RER23 Eng Final

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Growth with moderation anduncertaintyRussian Economic Report 23November, 2010

THE WORLD BANK GROUP


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The World Bank in Russia

Russian EconomicReport 1

23November, 2010

With heightened uncertainties and moderating global and Western European growth and oilprices, and volatile capital ows, Russia is likely to grow by 4.2 percent in 2010, followed by4.5 percent in 2011 and 3.5 percent in 2012 as domestic demand expands in line with gradualimprovements in the labor and credit markets. Unemployment situation is likely to get worsebefore it gets better later in 2011. Fiscal risks have risen with likely expenditure pressures anddownside risks to oil. While there is huge diversity across regions in the patterns of labor marketrecovery, smaller regions with a larger share of SMEs, better investment climate, more FDI,and stronger nancial sector presence tend to show a more robust recovery.

Growth with moderation and uncertainty

WORLD BANK

http://www.worldbank.org.ru

1 The report was prepared by a World Bank team consisting of Sergei Ulatov (Economist), Karlis Smits (Economist), OlgaEmelyanova (Research Analyst), Victor Sulla (Economist), and Zeljko Bogetic (Lead Economist for Russia and the teamleader). Annette de Kleine, and Shane Strei er (Senior Economists) contributed on the international environment and theglobal oil market. Victor Sulla (economist) and Ken Simler (Senior Economist) authored the note in focus on unemploy-ment. The team expresses gratitude to the World Bank Global Economic Prospects team lead by Andrew Burns (Manager,

DECPG) for close collaboration and discussions on global economic environment and its linkages with Russia.


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I. Recent Economic Developments | 3

IRecent Economic Developments

Summary. The global economy has returned to moderate growth amid uncertainty, but the feared

double dip recession remains unlikely. The Europe and Central Asia regionhardest hit by thecrisisis growing slower than the rest of the world. In Russia, growth is being led more by domesticdemandconsumption and investmentand credit is beginning to ow. But the way Russianpolicymakers manage the short-term macroeconomic risks of scal spending and in ationand thelong-term challenge of competitiveness and diversi cation under tighter budget constraintwilldetermine the medium-term prospects.

Global trends moderate growthGlobal industrial production and trade have recovered to pre-crisis levels in recent

months but growth has been moderate ( gure 1.1). Industrial production has slowed world-wide (from 11.7 percent, annualized, in the rst quarter of 2010 to 8.7 percent in the second),and the bounce-back in global trade has ended ( gures 1.21.3). Growth in the value of mer-chandise trade decelerated from 25 percent in the rst quarter to just 2.5 percent in the second,raising concerns about a double dip. While growth will be slower in the next few quarters, adouble dip is unlikely. This moderate growth will not make big inroads into high unemploy-ment and spare capacity.

In developing countries, growth is also easing but remains robust in developing Asia . Chinas growth eased from 11.1 percent in the rst half of 2010 to a still vibrant 9.6 percentin the third quarter (on a seasonally adjusted annualized basis), with industrial productionslowing in tandem from 18 percent to 7.9 percent. In India growth slowed from 11.2 percentin the rst quarter to 10 percent in the second. Other large middle-income countries includingBrazil, South Africa, Malaysia, and Thailand show similar trends. Excluding China, industrialproduction for developing countries has stalled, slipping from 10.2 percept growth in the rstquarter 2010 to minus 0.5 percent in the three-months ending in August.

Non-bank capital ows to developing countries (such as bond issuance) continue torecover, but bank ows remain weak. CDS spreads for developing countries with goodcredit histories and conditions (including Russia) have not risen, while those of more vul-nerable developed countries have increased ( gure 1.4). Since May 2010 bond spreads havenarrowed, and bond issuance by sovereigns and emerging market corporations has pickedup ( gure 1.5). With large repayments and limited new ows, however, net bank ows todeveloping countries are likely to be negative this year. Equity ows to developing coun-tries reached USD 72 billion over the year to date, 50 percent above 2009 levelsmostly

to China. FDI ows to developing countries so far remain close to the second half of 2009.They are expected, however, to reach USD 438 billion in 2010, up from USD 364 billion in2009. But outward FDI from middle-income countries has remained more resilient that thatfrom high-income countries.


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4 | Russian Economic Report. 23. November, 2010

Figure 1.1. Domestic demand strength in U.S. and Europe offset or amplified by external trade

Domestic demand growthgrowth at seasonally-adjusted annualized rates

Foreign tradecontribution to growth a annualized rates

Source: World Bank, DEC Prospects Group.

Figure 1.2. Global Industrial production

Output momentum fading acrossall developing regions industrial production,

% seasonally adjusted annualized rate

Figure 1.3. Global Trade

Global trade growth is slowing rapidly aspre-crisis levels regained

Source: World Bank, DEC Prospects Group.

Figure 1.4. Selected CDS spreads Figure 1.5. Capital flows to developing countries

5-year sovereign credit-default swaps,basis points (bps), 2010

Source: Global prospects, World Bank.

Most countries in the Europe and Central Asia (ECA) regionwhich was hardest hit bythe crisisreturned to growth, albeit less robust than in other regions. Growth in the region is

driven by the bounceback of external trade but domestic demand is also growing, especially


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in the largest regional economies, Russia, Poland, and Turkey. Metals prices, important forexporters such as Russia, are back to pre-crisis levels, as are many food prices. Capital in owsrose to about 10 percent of the regions GDP (from just over 7 percent) on account of of cial ows, FDIs, and other private ows. However, this moderate growth in most countries isunlikely to make a big dent in the high unemployment, especially in the Central and EasternEuropean countries, while in the CIS countries, unemployment is lower, but continues to rise

in several countries.Figure 1.6. Most economies in the Europe and Central Asia contracted in 2009

(real GDP growth, %)

Source: WB staff estimates.

