Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No.31414-RU

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

PROGRAM DOCUMENT

FOR A PROPOSED W A N MUNICIPAL DEVELOPMENT LOAN

IN THE AMOUNT OF US125 MILLION

TO

THE RUSSIAN FEDERATION

January 27,2005

Infrastructure and Energy Department Europe and Central Asia Region

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. I t s contents may not otherwise be disclosed without World Bank authorization.

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CAS C F A A CFP C I F A CPAR C U E EIA GDP GOR GRP HCS HOA LMF KEP KMDL LDP MOEDT MOF MUE NOBUS PER PPL RT RUR RzhU SER SPAL U S D WTO

RUSSIAN FEDERATION - GOVERNMENT FISCAL YEAR January 1 -December 31

CURRENCY EQUIVALENTS (Exchange Rate Effective as o f November 29,2004)

Currency Unit Russian Ruble US$1 .oo 28.27

Weights and Measures Metr ic System

ABBREVIATION AND ACRONYMS

Country Assistance Strategy Country Financial Accountability Assessment Center for Fiscal Policy Core Integrated Fiduciary Assessment Country Procurement Assessment Report Communal Unitary Enterprise Environmental Impact Assessment Gross Domestic Product Government o f Russia '

Gross Regional Product Housing and Communal Services Home Owners Association International Monetary Fund Committee o n Economic Policy Kazan Municipal Development Loan Letter o f Development Policy Ministry o f Economic Development and Trade Ministry o f Finance Municipal Uni tary Enterprise National Survey o f Households' Welfare and Social Programs Participation Public Expenditure Review Public Procurement L a w Republic o f Tatarstan Russian Rubles District Housing Directorate State Environmental Review Social Protection Adjustment Loan U S Dollars Wor ld Trade Organization

Vice President: Shigeo Katsu

Sector Manager: S. Lee Travers Country Director: Kristalina Georgieva

Task Team Leader: Andrei Darusenkov

FOR OFFICIAL USE ONLY

- Th is document has a restr icted d is t r ibut ion and may be used by recipients on ly in the performance o f their of f ic ia l duties. I t s contents may n o t be otherwise disclosed w i thout W o r l d Bank autl ior izat ion.

RUSSIAN FEDERA TION KAZANMUNICIPAL DEVELOPMENT LOAN

TABLE OF CONTENTS I. Background and Rationale

11. Kazan: Challenges and Reforms: Budget and financial management The Social Protection System The Housing and Communal Services Sector

111. Bank Strategy Link to the Country Assistance Strategy Analytical Underpinnings o f the Proposed Loan Lessons learned from the Lending Operations

IV. The Proposed Loan Objectives Loan Amount and Tranches Conditions Social Impact Environmental Aspects Outcomes Monitor ing and Evaluation Implementation Arrangements Fiduciary Aspects Disbursements and Audits

V. Risks Federal Level Kazan

ANNEXES Annex 1 : Tatarstan's letter o f Development Policy Annex 2: Kazan Letter o f Development Policy Annex 3 : Policy Matr ix Annex 4: Country at a Glance Annex 5: IMF Relations M A P # IBRD 33822

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7 9

20 24

29 29 31 32

34 34 34 29 36 39 39 39 40 40 44

45 45 47

The Kazan Municipal Development Loan was prepared by an IBRD team consisting o f Andrei Darusenkov, Richard Clifford, Stepan Titov, John Litwack, Andrei Markov, Sandro Zanus Michiei, Alexander Roukavishnikov, Ashot Harutounian, Michael Haney, Ka r l Skansing, Maria Shkaratan, Elena Lukyanchikova, and Ir ina Kazakova.

LOAN AND PROGRAM SUMMARY

RUSSIAN FEDERA TION KAZAN MUNICIPAL DEVELOPMENT LOAN

Sorrower

[mplementing Agency

4mount

Terms

rranching ~~

Description

Benefits

Risks

Russian Federation

City o f Kazan

USD 125 mi l l ion

Variable-Spread Loan (VSL), 5 years grace period, 17 years to maturity, commitment fee o f 0.75 percent, front-end fee o f 1-00 percent to be paid by the Borrower subject to any waiver o f a portion o f such fees as may be determined by the Bank f rom time to time. USD 50 mi l l ion upon completion o f f i r s t tranche conditions. U S D 75 mi l l ion upon completion o f second tranche conditions. This adjustment operation aims to address a number o f areas that are priority for ensuring sustainable development o f the c i ty o f Kazan. In 2003 the ci ty approved a comprehensive “Kazan Development Strategy Up to the Year 201 5” that outlined development prospects for the city. Building upon the Strategy and the recent conferral o f the municipal status on Kazan, the proposed loan will support the program o f reforms to improve the city’s (i) budget and financial management; (ii) social protection system; (iii) housing and communal services sectors. The loan aims at: (i) improving the overall fiscal situation in the City; (ii) improving municipal budget and asset management; (iii) providing more efficient delivery o f housing, utility and social services to the population, through better targeting, enhanced transparency and accountability.

Significant economic growth should continue in Russia over the medium term, although very much affected by o i l and gas prices. If o i l prices were to fall, it would (i) affect the economic growth rates and eliminate the budgetary surpluses; (ii) put downward pressure o n the exchange rate, thereby causing potential problems for many enterprises with large borrowings in foreign currency and generally weak Russian banking sector. Therefore, healthy macroeconomic pol icy wil l need to be maintained in order to preserve the considerable cushion that has been built in recent years against a potential external shock.

The new decentralization framework also carries some risks, including those related to an imbalance in the Government’s approach to fiscal federalism. Although expenditure responsibilities continue to increase at local government levels, they have less and less control over their sources o f revenue. Continuous monitoring and oversight will be required to assess how revenue assignments match up with expenditure assignments.

