 88.6 88.6 87.4 87.3 87.5 87.6 87.3 87.9 86.5 85.3 83.2 81.7 80.0 78.0 78.0 74.0 74.9 Reserves (including gold) billion $, end-o-p 478 427 439 479 499 538 510 499 493 486 472 467 478 469 465 454 429 419 385 385 376 360 Balance of Payment Indicators Trade Balance, billion $ (monthly) 123.4 177.6 113.2 147.0 196.9 191.7 181.9 18.7 12.5 19.8 20.0 18.0 13.9 17.0 16.2 12.2 14.2 13.4 12.9 188.7 15.0 Current Account, billion $ 72.2 103.9 50.4 67.5 97.3 71.3 34.1 - - 26.8 - - 12.9 - - 6.4 - - 10.5 56.7 - - Export of goods, billion $ 346.5 466.3 297.2 392.7 515.4 528.0 523.3 39.6 36.5 47.0 47.7 44.1 40.6 46.2 41.5 38.1 41.1 36.7 37.6 496.7 27.5 Import of goods, billion $ 223.1 288.7 183.9 245.7 318.6 335.7 343.0 20.9 24.0 27.3 27.7 26.1 26.7 29.2 25.3 26.0 26.9 23.3 24.7 308.0 12.5 Financial Market Indicators Average weighted lending rate for enterprises, % 3/ 10.8 15.5 13.7 9.1 9.3 9.4 9.4 9.2 9.4 10.3 10.5 10.6 10.7 10.7 10.6 10.6 10.8 12.0 18.3 18.3 19.9 CBR policy rate, %, end-o-p 10.0 9.5 6.0 5.0 5.3 5.5 5.5 5.5 5.5 7.0 7.5 7.5 7.5 8.0 8.0 8.0 8.0 9.5 17.0 17.0 17.0 15.0 Real average rate for Ruble loans, % (deflated by PPI) -3.4 -6.8 -0.1 -6.5 -3.2 3.9 5.5 4.5 6.0 5.0 3.1 1.6 1.7 1.6 4.6 6.9 5.4 5.6 11.7 11.7 12.0 Stock market index (RTS, eop) 2,291 632 1,445 1,770 1,382 1,527 1,443 1,301 1,267 1,226 1,156 1,296 1,366 1,219 1,190 1,124 1,091 974 791 791 737 897 Income, Poverty and Labor Market Real disposable income, (1999 = 100%) 245.6 251.5 259.3 272.5 274.7 286.2 297.7 202.8 267.8 258.8 298.3 273.6 287.9 290.6 299.8 277.6 297.8 289.9 398.7 294.7 200.7 266.2 Average dollar wage, US $ 532 697 588 698 806 859 942 838 812 882 923 929 1,003 910 833 811 748 660 749 841 449 500 1/ Share of people living below subsistence, % 13.3 13.4 13.0 12.5 12.7 10.7 10.8 - - 13.8 - - 13.1 - - 12.6 - - 11.2 11.2 - - Unemployment (%, ILO definition) 6.1 7.8 8.2 7.2 6.1 5.1 5.6 5.6 5.6 5.4 5.3 4.9 4.9 4.9 4.8 4.9 5.1 5.2 5.3 5.3 5.5 5.8 Source: Rosstat, CBR, EEG, staff estimates. 1/ Cumulative from the year beginning. 2/ Annual change is calculated for average annual M2. 3/ All terms up to 1 year. 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