Figure 1.7. And most returned to growth in 2010

Source: WB staff projections.


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Figure 1.8. Unemployment (left panel) and labor force aggregates (right panel)

Source : Rosstat.

A more detailed look at the hiring and ring of workers suggest that only a few sectorsresumed signi cant hiring. These data and the replacement ratio of the number of hired and

red workers in major sectors suggest that the economy is not absorbing enough labor tomake a sustained dent in the unemployment rate. Finance is the only sector in which hiringrates now exceed the ring rate, after a period of large job losses. Manufacturing, energy andgas, transport, and communication are gradually improving, if still with fairly low replace-ment ratios ( gure 1.9). Vacancy data also indicate that manufacturing is the only major sectorlooking for quali ed workers ( gure 1.10). And the coming winter season is bound to resultin seasonal increase in the overall unemployment.

Figure 1.9. Hiring and firing in the economy (left panel) and major sectors (right panel)

Source : Rosstat, WB staff calculations.

Figure 1.10. Vacancies in the economy (left panel) and by sectors (right panel)

Source : Rosstat.

0

1

2

.09

.09

.10

.10

Replacement rate (hiring/ring) by selected sectors

200

250

300

350

400

thousands

dec. 08

feb. 09

apr. 09

jun. 09

aug. 09

okt. 09

dec. 09

feb. 10

apr. 10

jun. 10

aug. 10


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TABLE 1.3. Labor productivity, disposable income, wages, and unemployment, 20062010

2006 2007 2008 2009 2010

Jan-Dec Jan-Dec Jan-Dec Jan-Dec Jan Sep Sep

GDP growth, percent, year on year .................................... 8.2 8.5 5.2 -7.9 4.2 a n/a

Total employment, million people ...................................... 68.8 70.5 70.9 69.4 69.7 71.1

Employment growth, percent, year on year ........................ 0.8 2.4 0.5 -2.1 0.3a -0.1Labor productivity growth, percent, year on year .............. 7.3 6.0 4.7 -5.9 3.9 a n/a

Real disposable income growth, percent, year on year ...... 13.5 12.1 1.9 1.9 4.8 1.5

Real wage growth, percent, year on year ........................... 13.3 17.2 11.5 -2.8 5.0 5.1

Average monthly wage, USD .............................................. 392.5 533.2 692.1 593 678.2 703.2

Unemployment (percent, ILO definition, e-o-p) ................. 6.9 6.1 7.8 8.2 6.6 6.6

Source : Rosstat.a Data for the first half of 2010.

Balance of payments improved, but then deteriorating due to a rapidgrowth in imports

The external current account balance improved in the rst half of this year due to higher oil prices and sluggish imports, but deteriorated in the third quarter as imports picked up.According to the preliminary estimates from the Central Bank of Russia (CBR), the currentaccount surplus amounted to USD 60.9 billion in the rst three quarters of 2010, up from onlyUSD 33.3 billion in the corresponding period of 2009, mainly because of higher-than-expectedoil and resource prices ( gures 1.111.12). But in July-September, import growth accelerated,and the trade balance narrowed considerably despite relatively high oil prices. According topreliminary estimates, the current amount surplus narrowed to only USD 8.7 billion in thethird quarter, compared with USD 33.5 billion and USD 18.7 billion in the rst two (table 1.4).The current account surplus is likely to narrow further in the last quarter of 2010, re ecting

further import growth supported by economic recovery.TABLE 1.4. Balance of payments (USD billions), 20062010

2006 2007 2008 2009 H1-09 H1-10 Q3-2010 a

Current account balance ....................................... 94.7 77 103.7 49.4 17.9 52.2 8.7

Trade balance ...................................................... 139.3 130.9 155.4 111.6 43 86 28.5

Capital and financial account ................................ 3.3 84.8 -131.3 -43.49 -29.3 -2.3 -4.4

Errors and omissions .......................................... 9.5 -12.9 -11.3 -2.6 -4.9 -7.2 -1.6

Change in reserves (+ = increase) ........................... 107.5 148.9 -38.9 3.4 -16.3 42.7 2.7

Source: CBR a Preliminary estimates.

With a lower current account surplus and downside risks for capital account, the balanceof payments position could deteriorate toward year-end. Net capital out ows from Russiafell during the rst nine months of 2010, allowing the balance of payments to strengthen andthe CBR to accumulate USD 51 billion in international reserves. According to the CBR pre-liminary estimates, the capital account registered an out ow of only USD 6.7 billion duringthe rst nine months of 2010 compared to USD 56.3 billion in the corresponding period of2009. But disaggregated data convey a more mixed picture: capital ows remained volatile,with net in ows into the banking sector but sizeable out ows from non-banking corporations(table 1.5). With the uncertain global growth and capital ows to emerging markets, Russiasbalance of payments position could deteriorate further toward year-end, becoming more vul-nerable to a new terms-of-trade shock due to a drop in oil prices.


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Figure 1.11. Oil prices and the trade balance Figure 1.12. Current account balances and the realeffective exchange rate

Source : CBR and World Bank staff estimates. Source : World Bank staff calculations based on Rosstat and CBR data.

TABLE 1.5. Net capital ows (USD billions), 20062010

2006 2007 2008 2009 H1 2009 H1 2010 Q3 2010

Total net capi tal inflows to the private sector ................. 41.4 81.7 133.9 56.9 -31.6 -11.8 -4.2

Net capital inflows to the banking sector ..................... 27.5 45.8 56.9 31.4 -12.8 7.6 8.3

Net capital inflows to the non banking sector ............... 13.9 35.9 77 25.4 -18.9 -19.5 -12.4

Source : CBR.