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I There i s a risk with respect to the Kazan administration’s capacity to carry out the reform agenda and the potential for a lagging commitment over the longer term. These i s also a risk o f backlash to the reform program by the city’s inhabitants. The significant pr ior actions that have been taken by Kazan are expected to have a mitigating affect on this risk. To further manage this r isk, the loan i s structured with two-tranches, with a greater weight assigned to the second tranche. T o date, the Kazan administration has shown significant sk i l l in building consensus and maintaining broad based public support. In addition, the federal authorities are committed to provide funds to build monitoring and evaluation capacity for the

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INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT PROGRAM DOCUMENT FOR A

KAZAN MUNICIPAL DEVELOPMENT LOAN TO THE RUSSIAN FEDERATION

I. BACKGROUND AND RATIONALE

1. Russia’s macroeconomic fundamentals have improved considerably since the 1998 crisis. GDP growth during the period f rom 1999 through 2003 exceeded 38 percent, the fiscal and current accounts were recording healthy surpluses, and poverty rates declined by over 30 percent. In 2003, intemational agencies upgraded Russia’s sovereign rating to an investment grade rating both on local currency (Moody’s and S&P) and on foreign currency borrowings (Moody’s). Primary economic indicators have continued to exhibit strong favorable trends in 2004 as well: real GDP grew by 7.4 percent in the f i rs t ha l f o f 2004, and the reported growth rate o f fixed capital investment amounted to 12.6 percent, as compared to 11.8 percent during the same period o f 2003. The federal government i s now running the overall budget surplus for the fourth year in a row. The Ministry o f Finance (MOF) reported a surplus o f 4.4 percent o f GDP for the f i rs t ha l f o f 2004, and a surplus o f over 3 percent i s projected for the whole fiscal year. The current account surplus strengthened to U S D 22.6 b i l l ion in H1 2004, helping to push up the Central Bank’s reserves to U S D 88.2 b i l l ion by the end o f June. CPI inflation (DeciDec) gradually declined to 12 percent in 2003, and may be even lower in 2004.

2. GDP growth since the crisis in 1999 has been pro-poor, due primarily to rapid growth in real wages in almost a l l branches o f the economy. Real incomes grew by an estimated 14.5 percent in 2003, and rapid growth continued in the f i rst ha l f o f 2004 (9.8 percent growth relative to H1/2003). During this period, real wages increased by an estimated 10.4 and 14.1 percent, respectively. The average nominal wage amounted to 6980 rubles (USD 247) in June 2004, compared to 5550 rubles (USD 196) a year ago. According to recent revised estimates, the number o f people below the poverty level fe l l f rom 25 percent in 2002 to 20.4 percent in 2003. Preliminary estimates also suggest that the poverty level continued to decline during the first ha l f o f 2004. Unemployment has been more persistent, however. According to the latest estimates, the average unemployment rate (ILO definition) was 8.1 percent during the f i s t ha l f o f 2004, compared to 8.6 percent reported for the same period o f 2003.

3. President Putin has now placed before his Cabinet the challenge o f doubling GDP by 2012 and reducing poverty by h a l f by 2007 (in both

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cases using 2002 as the base year). In keeping with these goals, following his re-election in March 2004, the President launched a plan for the comprehensive reform o f public sector management. Other important reform initiatives are under preparation and implementation in the areas o f banking, housing, tax and interbudgetary relations, and social protection.

4. A uniting theme o f the various initiatives comprising the Government’s reform program i s the clarification o f the respective spheres o f responsibility and associated financing on the different levels o f government. Relations between the federal government, the regions, and local governments have presented one o f the greatest challenges for the economic and polit ical transformation o f Russia. Beginning with the extreme centralization o f the Soviet period, Russian regions and republics’ became increasingly independent and assertive in the 1980s, thereby filling the vacuum lef t by declining central power. Economically r i ch or ethnically non-Russian regions often became particularly independent and, in some cases, openly defiant o f the central government.

5. T w o legislative acts passed in 2003 wil l have a significant impact on the country’s administrative and polit ical structure as a Federation. The f i r s t i s a l aw that introduces revisions to the existing Federal l aw o n the general principles o f organization o f legislative and executive organs o f power o f the subjects o f the Federation, to enter into effect on January 1, 2005. The second i s a law on the organization o f local self-governance that will fully enter into effect by January 2006 (transitional arrangements have been effective since the law was promulgated in October 2003). This law has introduced a fundamentally new blueprint for the country’s administrative structure on the local level, with corresponding implications for higher levels o f government. It will impact every community in Russia, leading to a redefinition o f local government responsibilities (e.g., as concerns local infrastructure and social services), to changes o f borders in many cases, and the creation o f new municipal entities.

6. Overall, the approach to the organization o f local government that i s set out in the l aw clarifies intergovernmental relations but reduces flexibil i ty for local arrangements. The new law clarifies the structures within the region, and makes i t somewhat easier for the federal center to propose legislation related to local government as a whole. In theory, this should help to rationalize expenditure assignments and revenue allocations. In practice, however, i t remains to be seen whether the application o f a similar structure across vastly different regions in terms o f size, wealth, and abil ity to deliver services will be implemented effectively. Certainly, the imposition o f a local government structure f rom the center reduces the federal nature o f the system in which regions could determine the system that would work best for them.

’ The Russian Federation consists o f 89 subjects o f the Federation. These are variously termed regions, autonomous regions and republics.

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7. The laws embodied in the recent reforms also specify the responsibilities o f each level o f government, including the new tiers in local government. A few items are particularly noteworthy. Under the new laws, determination o f public wages wil l be the responsibility o f each level o f government, as opposed to being determined by the central government. This allows localities some discretion in controlling their wage bill. Subsidies to agriculture are now to be provided at the regional level, whereas subsidies to other non-state- owned enterprises will be determined and provided by the central government, A very important change, one that i s key to reducing unfunded mandates, i s that regions wil l now. be responsible for determining and funding many social policies, including chi ld allowances, and support to the disabled, low-income families, orphans, and the like. Regions wil l also be responsible for specialized health care.

8. The Republic o f Tatarstan, one o f Russia’s 89 subjects o f the Federation, which i s one o f the most autonomous regions, i s now entering the final stage o f a long process o f normalization o f i t s relationship with the federal center. In 1994, the Republic o f Tatarstan and the federal government signed a Power-Sharing Treaty that formalized special tax and budgetary conditions in Tatarstan relative to other regions. This treaty was renewed for a five-year period in 1999, although the special status o f Tatarstan was diminished. The treaty i s now being phased out altogether in keeping with President Putin’s pol icy o f standardization o f federal-regional relations. In 2000, the Russian government established the Federal Targeted Program, “Socio-economic Development o f the Republic o f Tatarstan to 2006”.2 The program’s a im i s to assist the Republic in i t s transition to “normality,” and to partly compensate for losses in revenues associated with the change in federal-regional relations. The Ministry o f Finance o f the Republic o f Tatarstan (RT) estimates the potential losses to the consolidated budget f rom these changes in relations with the federal center, as wel l as in the Tax and Budget Codes, to be 76.6 b i l l ion rubles (USD 2.71 bil l ion) for the period o f 2001-2005. Roughly 59 b i l l ion rubles has been transferred to the Republic by the federal center as a subsidy through the Federal Targeted Program, thus leaving an estimated revenue shortfall o f about 17.6 b i l l ion rubles (or about U S D 622 mill ion) under the new arrangements.

9. As part o f these changes in the Republic o f Tatarstan, the c i ty o f Kazan acquired the legal status o f a municipality in September 2004 and now faces several c h a l l e n g e ~ ~ l i k e a l l other Russian municipalities, Kazan faces a systemic risk o f l imi ted control over revenue sources and overdependence on intergovernmental transfers.

Federal Targeted Programs in Russia are a planning too l used to identi fy priorit ies for the federal budget over a multi-year period that by design stipulate the identification o f other sources o f financing, e.g. regional and local budgets and private investors.

Previously, Kazan was an administrative division o f the Republic o t Tatarstan.

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Secondly, the city has been extremely dependent o n the decisions o f federal and Tatarstan authorities with respect t o capital expenditures. In 2005, Tatarstan and Kazan will graduate f rom the program and such transfers wi l l cease to exist. Pressing capital needs, such as repair o f educational institutions, social protection facilities, health care institutions, and social housing wil l not be met if additional financing cannot be found.

10. With these changes in the decentralization framework and in line with i t s new status within the Republic o f Tatarstan, the c i ty i s undertaking reforms in a several key areas: (i) improvements in municipal financial management through better financial planning, treasury control, gradual phasing out o f overdue payables, better public procurement practices, and better management o f municipal assets; (ii) improved targeting o f social protection through the monetization o f in-kind benefits and concentration o f subsidies on vulnerable groups; and (iii) improvements in housing and utilities management through the elimination o f budget subsidies to enterprises in district heating, the privatization o f housing maintenance services, and entering into a management contract with a competitively selected private company to run the water supply facility. T o aid this reform effort, the Russian Federation has requested a USD125 mi l l ion Kazan Municipal Development Loan (KMDL) to enable it to provide support to the municipality’s reform effort. These funds will enable an efficient financial and economic transition to the city’s status as a full-fledged municipality o f the Republic o f Tatarstan. The loan would be made to the Russian Federation and then passed on as a grant to Kazan.

11. KAZAN: CHALLENGES AND REFORMS

11. Kazan i s the largest c i ty in the Republic o f Tatarstan. The Republic i s located in the Volga region o f Russia, and has a population o f about 3.8 mil l ion (2002 census), or 2.6 percent o f the total population o f the Russian Federation. The region i s home to a large number o f nationalities, including most significantly Tatars (52.9 percent according to the 2002 census), Russians (39.5 percent) and over 100 other nationalities. The Republic enjoys a reputation for the inter-faith and inter-ethnic amity between various ethnic groups and, importantly, among the two religions most prominently represented in the region, Islam and Christianity. Tatarstan ranks as the largest and most influential Muslim area in Russia and it i s viewed as highly significant for national stability. Tatarstan i s an oil-rich territory, and i t s economy i s l inked strongly to o i l production and processing. The recent changes in the Republic’s status will result in the reduction o f revenues from oil-related activities. Tatarstan i s also one o f Russia’s most industrially developed regions, accounting for 3.2 percent o f Russia’s gross regional product (GRP), equivalent to RUR 202 bi l l ion (approximately U S D 7.14 billion). Nevertheless, Tatarstan’s poverty indicators are broadly similar to the overall national levels: the number o f people living below the poverty level in

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2002 was 23 percent in comparison with the 25 percent average for Russia.