External debt Private sector repaying its debtOf cial debt statistics suggest that massive deleveraging in the banking sector in 2009

slowed down . According to CBR, the outstanding external debt of the banking sector declined

only marginally to USD 120.1 billion by end-June 2010, from USD 125.7 billion at end-December2009 (in 2009 the banks total outstanding debt fell by almost USD 40 billion, or 24 percent). Asexpected, no major defaults on foreign debt obligations by banks were reported in this period.Although the banks aggregate rollover capacity might have improved, the banks seem tohave restarted short-term borrowing. Their outstanding short-term liabilities increased to USD30.3 billon by end-June 2010, up from USD 27 billion at the end of 2009 and USD 24 billion atthe end of Q3-2009. It is likely that the banks are using (at least partly) short-term borrowingsto pay off their long-term liabilities. In the second half of 2010 the banks have to pay about USD24.3 billion (including interest payments), most in the third quarter.

The external debt exposure of private non nancial corporations fell in the rst half of 2010, likely re ecting limited rollover capacity. According to the CBR, the outstanding ex-ternal liability of private non- nancial corporations fell to USD 234 billion at the end of June2010, from USD 249 billion at the end of 2009. So, many companies were forced to delever-age their balance sheets. Thus the aggregate external debt exposure might fall further byyear-end. According to the CBR, private non- nancial corporations have to pay almost USD50.3 billion in the second half of 2010 (including interest), with USD 24 billion falling due inthe last quarter of the year.

Monetary policy and creditsin search of a ne balanceMonetary conditions remained loose in the third quarter as the CBR kept its key policy

rates unchanged despite an in ation scare from rising food prices. Gradual loosening of mon-

etary conditions in 2009 and 2010 resulted in a 33 percent increase in money supply (M2) by


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August 2010 (y-o-y). Given the recovery in money demand, the observed rapid monetizationof the economy could have been excessive and led to a buildup in in ationary pressures. Thesituation was complicated by rising food prices in August-September 2010 due to a severedrought in the European part of Russia. According to Rosstat, the declining in ation trendreversed in August, with 12-month CPI in ation rising to 7.0 percent in September, up from5.5 percent in July ( gure 1.18). Also, in September 2010, producer prices increased by 8.2 per-

cent relative to December 2009 (by 10.5 percent in manufacturing). But despite rising in a-tionary pressure the monetary authorities kept the re nancing rate unchanged, but revisedits end-year in ation target up by 1 percentage point to 7.5 percentto account for a one-offeffect of food prices.

The CBR is currently facing a dif cult trade-off between keeping the main policy rateslow and a potential buildup of in ationary pressure. The problem with the currently lowrate is that even with the rapid monetization of the economy (M2 increased by 33 percentin August 2010, year-on-year) and considerably improved liquidity in the banking sector,credit activities remained very weak during 2010. Net credit to the private sector increasedslightly in April-August 2010 ( gure 1.14). But most of this increase is due to new credits toenterprises, while net credits to households remained limited. With real policy rates now in

negative territory, the observed marginal recovery in credits suggests supply constraints inthe banking sector.Banks have been keeping wide spreads between the re nancing rates and effective lend-

ing rates ( gure 1.13). This suggests that most banks still perceive credit risks of potentialborrowers (especially households) as very high. Given the slow economic recovery and lowpro tability, prevailing interest rates on new loans for rms and households remain high (ef-fective rate for consumer loans may vary from 18 to 40 percent). Under these conditions, somemonetary tightening might not affect credit, but may limit in ationary pressure.

The recovery in credits depends, among others, on strengthening of bank balance sheetsand increases in borrower pro tabilityand this will take time. Data from the CBR suggestlittle or no improvement in the share of non-performing loans during 2010, although theirrise has slowed substantially. On October 12 Moodys Investors Service raised the outlookfor Russias banking sector to stable from negative, citing its improved liquidity andloan-loss provisioning buffers. Interestingly, many banks restructured a large share of defacto non-performing loans during 2009 and 2010 although the nature of such restructuringvaries widely. The Russian banking system is relatively well provisioned (18 percent of totalloans), but the long term performance of many restructured loans remains uncertain, whichmeans that such banks may be under-provisioned and some under-capitalized.

Figure 1.13. Lending rates and inflation in Russia20062010

Figure 1.14. Stock of credits to companies andhouseholds in 20072010

Source : CBR; World Bank staff estimates.


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Faced with balance of payments pressures and remaining volatility in oil prices, CBRhas further widened the exchange rate corridor. In March 2010 the CBR, moved to a more exible exchange rate management, smoothing volatility but not defending the absolutelevels of the targeted corridor for the Euro/USD currency basket. This made the CBR policymore effective in avoiding a possible carry-trade and destabilizing speculation against theruble. However, with deteriorating balance of payments and capital account volatility, CBR

prudently decided in October to widen the exchange rate corridor and further reduce the sizeof interventions in a move to make the exchange rate more exible and less predictable in theface of volatile external conditions.

Fiscal policy rising scal risksThe scal outcome for 2010 is likely to be better than expected as a result of favorable

oil prices. According to preliminary Min n estimates for the rst nine months of 2010, theFederal budget was executed with a de cit of only 2.2 percent of GDP, down from 4.0 per-cent of GDP in the same period in 2009 and a budgeted de cit level of 5.4 percent of GDP for

2010. This is mainly due to higher revenues from oil: in Jan-Sep of 2010 revenues amountedto 18.3 percent of GDP, up from the budgeted 17.3 percent for 2010. Similarly, expendituresin the rst nine months of this year were only 20.5 percent of GDP, down from 22.7 percentof GDP in the budget. But budget execution will accelerate in the nal quarter of the year,resulting in the higher de cit than so far in the year, but lower than budgeted.