12. Contemporary Kazan has a population o f 1.1 mi l l ion people (2003), making it by far the largest c i ty in Tatarstan, and the seventh largest c i ty in Russia. The annual per capita GRP i s 95,000 rubles (2003) or slightly more than U S D 3360. The structure o f the city’s economy reflects the Soviet legacy, with a high share o f large enterprises in heavy industry, including in the military-industrial complex. The ci ty o f Kazan accounts for about 40 percent o f the Republic’s Gross Regional Product. Major sectors o f the city’s economy are: industry (33.8 percent o f the c i ty GRP), trade and public catering (27.4 percent), transportation (8.2 percent), and construction (6.1 percent). Kazan continues to be the industrial heart o f the Republic o f Tatarstan, primarily in the areas o f machine-building, chemical industry, and food processing. These industries plus a growing services sector are expected to be the engines o f growth for the c i ty in the foreseeable future.

13. Kazan faces a wide spectrum o f developmental challenges, many o f which are typical for municipalities in Russia in general, and some o f which are unique to Kazan. L i ke many Russian cities, Kazan must address the Soviet legacy o f inefficient spatial distribution o f human and physical resources, weak links to the rest o f Russia and external trading partners, a severely dilapidated housing sector, and inefficient delivery o f municipal services. Specific to Kazan are the challenges deriving f rom the prevailing administrative structure in the Republic o f Tatarstan, under which Kazan has not been an independent municipal entity as defined under Russian legislation, but rather, as noted above, has been, in effect, a division o f the administration o f the Republic o f Tatarstan. The administrations o f the Republic o f Tartarstan and the ci ty o f Kazan recognize that this state o f affairs has hindered the development o f democratic processes in the ci ty and the emergence o f c i v i l society, and are committed to supporting Kazan’s effort to enter into the mainstream o f social, economic and polit ical reforms as they are being implemented in Russia.

14. Consistent with the Russian Federation’s framework for decentralization and the recent changes in the federal legislation, the Kazan administration has been preparing for the city’s transition to municipal status. With the passage o f the Republic o f Tatarstan l aw “On the territorial borders and municipal status o f the c i ty o f Kazan” in September 2004, Kazan obtained the status o f a municipal formation as defined by Russian federal law. Most importantly, i t now has the full legal status o f a municipality, in conformity with Russian

‘legislation, and has the legal authority to carry out pol icy and institutional reforms. The RT also delegated the authority for social protection to the Ci ty o f Kazan through the RT law No 64 -3 PT o f December 5,2004.

15. In April 2003, the Ci ty Council o f Kazan approved a comprehensive document, “Kazan Development Strategy Up to the Year 201 5”. The Strategy identifies Kazan’s geopolitical position, i t s key role in Russian history, and i t s religious and cultural heritage as fundamental competitive strengths that will serve as the foundation for the development o f local governmental institutions and wil l spur economic growth. This Strategy was a product o f a multi-stakeholder

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dialogue and advanced the level o f public participation in city affairs. It aims to ensure a gradual increase in the quality o f people’s l i fe through actions in the following three areas:

e Strong societv: through development o f the modern education system, including higher education; access to Kazan’s cultural heritage and provision o f social and cultural services; strengthening public health; a balanced social structure o f the city; and strengthening o f c iv i l society and local self-government.

Dynamic economy: by ensuring sustainable economic growth through attraction o f investments; growth in real income; increased competitiveness o f local businesses; increased export by local companies; development o f a favorable business climate; and conversion o f the budget into a reliable tool o f funding service delivery to population.

e Sustainable urban environment: through upgrading and construction o f the physical infrastructure in the city; development o f institutions that govern urban environment, including development o f the real estate market.

16. The pol icy initiatives that underpin Kazan’s City Development Strategy are described in the Kazan Letter o f Development Policy (Annex 2). Whi le the Bank will support the broad strategy, e.g. with technical advice, implementation o f certain key actions i s l inked to loan disbursements, as outlined below.

Budget and Fin an cia1 Management

17. T o achieve longer term fiscal sustainability the c i ty must improve the planning and management o f i t s financial flows. This need derives largely f rom the city’s previous relationship with Tatarstan and the federal government, in which it did not exercise control over i t s finances.

18. Over the period 2000-2003, Kazan faced strong systemic r isks on the fiscal side, stemming largely f rom the on-going incorporation o f the Republic o f Tatarstan into the Russian federal tax and budget legislative environment and from unpredictable changes in revenue assignments. Kazan’s tax-sharing arrangements with Tatarstan have also been unstable and subject to change each year due to frequent modifications in the federal and Republic o f Tatarstan legislation. As a result, on the one hand the ci ty managed to get additional resources in the form o f federal and RT subsidies (mostly capital investment grants), but on the other hand the ci ty was deprived o f such revenue sources as VAT, excises, sales tax and enterprise prof i t tax. In 2000- 2003 Kazan’s overall budget balance exhibited quite different trends: the year 2001 was the best year it terms o f fiscal performance as the city managed to reduce drastically (from 12 percent o f revenue on a cash basis and 22.1 percent o f revenue o n a commitment basis) i t s

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budget deficit to less than 1 percent on a cash and achieve a budget surplus (4.3 percent o f revenue) on a commitment basis. But, f rom 2002 the fiscal position began to deteriorate, and in 2003 the budget deficit (both cash and commitments) varied around 10 percent o f revenue.

Table 1. Kazan: Selected Budget Performance Indicators, 2000-2004

Commitments)/Revenue

Source: Kazan Finance Committee, Kazan Committee for Economy & Industv, Center for Fiscal Policy database

19. In 2003 total revenue was about U S D 300 mill ion, o f which transferdgrants f rom the Russian Federation and the Republic o f Tatarstan made up 43 percent (in 2002 this share was about 24 percent and it was 4 percent in 2000). The most important revenue sources in 2003 included personal income tax (up to 34 percent o f total revenue), and transfers/grants f rom the federal budget, while revenues from property taxes and from leasehent o f municipal assets were much less important. One o f the problems with the revenue flows from intergovernmental transfers was that a large portion o f them were negotiated in the course o f the fiscal year, when execution o f the approved budget had already begun. In addition, the c i ty i s owed about U S D 15 m i l l i on in accounts receivable (tax arrears).

20. The major expenditure categories, according to the functional classification, are construction (38 percent), education (22 percent), housing and communal services, health. According to the economic

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classification, in 2003 Kazan was spending 43 percent o f total expenditures on capital expenditures (36 percent on capital construction), and 20 percent on salaries. Industry and construction represent mainly capital investment into housing construction and rehabilitation under the Federal Targeted Program for Tatarstan. This structure o f spending, with a high level o f construction, i s not typical for Russian municipalities that are regional capitals. Moreover, Kazan’s spending was largely dependent on expenditure norms approved by the Republic o f Tatarstan. The ci ty had a multi-year capital-spending plan that was subject to approval by the RT. Capital investment i s almost entirely funded by RT and RF. The ci ty had discretion only over capital repair spending and a small level o f capital investment funded from “extra” (i.e. higher than planned) revenue. In 2001-2004 the city received a significant amount o f federal and RT capital transfers, but most o f them (about 80 percent according to the Kazan Committee o f Economy and Industry estimate) were o f a targeted nature and went to construction o f new residential housing, a subway system, and cultural monuments. In addition, the c i ty was extremely dependent on decisions o f the Tatarstan authorities over capital expenditure mix and was unable to significantly increase the share o f capital repair. Thus capital repair o f educational institutions, social protection facilities, health care institutions, and o f social housing was not sufficient, raising concerns about service delivery in these sectors.

21. The ci ty budget i s executed through the Kazan department o f the Republic o f Tatarstan treasury. On the positive side this arrangement gives better control over budget execution: (i) compliance with approved budget within approved spending limits i s ensured; (ii) commitment control (through contract registration and verification system) strengthened; and (iii) comprehensive cash accounting and reporting i s ensured, which contribute to improved financial management. An additional positive feature i s the creation o f a special division within the Tatarstan treasury that executes additional control over construction contracts. On the downside, al l treasury related benefits o f better cash management (o f cash balances) accrue to the Republic, rather than the ci ty budget, and the abil ity o f the c i ty to make fast financial decisions on a daily basis i s somewhat constrained. Though the establishment o f the Tatarstan treasury with a computer-based information network and locally developed software, was a qualitatively new development, the single account concept has not been fully implemented, and in reality multiple accounts are s t i l l used. Currently the RT treasury i s undergoing a process o f transformation to a new software that would implement the single account concept.

22. As a result o f the weak revenue position, insufficient management and changing federal-regional relations, the c i ty budget ran payment arrears (overdue accounts payable) in 2000-2003. The total stock o f overdue payables (of the c i ty budget and budget organizations) as o f January 1, 2004 was 2.4 b i l l ion rubles or about USD 80 mill ion. The treasury control over contract registration was

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weak (as some contracts were signed without stamp o f the treasury). In addition some budgetary institutions did not get enough funds from the city budget to comply with restructuring agreements with the Federal Pension Fund on overdue pay able^.^ All this posed a significant threat to the sustainability o f the city’s fiscal position. In this respect, according to the Kazan reform program, contracts’ registration (validation) by treasury wil l be strengthened and enforced (without a treasury stamp a contract should be declared void, and i f such contract i s signed between a budget administrator and a contractor, then the budget administrator i s sanctioned). Most o f the arrears are payroll tax insurance obligations to the Federal Pension Fund and obligations for capital construction since, unlike many other Russian municipalities, Kazan has n o wage arrears. Under the Kazan reform program, an inventory o f capital construction overdue payables will be conducted and such arrears wi l l be phased out. In addition, the municipal budgetary organizations5 are expected to remain current on their payroll tax insurance obligations (to the Pension Fund) and to repay o ld payroll tax debt (on an agreed schedule). As a result, i t i s expected that their overdue accounts payable obligation wi l l decline by about a quarter in the next few years.

23. Quasi-public expenditures o f the c i ty include primarily issuance o f guarantees and contingent liabilities o f the communal unitary enterprises (CUE).6 According to the Wor ld Bank estimates, total municipal guarantees amount to approximately USD 2.6 mill ion. There are 38 CUEs, o f which the largest include heating, water and transportation. Their liabilities represent contingent liabilities o f the city administration. On aggregate, total CUEs payables exceed CUEs receivables by about USD 10 mill ion. Some CUES engage in short- term (cash-flow) borrowing. The CUES borrowings in combination with overdue accounts payable (estimated at USD 40 mill ion) present a potential financial risk for the c i ty and/or the Republic that will be addressed through the reform program.

24. The ci ty now plans to address this systemic imbalance, and seeks to improve financial sustainability through a series o f reforms to the budget, the municipal treasury, procurement procedures, and the management o f municipal assets.

25. Citv Budget. From 2004 the ci ty has been preparing Financial Plans as part o f medium-term budget planning. The plan i s used as a

Federal Pension Fund arrears by Kazan budget organizations represent overdue payables o f such organizations to the Pension Fund accumulated over several years in the past. Such arrears consist o f two parts: overdue payments o n a payment (percentage o f a payroll) and an accumulated penalty. The restructuring arrangement requires the budget organizations to make a l l current payments to the Pension Fund plus repay the “principal” amount o f arrears over several years according to an agreed schedule plus repay 15 percent o f the penalty. ’ These are city run services such as schools, hospitals, etc. They are covered by budgetary law.

other smaller entities such as cafeterias. In this document this term i s used interchangeably with the term municipal unitary enterprises (MUEs), which i s the more common term for these entities used in the rest o f Russia. B o t h CUEs and MUEs are covered by corporate law.