The Government is now planning a gradual scal adjustment to eliminate the federalde cit by 2015. The draft Federal budget law for 20112013 indicates a commitment to reducethe federal budget de cit from 5.4 percent of GDP in 2010 to 2.9 percent in 2013 (table 1.6).

TABLE 1.6. Medium-term scal parameters (as a share of GDP

2009 2010 2011* 2012* 2013*

Revenues (Consolidated) .......................................................................34.4 33.4 35.0 34.0 32.8

Of which Federal budget . .. .. .. .. .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. ... .. .. .. .. .. .. . 18.8 17.3 17.4 16.5 16.1

Expenditures (Consolidated) ................................................................... 40.6 39.1 38.7 37.0 35.2

Of which Federal budget . .. .. .. .. .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. ... .. .. .. .. .. .. . 24.7 22.7 20.9 19.6 19.0

Federal budget Non-oil deficit ................................................................. -13.6 -13.7 -11.6 -10.5 -9.8

Federal budget balance ........................................................................... -5.9 -5.4 -3.6 -3.1 -2.9

Consolidated budget balance ................................................................. -6.2 -5.7 -3.7 -3.0 -2.4

* Draft Budget.Source: World Bank staff estimates based on draft budget documents, the Ministry of Finance.

On the expenditure side, despite sizable changes in expenditure priorities, Russia faces

additional expenditures to close the infrastructure gap, support diversi cation, and imple-ment military reform. According to the draft federal budget for 20112013 aggregate expendi-ture reductions total 3.7 percent of GDP. And the federal government has an ambitious planto increase scal space to almost 6 percent of GDP over the next three years by reprioritizingand optimizing existing expenditure structure. Although this is ambitious, it might not beenough to address additional spending pressures likely to emerge over the medium term.Russias well documented demographic trendsdeclining population, aging, and increasingdemand for pension and health services and the changing structure of demand for educa-tionwill increase social expenditures by 3.5 percent of GDP in 20162020. 21 2 Bogetic, Zeljko, Karlis Smits, Nina Budina and Sweder van Wijnbergen (2010). Long-Term Fiscal Risks and Sustainability in

an Oil-Rich Country: The Case of Russia, World Bank Policy Research Paper No. 5240, 2010/03/17, World Bank, Washington

D.C. Available at the World Banks external website www.worldbank.org.


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TABLE 1.7. Preliminary estimates of additional funding needs in 20112013 (as a share of GDP)

2011 2012 2013 Total

Net Expenditure Measures ........................................................................................... -1.8% -1.3% -0.6% -3.7%

1. New spending pressures .......................................................................................... 1.2% 0.3% 0.6% 2.1%

Transport .................................................................................................................. 0.1% 0.1% 0.1% 0.3%

Military ..................................................................................................................... 0.1% 0.0% 0.4% 0.5%International events* ................................................................................................ 0.0% 0.3% 0.4% 0.7%

Health ....................................................................................................................... 0.5% -0.1% -0.2% 0.2%

Modernization/Innovation ......................................................................................... 0.5% 0.0% -0.1% 0.5%

2. Reprioritization of existing expenditures .................................................................. -3.0% -1.6% -1.3% -5.8%

Net revenue measures ................................................................................................. 0.0% -0.8% -0.4% -1.2%

Oil revenues ............................................................................................................. -0.3% -0.7% -0.5% -1.4%

Non-oil revenues ...................................................................................................... 0.3% -0.2% 0.1% 0.2%

Net consolidation ......................................................................................................... 1.8% 0.5% 0.2% 2.5%

* Sochi Olympic games in 2014, APEC summit, Summer University in Kazan.

Oil and gas revenues are expected to decline by a cumulative 1.4 percent of GDP in themedium term due to at output not offset by higher mineral prices. A drop in oil revenuespresents two challenges. First, the non-oil revenue base remains narrow and is unlikely tooffset oil revenue shortfalls without additional increases in excise taxes or broadening ofthe non-oil base. Second, and more important, the draft federal budget is based on a favor-able oil forecast the price of Urals is estimated to be USD 75 per barrel in 2011, USD 78 in2012, and USD 79 in 2013. Although this forecast is broadly consistent with market expecta-tionsthe World Bank oil price forecast (Dubai, Brent & WTI) is USD 73.2 a barrel in 2011,USD 73.1 in 2012 and USD 74.6 in 2013such oil prices make Russia more vulnerable to anew, sudden drop in oil prices ( gure 1.15). If, for example, oil prices fall to USD 60 a bar-rel (close to the long-term historical average), oil revenues could fall by 2.0 percent of GDP,pushing the de cit in 2011 well above 5 percent of GDP and raising the issue of nancingsuch a large de cit.

Figure 1.15. Initial oil price assumed in the draft budgets vs. actual price andWorld Bank forecast

Source: State Duma database, Bloomberg, WB


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Box 2. A sizeable but temporary grain shock

In 2010, Russia has experienced the worst drought in decades, contributing to higher food prices. The lack of rainfall in Central Russia and in the West along the Volga river caused a massivedrought affecting many food items. The harsh weather has destroyed close to 40 percent of crops in theaffected regions producing grains, meat and potato. Bloomberg noted that the drought led to the biggestjump in the price of wheat since 1973, affecting a range of food prices (e.g., meat and dairy products).So prices of grains and related products have been soaring since July, 2010. During June-October, buck-wheat prices more than doubled and potato prices rose by 30 percent. Prices of meat, eggs and cerealshave increased more than typical during the summer period (Figures 1-2.). As the worlds third largestgrain exporter, the drought also played a role in global food developments, but less than feared.