These are essentially revenue earning entities owned by the city. They include public utility companies and

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tool to evaluate different fiscal choices within overall resource constraints in view o f the ambitious reform program and systemic r isks (principally, the overdependence o f the ci ty revenue o n intergovemmental fiscal transfers). The f i rs t plan covers three years (2005-2007), and will be updated periodically on a rol l ing basis by the city's Finance Committee. The main goals o f the Financial Plan are to develop better forecasts o f aggregate revenues and expenditures by key categories in support o f improved budget planning, in order to incorporate into the budget major c i ty reforms in the areas o f social protection (accompanied by better service delivery in education and health), housing and utilities, asset management. The f irst plan i s based on certain key macro-economic assumptions: (i) moderate inflation growth (about 7 percent per annum), based on the RF Ministry o f Economic Development and Trade (MOEDT) forecasts; (ii) robust GDP growth in the ci ty (more than 9 percent in 2005-2006 and 7.4 percent in 2007); (iii) payroll growth rate i s l imited to growth rates for federal employees payroll (i.e. not more than 21 percent annually); (iv) housing and utilities tariffs increase by 50 percent in 2005, 30 percent in 2006, and 30 percent in 2007; (v) RT delegates responsibilities for social protection to the c i ty and such services are managed by a special c i ty department; (vi) a l l municipal employees are to be funded exclusively f rom the municipal budget f rom the year 2006; (viii) the ci ty i s granted at least a minimum share o f personal income tax f rom 2006 (envisaged by the reform o f local self- governance in Russia).

11.0 s from higher-level budgets

26. The Financial Plan for 2005-2007 will be approved by the end of January 2005 and i t s key financial indicators are shown in Table 2 below.

76.9 9.0 74.4 7.5 66.4

Table 2. Kazan Financial Plan, Selected Indicators, 2005-2007

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I percent

2005 I 2006 I 2007

RUR billion percent RUR billion Subsidies & Subventioi s from RF & RT’ Indicative RT Equalizatii n Transfer Indicative Federal Grant financed with W B loan proceeds

2. Total expenditures 2.1. Current Expenditure

Wages & Salaries

Interest

100

50.3

12.8 100 11.9

8.9 69.5 8.8

5. Overall Budget Deficit Minus

-2.1 -4.2 -2.1

:UR billio percent

53.1 9.5

13.3

1.5

14.9

7.5

100

73.9

2.2 14.8 1 2.6 I 20.3 I 3.1 26.1

0.3 2.0 I 0.3 1 2.3 I 0.2 1.7

7.4 Expenditure S

Capital

Capital Construction

Repair 2.3. Net lending minus repayment 3. Overall Budget Deficit 3.1. Overall Budget DeficiUReve nue 4. Primary Budget Deficit

26.1

16.8 6.0

1.3 8.7 1 1.9 I 14.8 I 1.0 8.4

0.0 1 0.0 1 0 . 0 1 0.0

-0.7 -0.6

0.0 0.0

-0.6

-0.04

-0.3

’ These will decline irrespective o f theworld Bank support.

14

Indicative RT & federal Grants 6.1. Overall Budget Deficit Minus Indicative -0.14 -0.33 RT & federal grants/Expen ditures

27. The city’s overall financial plan for 2005-2007 i s based on fairly conservative assumptions and fully financed. Prospects for the slowly emerging federal and RT framework are that the c i ty may receive additional resources beyond the medium-term for functions transferred to the city. These would support long-term sustainability o f current expenditure levels once the proposed reform program has been implemented. Kazan’s fiscal framework (inter alia Kazan medium t e r m financial plan) i s determined by the RF municipal reform (starting f rom the year 2006). According to municipal reform legislation Kazan i s entitled to raise only several taxes as i t s revenue - land tax, imputed income tax, and 30 percent o f the personal income tax (PIT). All other taxes accrue either to the federal center or Republic o f Tatarstan. From 2006 the ci ty will start to receive general purpose equalization transfers f rom the RT budget (according to local self governance reform in Russia), but the amount o f this transfer i s unclear (20 percent o f P IT i s to be allocated among RT municipalities). The ci ty starts to get special subsidies for social protection f rom the RT budget and thus social pol icy spending will likely drastically increase in the ci ty budget. In addition, Kazan may receive targeted transfers f rom the Republic o f Tatarstan’s Municipal Development Fund and Social Co-financing Fund, which are to be created according to RF legislation in the year 2006. These two funds are subject to bargaining between RT municipalities and the RT govemment, their amount i s unknown at this stage, and thus transfers f rom such funds were not included into revenue/expenditure projections o f the ci ty budget for the years 2006-2007. In general, the adjustment in the federal-regional relations has created additional prospects for revenue transfers enhancing the possibility that the c i ty will sustain the current expenditure level once the program i s implemented.