Figure 1. Changes in prices of selectedfood prices

Figure 2. Domestic buckwheat price shock:Ten most affected regions

Source : ROSSTAT. Weighted by share of householdconsumption for each item.

Source : ROSSTAT, June 4 October 7 th period.

Figure 3. Poverty increase due to changesin grain prices

Twenty seven (out of 88) regions in Russia havedeclared emergency at the onset of the drought. The prices increases spread all over the country, butregions in Central and Western Russia were particularly

affected. The largest increases in buckwheat priceswere observed in the Moscow oblast (149 percent),Vladimirskaya oblast (148 percent), and in Kostromaoblast (147 percent). In Russia, one-time increases infood prices are somewhat confused by the public asa return of sustained inflation and this inflation scarewas no exception. So for this reason and for reasonsof policy, it is useful to understand just how deep andsustained was the impact on household welfare?

Source: World Bank staff estimates using householdsurvey data.

To this end, we use a micro-macro simulation method to estimate the impact of the food price shocks on the household consumption and poverty. The net effect of the price shocks on thehouseholds consumption has been estimated as a loss in real household income due to an increase inexpenditures as result of higher food prices. Figure 3 illustrates the impact of the drought on selectedpopulation groups, categorized by the sector of employment. It appears that the net direct and indirect effect of the drought will result in 1.0 percentage point increase in poverty rate in the entire country morethan 1.4 million people may have temporarily fallen into poverty (on top of the 13.6 percent of the Russianpopulation in poverty in 2010), holding all other factors constant, including any increases in wages andsalaries that may take place since the beginning of the shock. This is not a marginal impact even thoughit is a one-time shock likely to dissipate over time with increases in household incomes. Pensioners andothers on fixed incomes are the most vulnerable group with a 2.6 percentage point increase in poverty.In sum, the household income loss and the impact on poverty was sizeable but temporary. This is animportant finding in a debate to formulate appropriate policy (Box 3).


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Box 3. Policy debate effectiveness of the temporary export ban on grain.

On August 5, in response to the escalating grain prices, the Russian government imposed atemporary export ban on wheat, barley, rye, maize, wheat and wheat-and-rye flour from August15 to December 31 2010; on October 20 the Russian government extended export ban on graintill the end of June 2011 yet flour export ban was not extended . The export ban is a responseto the drought induced shortfall in the grain harvest and the associated rapid grain price increases. According to the preliminary official estimate for October 20 farmers harvested 62.3 mln tons of grain,a decline of 36.8% compared to 2009, resulting in sharp increases in grain prices in domestic as wellas in international markets.

The export ban is aimed to insulate Russia from highly volatile world grain prices by reducingexports in 2010-11 to the 3 million tons already shipped, resulting in a drop of nearly 12 milliontons compared to initial projections for the year. Nevertheless, given the current production estimates,and domestic consumption estimated at 78m tons, it is likely that Russia will become a net importer ofgrain, depending on the use of reserve stocks 1.

In these circumstances, the export ban will be largely ineffective in reducing domestic pricesas they will continue to be influenced by world grain prices. For Russia, an export ban could alsohave unintended and often undesirable side effects such as undermining Russias long-term policy goal of

becoming an important player in the global grain market; encouraging hoarding in expectation of the bansremoval; distorting prices and affecting the investment and production responses .

Alternatively, domestic inflationary pressures and food security could be addressed in theshort term by

Using global markets to fill any temporary grain shortfalls. Protecting the poor through reducing taxes and tariffs on key food products. Making full use of the grain intervention fund to reduce pressures in the domestic market .

And in the medium to long run by: Targeting cash transfers to vulnerable groups. Various kinds of cash transfer programs are currently

used in many countries including Brazil, China, Mexico, and South Africa. Cash transfers are effectivein ensuring income transfers to vulnerable population segments and, unlike export restrictions, do notreduce farm-gate prices and induce a negative supply response.

Improving transport and logistics. In many countries, transport and logistics costs are a key com-ponent of food prices and are generally far higher than OECD benchmarks of around 9 percent. While countries can do little to reduce ocean shipping costs, they can act to lower the overall cost ofdomestic distribution . Severe difficulties with exporting the 2008 bumper crop in Russia highlight theimportance of sufficient and efficient transport and distribution infrastructure.

Encouraging a more robust agricultural insurance framework. Russian farmers have keen perceptionsof risk, but they are concerned about high premium costs and inadequate claims settlements; on thewhole, they remain seriously underinsured. It would also boost investment in infrastructure such ason-farm storage, making natural disasters somewhat more manageable.

Increasing priority to public investment programs to support (a) agricultural productivity improvements(b) national irrigation development and rehabilitation program and (c) nation-wide price market priceinformation services.

Strengthening capacity for food policy formulation. 1 Grain stocks are estimated at 26.3m tones as of July 1, 2010, of which 9.6 m is part of governments grain intervention fund.

The federal budget de cit is planned to be nanced mainly from domestic borrowing supplemented by a modest amount of external borrowing. In 2011 part of the de cit will be nanced by a drawdown of the reserve fund, but in 20122013 the de cit will be nancedmainly from domestic sources. The domestic nancing sources include the privatizationrevenues from the sale of state assets, about 0.5 percent of GDP a year, and the issue ofdomestic bonds.


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TABLE 1.8. Preliminary estimates of additional funding needs in 20112013 (as a share of GDP)

2008 2009 2010Draft Federal budget law

20112013

Actual ActualOriginal

lawRevised

lawActual

(Jan-June) 2011 2012 2013

Total deficit ................................................... -4.1% 5.9% 6.8% 5.4% 2.0% 3.6% 3.1% 2.9%

1. Drawdown from the oil funds..................... -4.8% 5.2% 5.2% 3.2% 1.9% 0.5% 0.0% 0.0%

2. Net external financing ............................... -0.3% -0.3% 1.0% 0.2% 0.6% 0.1% 0.1% 0.1%

3. Net domestic financing 1.0% 1.1% 0.6% 2.1% -0.6% 3.0% 2.9% 2.7%

Source: World Bank staff estimates.

Reliance on domestic nancing of the de cit presents at least two sets of challenges.First, although there is enough liquidity in the domestic market to nance an overall scalde cit below 3 percent of GDP, even if the 20112012 budgets are implemented as planned,there is a real risk that interest rates will rise and crowd out bond issues by SOEs or large

enterprises. Second, the scal adjustment on the expenditure side could become slower andthe de cit higher in the election cycle in 20112012, putting further pressure on the domesticmarket, aggravating the interest rate and crowding out effects.

Given the scal constraints, some post crisis priorities might be nanced by off-budget vehicles, increasing contingent liabilities. The budget code limits the governments abilityto lend directly to commercial entities, so the Vneshekonombank (VEB) has become a defacto source of long-term nancing for large investment projects in infrastructure and otherstrategic sectors. It is expected in the medium-term that the VEB will support governmentspriorities in fostering innovation, modernization, and diversi cation (including addressingthe monotowns). The VEB is also supporting preparations for Sochi Olympic Games in 2014. Inrecent years it has bene ted from capital injections nanced by the federal budget. 32

Overall, scal risks have increased, suggesting the need to rethink the scal strategy inthe face of heightened uncertainty and downside risks in the oil market . First, the pace of s-cal adjustment in the 20112013 budgets is slower than initially envisaged, pushing the harddecisions on expenditure adjustments into the future. As discussed in the RER22, a morerapid adjustment would lead to a faster convergence of the non-oil scal de cit to a long-term sustainable level of about 4.3 percent of GDP. Second, as in other countries, expenditurepressures may increase in the election cycle 20112012 leading to further weakening of scaladjustment. Third, with high budgeted price of oil close to the current forecast, Russias bud-get has lost the cushion it had in previous years, becoming more vulnerable than in the pastto sudden drops in the price of oil. A sustained USD20 dollar drop from the current levelscould raise Russias scal de cit in 2011 by two percentage points of GDP.

3RUB 180 billion in 2007, RUB75 billion in 2008, RUB121 billion in 2009.


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II. Economic and Social Outlook for Russia 20102011 | 17

IIEconomic and Social Outlook for Russia,

20102012

Summary: With moderating global and Western European growth, uncertain oil prices and capital ows, Russia is likely to grow by 4.2 percent in 2010, followed by 4.5 percent in 2011 and 3.5 percent in2012 as domestic demand expands in line with gradual improvements in the labor and credit markets.With such moderate growth prospects, unemployment situation is likely to get worse before it getsbetter later in 2011.

Preliminary updates to the World Banks forecast suggest global GDP growth of about 3.5 percent this year, slowing to 3.2 percent in 2011 before recovering to around 3.6 percent in 2012 . Developing countries are expected to continue outperforming high-income countriesby a wide margin, with GDP growth of about 6.6 percent in 2010 and just less-than 6 percentin 2011 before rming somewhat in 2012 (table 2.1). This compares favorably with the2.5, 2.3 and 2.8 percent anticipated for high-income countries. Excluding China and India,developing countries are projected to grow at 5.2, 4.5 and 4.8 percent, with average growthabove 4 percent in all regions (except Sub-Saharan Africa), and above 7 percent in East- andSouth Asia.

TABLE 2.1. The summary of the global outlook

2009 (actual) 2010 2011 2012

World ................................................................................... -2.1 3.5 3.2 3.6

High income countries ......................................................... -3.3 2.5 2.3 2.8

Developing countries ............................................................ 1.8 6.6 5.9 6.1China .................................................................................... 8.7 9.5 8.5 8.2

Japan ................................................................................... -5.2 2.4 1.6 2.0

The United States ................................................................. -2.6 2.6 2.3 2.9

Euro area .............................................................................. -4.1 1.3 1.7 2.1

Russia .................................................................................. -7.9 4.2 4.5 3.5

Source: Global Economic Prospects, The World Bank.

The global transition from todays very loose macro policies to a more neutral stanceis a key challenge for all countries . Too abrupt a tightening could cut into the recoverytooslow a response could see demand outstripping supply. The latter point is of special concerngiven uncertainty over potential outputespecially in high-income countries at the heart ofthe nancial crisis. If recent research suggesting that nancial crises tend to reduce potentialoutput by between 4 and 6 percent of GDP is correct, then the U.S. and European economiescould be close to their potential, with high structural unemployment. If so, an excessive de-mand stimulus and low interest rates could be counterproductive, leaking out imports andrecreating earlier imbalances. For developing countries, many of them already at or closingin on potential GDP, tightening may attract unwanted and potentially destabilizing capitalin ows, as the difference between their interest rates and the low interest rates in high-incomecountries widen.