-0.18

28. K e y elements o f the Financial Plan over 2005-2007 are:

the overall budget i s expected to have a small remaining deficit to be financed with loans and privatization receipts, under assumption that both RT equalization grant and the federal grant financed with the loan proceeds are available to the city; fiscalgap:

15

i. in 2005 - deficit o f about U S D 70 mi l l ion (about 70 percent to be covered by the federal grant financed with the Bank loan; the rest - by borrowing and privatization proceeds;

ii. in 2006 - deficit o f about U S D 130 mi l l ion covered by equalization transfers f rom RT (25 percent), federal grant to Kazan financed with the Bank loan proceeds (about 60 percent), borrowing and privatization proceeds;

iii. in 2007- deficit o f about U S D 65 million, covered by equalization transfers f rom RT (70 percent), municipal borrowing, and privatization proceeds;

revenues are expected to decline f rom 11.5 percent o f GRP in 2005 to 7.8 percent in 2007 because o f the new tax sharing arrangements according to the federal legislation and due to graduation f rom the Federal Targeted Program. reflecting the revenue trends, expenditures are projected to decrease as a share o f GRP from 12 percent o f GRP in 2005 to 8.2 percent o f GRP in 2007. Year 2005 i s the last year o f high capital construction in the city. The federal targeted investment program i s completed in 2005 and thus federal transfers sharply decline f rom 2006. The city plans to increase significantly capital repair spending (from 5.2 percent in 2003 to 8.7 percent in 2005 and 14.8 percent in 2006). F rom the year 2006 share o f capital spending will gradually go back to ttnormalt' level (pre-millennium) and will stabilize in 2007 at the level o f about 26 percent o f total expenditures. Spending on wages and salaries will increase significantly in 2006 and 2007 to 26 percent o f total expenditures (as a l l municipal employees wil l be funded exclusively f rom the municipal budget); the c i ty plans to spend at least U S D 15 mi l l ion over 2005- 2006 to reduce overdue accounts payable o f the budget and budget organizations by about U S D 25 mill ion; public debt i s expected to fa l l f rom 1.4 percent o f GRP to 0.7 percent o f GRP and debt service expenditures are small; privatization proceeds are moderate at about RUR 200-300 mi l l ion a year.

0

0

0

0

29. As part o f i t s reform program, the city wi l l maintain the financial planning up-to-date, develop a three-year rol l ing financial plan, and ensure that the following i tems are appropriately reflected:

0

0

0

0

the share o f capital expenditures for social protection, health, and education maintained at agreed levels; arrears (i.e. accounts payable) by budget organizations and by the budget are reduced by agreed amounts; an inventory o f capital construction overdue payables carried out; restructuring agreements between budget organizations and Federal Pension Fund updated and observed, and the necessary funding to stay in compliance with restructuring agreements provided.

16

30. As a result o f the reforms pursued in 2005-2006 the ci ty wi l l enhance budget management practices and strengthen i t s fiscal position by phasing out budget arrears f rom 27 percent to 11 percent o f revenue and by maintaining small budget deficit on a cash basis o f about 5 percent o f revenue and reducing i t s stock o f public debt to about 10 percent o f revenue. These changes are supplemented by hardening budget constraints for the ci ty due to the following factors:

F rom the year 2006 Republic o f Tatarstan and the ci ty o f Kazan graduate f rom the Federal Targeted Program for the Development o f the Republic o f Tatarstan and thus “soft” federal funds wil l not be available anymore; Under 2006 municipal reform each RF municipality i s assigned with a clear minimum amount o f revenues and expenditure responsibilities; Kazan emerges as an independent municipality with i t s own departments and a treasury; RF Budget Code puts a cap on subnational borrowing and debt service, and from the year 2007 the notion o f insolvent regiodmunicipality becomes effective in the Russian legislation, allowing the federal government to forgo bail ing out fail ing regions or cities and creating incentives for markets to evaluate their financial risks.

0

31. Municipal treasury. As part o f this improved budgeting and financial management the c i ty wi l l also improve i t s treasury operations in three ways designed to improve planning and control. First, a single treasury account concept wil l be implemented within the treasury system. Second, i t will strengthen the system o f contract registration and validation in such a way that without a treasury stamp, a contract wi l l be declared void. And third, i t wil l ensure that off-budget revenues o f budget organizations are covered by the municipal treasury.

32. MuniciDal asset management. In Kazan, until the recent conferral o f municipal status upon the city, assets commonly referred to as “municipal” were, in fact, property o f the Republic o f Tatarstan, with their management entrusted to the c i ty government within certain limits. This presented a fundamental constraint on the city’s abil ity to develop and implement a strategic approach to asset management.

33. Despite the constraints o n i t s autonomy and ultimate authority over assets that are inherently municipal, over recent years the city has achieved certain progress in various areas o f municipal asset management. More specifically, in the consumer services sector, the city managed to have, by year 2000, almost 120 retail and catering enterprises corporatized. By the end o f 2002, the shares of those enterprises held by the ci ty were sold to private investors.

34. At the moment, there are almost 1000 privately owned buildings and premises in Kazan. Since 2002, the practice o f direct allocation

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o f land has been completely stopped, and competitive auctioning i s now the only method for land plots disposal. In two years time the new practice succeeded in driving land prices f rom U S D 5-10 to U S D 100-200 per square meter, creating shortage o f sellable land in the central part o f the city. From January through September 2004, 33 publicly held auctions resulted in sale o f 116 pieces o f municipal property for a total o f 5 1.3 thousand square meters o f buildings and premises and o f 58.8 hectares o f land plots.

35. T o date, there are 2,199 effective contracts for the lease o f property o f a total floor area o f 482,000 square meters. At the end o f 2003, the city adopted a new procedure for assigning lease rates that established the minimum lease rate for municipal assets o f n o less that 75 o f rates charged in the commercial sector. This arrangement represents a considerable improvement over previous period, when only 35 percent o f the c i ty land rented was paid for, o f which almost 70 percent - at preferential rates.

36. Recently the ci ty has adopted a regulation to annually audit municipal unitary enterprises (MUEs). I t sets out, as an audit objective, a requirement to identify and then divest and register with the city’s Asset Register any surplus or unutilized assets originally under MUE management. Stripping MUEs o f surplus assets should help raising their performance efficiency. The municipal Asset Register has been operational since 1993 and remains the most comprehensive data compendium o f the municipally owned property (except land plots), enterprises and stock.