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Box 2.1. World Oil Market: Recent Developments and Prospects

Developments. Oil prices (WB average) have been relatively stable over the past 13 months,averaging around $77/bbl. Prices have been supported by strong demand in China and the U.S., and largeproduction restraint by OPEC producers. However, prices have been unable to rise sustainably higherbecause of large stocks, substantial surplus capacity of oil production and refining, strong increases innon-OPEC supply, and concerns about the outlook for the global economy. In October, prices rose above$83/bbl, partly due to a weak dollar and tight distillate market. A strike at the large French Mediterraneanport of Fos-Lavera began September 27 th, and spreading strikes closed most of Frances refineries, whileprotestors blocked oil product depots resulting in fuel shortages at many of Frances petrol stations. Sofar the impact has been local and had limited impact on global crude and product markets, a reminderthat supply is plentiful. Crude stocks on-land remain high, especially in the U.S., while much of the largefloating storage earlier in the year has been brought ashore. Product inventories remain high on-land andat-sea, particularly middle distillates, but a lengthy strike in France could pull product stocks lower.

The price of Urals crude has fallen dramatically relative to Brent from its recent highs because of theFrench strikes. With millions of barrels blocked at the French Fos-Lavera terminal, refiners are limitingtheir spot purchases, and Urals sellers have to find alternative buyers.

World oil demand growth has been strong this year, with OECD demand turning positive in 2Q 2009and joining very strong gains in non-OECD countries, particularly China. Global oil demand is projectedto increase by 2.1 mb/d or 2.5% in 2010, topping the pre-crisis peak in 2007, and recording the largestvolumetric increase in more than 30 years with the sole exception of 2004. Meanwhile, non-OPEC sup-plies have recorded very strong growth, with output up more than 1 mb/d in the first three quarters ofyear. Russias oil production has risen by 0.2 mb/d in each of 2009 and 2010 due to new fields coming onstream, such as Rosnefts Vankor field in East Siberia, and TNK-BPs Uvat project in West Siberia

OPEC producers have largely maintained their production cuts in an effort to keep prices within a$7080/bbl range, which they deem acceptable. OPECs spare capacity is around 6 mb/d, with about5 mb/d of the surplus is in the Gulf, and nearly two-thirds of the total in Saudi Arabia.

Prospects. Oil prices are expected to remain relatively constant in real terms over the forecast period,with the WB average currently projected at $76.4/bbl for 2010. Nominal prices are projected to drop to$73.2/bbl, owing to a large drop in the WB MUV index. The market is expected to remain well suppliedgoing forward with large spare capacity in OPEC production and global refining. Oil demand is expected

to increase by 1.2 m/bd or 1.4% in 2011, with all of the growth in developing countries. Non-OPECsupply is projected to grow by at least 0.5 mb/d, and OPEC NGLs are expected to increase by more than0.6 mb/d. This leaves a very modest call on OPEC crude oil production, and thus the oil market balanceis not expected to change materially. This suggests that oil prices will continue trading around levelsof the past year. Downside risks would be slower growth in oil demand, a further climb in inventories,and leakage of OPEC oil onto the market. Upside risks would include stronger demand in developingcountriesincluding emergency stock building in China when its new strategic petroleum tank capacitycomes online in the middle of next yeardisappointing non-OPEC supply, further depreciation of thedollar, and lack of an OPEC response should prices rise above the $70-80/bbl range.

Figure 2.1. World Bank oil price forecast; Average crude(Brent, Dubai and WTI), simple average, $/bbl

Source: World Bank Staff


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II. Economic and Social Outlook for Russia 20102011 | 19

With a slower-than-expected recovery in the rst quarter of 2010 and remaining downsiderisks to global economic recovery, we revised our real GDP projection to 4.2 percent in2010, followed by a 4.5 percent growth in 2011, and 3.5 percent in 2012 (table 2.2). After adisappointing rst quarter in 2010, the growth momentum has been regained throughout Q2and Q3, supported by recovery in household consumption and inventory restocking. In thesecond half of 2010, the sources of growth are likely remain the same, while net exports are

expected to be a drag on growth, as import volumes pick up in line with economic recovery( gure 2.2). We expect that the pace of economic growth in 2011 and 2012 will be constrained,and will depend on sustained gains in consumption and the pace of recovery in longer termcredit to the private sector, needed to facilitate growth in xed investment.

TABLE 2.2. Outlook for Russia, 20102012

2010 2011 2012

World growth, % ........................................................................................................................... 3.5 3.2 3.6

Oil prices, average, USD/bbl .......................................................................................................... 76.4 73.3 73.1

Russia

GDP growth, % .................................................... ..................................................................... 4.2 4.5 3.5

Consolidated government balance, % ....................................................................................... -4.4 -4.0 -3.1

Current account, USD bln. ......................................................................................................... 70 30 18

Capital account, USD bln. .......................................................................................................... -10 23 54

Source: Global Economic Prospects (World growth and oil prices), and Russian Economic Report, The World Bank.

Given the outlook for oil prices and rapid growth in import volumes, we expect thecurrent account to deteriorate in the last quarter of 2010, and further in 2011 and 2012. Thecapital account, by contrast, is expected to improve through 2011-2012, while capital owsare likely to remain volatile. If oil prices remain at their forecast levels, the surplus on theexternal current account would amount to about USD 70 billion in 2010 (about 4.9 percentof GDP) and would deteriorate to USD 30 billion in 2011 and further to USD 18 billion in2012. Given the limited rollover capacity of the private sector in 2010, the capital accountis projected to have a de cit of about USD 10 billion. But re ecting an increase in non-debtcapital in ows, lower debt repayments, and improved borrowing capacity of banks andnon- nancial corporations, we expect the capital account to improve to surpluses of USD 23billion in 2011 and USD 54 billion in 2012. As the current account deteriorates in 2011 and2012, the exchange rate will be increasingly driven by net capital ows, if oil prices remainwithin the projected range.

An increase in scal revenues due to higher oil prices is likely to be partly offset by newpressures from additional spending on infrastructure and modernizing the economy. Weproject the scal de cit at 4.4 percent of GDP in 2010, 4.0 percent in 2011, and 3.1 percent in

2012, given the global oil price projections. With the reserve fund down to less than 3 percentof GDP by the end of 2010 ( gure 2.4) the expected budget de cit in 2011 and 2012 will haveto be also nanced by domestic and (larger than planned) external borrowing. The downsiderisks associated with highly volatile oil prices and global demand will remain.

Given the current trends, in ationary pressure could intensify toward year-end. Buttightening of the monetary conditions could contain in ation later in 2011 and 2012. CPI in a-tion in 2010 is projected in the range of 8 to 9 percent, re ecting the substantial monetizationof the economy and a one-off effect of rising food prices. The upside risks for in ation willremain in 2011, re ecting the lag between the current money supply growth and its impacton prices, as well as possible monetization of the remaining scal gap. Thus we do not expectCPI in ation to decline below 8 percent in 2011 or below 7 percent in 2012, unless the scalstance is considerably tightened.


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III. In Focus: Unemployment and Recovery Across Regions | 21

IIIIn Focus: Unemployment and Recovery

Across Russias Regions

Summary. Regions that suffered most are the most developed, but they are not necessarily leading therecovery. While there is huge diversity across regions in the patterns of labor market recovery, smaller regions with a larger share of SMEs, better investment climate, more FDI, and stronger nancial sector presence tend to show a more robust recovery.

While the recovery is evident in the Russian labor market, the situation varies widelyacross Russias regions. More than 60 percent of the regions have higher unemployment ratesthan in 2008 ( gure 3.1). Some regions still have unemployment twice as high as in 2008with the highest in Mordovia, Chelyabinsk, Yaroslval, Moscow, Orel, and Tver regions. ButKamchatka, Karachaevo, and Tomsk have unemployment rates 30 percent lower than be-fore the crisis. What accounts for this highly differentiated employment performance acrossRussias space?

Figure 3.1. Unemployment changes across Russias regions, 2010* over 2008

Source: Rosstat; World Bank staff estimates. *Data for January August.

Charting regional employment and unemployment trends before and after the crisisreveals interesting patterns. Figure 3.2 shows the impact of the crisis on regional employ-

ment and unemployment during the crisis (left hand chart) and emerging results followingthe recovery (right hand side chart). The bubbles represent Russian regions (with size of thebubble proportional to the size of the population). The top-left quadrant contains regionswith worse outcomes, the lower-right regions where indicators have improved. Most regionshave experienced adverse effects, but the recovery process across regions (in the right chart)is differentiated.

Most of the big regions did not improve during the output recovery, either in employ-ment or unemployment. By contrast, several small and medium-size regions improved.Interestingly, several regions are in the top-right quadrant, where employment rates andunemployment rates both increased. This suggests that the process of growth and associatedlabor absorption across the regions is simply not strong enough to generate sustained reduc-tions in unemployment.


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Figure 3.2. Employment and unemployment changes during crisis (left) and recovery (right)

Source: Rosstat; World Bank staff estimates.

While the richer regions more open to foreign trade were hardest hit, the regional patternof recovery is not symmetrical. There is a strong negative correlation between the initial levelof unemployment and the increase in unemployment in the rst year of the crisis ( gure 3.3,left). But the pattern is not symmetrical. Regions, initially hit harder by the crisis are not nec-essarily those where the unemployment rates are falling faster. Some of these regions are stillin deep recession, while others are growing faster.

Figure 3.3. Increase in unemployment compared with initial unemployment during crisis (left) and recovery (right)


The nancial crisis had a strong impact on SMEs, but regions with sizable SME sectorsare also recovering faster. Small rms are particularly vulnerable due to their weaker nancialstructure, heavy dependence on credit, and limited recourse to nancial markets. But facedwith sharply tighter budget constraints, the response of the surviving SMEs seems to havebeen in cutting costs, adjusting production to lower demand, searching for additional sourcesof liquidity, and postponing or even canceling new business ventures. So while regions with ahigher proportion of SME employment had higher unemployment, they are recovering fasterthan the rest of the country.

Figure 3.4. SME employment and changes during (left) and the crisis (right)



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III. In Focus: Unemployment and Recovery Across Regions | 23

Similarly, FDI ows to Russia (especially some of the larger regions) were signi cantlyaffected during the crisis, but the recovery seems related to FDI and investment climate inregions. During the crisis, FDI dropped everywhere. Regions with higher FDI in 2010 alsohad higher industrial production. More developed regions that were more exposed to foreigntrade and foreign investments were most affected in terms of the loss of FDI. But some ofthese same regions are only slowly recovering. Interestingly, some of the smaller regions with

a larger share of foreign direct investment and better investment climate show less unemploymentin the recovery ( gure 3.5).

Figure 3.5. Foreign direct investment in Russias crisis and recovery


In sum, regions that suffered most are the most developed, but they are not necessarilyleading the recovery. Preliminary regressions of regional unemployment (explained vari-able) on a number of correlates (explanatory variables) suggests important roles for higherinvestment rates, higher GDP, openness, and the share of non-tradables in facilitating thelabor market recovery. But diversity is huge during the recovery. One tentative result is that

regions with a larger share of SMEs, better investment climate, more FDI, and stronger nan-cial sector presence tend to show a more robust recovery. The crisis may have provided anopportunity for reform and an impetus to rethink and accelerate public sector, nancial, anddiversi cation reforms at the regional levels.


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