37. Despite the achievements o f the past, the need for developing a long-term strategic approach to municipal asset management that would help maximize the benefits has become clear in the early days o f Kazan’s newly acquired status o f an autonomous municipality. T o that end, a Program to Increase the Efficiency o f Municipal Asset Management in Kazan was prepared by the City Administration and approved by the Kazan Ci ty Council o n September 30, 2004. The Program proposes a range o f actions to “increase the (positive) impact o f the municipal assets on the social and economic l i fe o f the city” through effective asset management including rational asset restructuring, maximizing profits and minimizing costs. More specific objectives o f the Program are to strengthen market principles in asset management, support market infrastructure by creating comprehensive legal framework and specifying the rules o f interaction between market participants. The Program also calls for continued inventory and monitoring o f municipal assets and transformation o f the existing Asset Register into an advanced database with embedded analytical capacity.

38. Together with the Program, the Ci ty Council adopted a Privatization plan, that l i s t s municipal assets to be privatized during 2005. According to the document, 2 1 MUEs, including al l those in the housing maintenance, are due for privatization next year. Over the same time period, shares o f 15 Joint Stock Companies (JSCs) created

18

earlier on the basis o f municipal enterprises and s t i l l held by the ci ty will be sold.

39. Both the Program and the Privatization plan are based on reform principles that have been extensively discussed between the city and the Bank. The reform plan includes the following steps:

Publicize, as a matter o f routine the following: notices o f auctions for sale or rent o f municipal property, information o n property to be auctioned, including land, information on auctions’ procedures and results;

Approve and commence the implementation o f a preemptive plan for land surveying (land plotting plan);

Complete the review o f a l l land allocations, compile a l i s t o f plots currently under design and construction, approve a regulation introducing l imitation on the number and duration o f extension periods for design and construction (one extension o f not more than 6 months);

Adopt a legal regulation to establish competitive bidding procedures for a l l categories o f municipal assets, including real estate property, as the only possible procedure for transfer or acquisition o f rights to municipal property;

Establish rent rates for municipally owned property at levels not lower than 90 percent o f commercial rates, revision o f previous land allocations and termination o f those expired.

40. Municipal procurement. Municipal procurement in the Ci ty o f Kazan i s coordinated by the municipal Committee for Economy and Industry (KEP, by i t s Russian acronym). Procurement responsibility i s delegated to 33 city departments, committees or state/municipal enterprises that are publicly listed and referred to as “municipal customers”. These customers have access to both c i ty budget funds as wel l as the Federal Targeted Program funds. Municipal-level utilities (water and sewage, heating and electricity) are also listed as “municipal customers” while they are at the same time very important suppliers o f services to the c i ty itself.

41. The procurement practices, while generally acceptable, have certain weaknesses. First, not a l l products are being procured competitively. The Tatarstan Cabinet o f Ministers usually directs that procurement o f certain commodities and services (fuel and lubricating materials, water, heat, electricity, communication and communal services) should be l imi ted to certain suppliers. This l i s t i s echoed in the Mayor’s order N 718 dated 29 April, 2004 that l i s t s companies that can be sole sourced. As a result, according to the KEP’s information, in 2003 direct contracts amounted to about 4 b i l l ion rubles or 55 percent o f the annual procurement. Second, if a

19

municipal customer has qualified staff that meets the requirements set by the Republic o f Tatarstan’s Ministry o f Economy, i t may establish a tender commission o f i t s own. In other cases, a municipal customer may assign the conduct o f tenders to an organization (public or private) having this accreditation. Bo th methods are legitimate, but, unfortunately, in either case the tender commission may not include suitably qualified technical specialists or beneficiary’s representative. Lastly, only contracts exceeding 200,000 rubles (USD 7,075) are registered in the KEP’s registry and are thus reviewed ex-post for compliance with procedural requirements. Contracts below this threshold are registered only by the procuring unit.

42. A number o f reforms are now underway. The ci ty has established an Expert Commission headed by the First Deputy Mayor that (i) has to clear a l l cases o f direct contracting, closed bidding and price quotations, and (ii) reviews complaints f rom bidders. Furthermore, the c i ty has prepared and approved a plan o f actions that addresses the above issues through a series o f steps that are expected to increase efficiency o f the municipal procurement both f rom the point o f view o f budget savings and increased quality o f service delivery. It will continue these reforms with a number o f additional measures: (i) preparing an independent assessment o f current c i ty procurement practices to establish a baseline quantifiable data against which agreed improvements will be evaluated; (ii) implementing improvements in the model bidding documents and procurement procedures; (iii) increasing the proportion o f contracts awarded and ci ty budget used under open bidding, inter alia through necessary legislative changes that would make direct contracting an exception subject to clearly defined criteria and limiting the l i s t o f companies eligible for direct contracting primarily to utilities (electricity, gas, heating, water and wastewater); (iv) carrying out independent audit o f c i ty procurement conducted in 2004 and 2005; (v) creating a unified contract registry for the c i ty that includes a l l contracts financed through the ci ty budget.

The Social Protection System

43. Kazan Administration faces numerous challenges in managing i t s social protection system. Raising the living standards o f socially disadvantaged groups o f the population i s a social pol icy priority for the city. In 2002 the share o f c i ty residents having incomes below the subsistence level equaled 23 percent, and another 19 percent had monthly incomes at or closely above the subsistence level (1,199.6 rubles a month as o f September 1, 2002). Some 52.9 percent o f the residents had monthly incomes below the minimum consumer budget, between 1,215.6 and 3,569.3 rubles a month and only 5.1 percent o f the ci ty residents had incomes at or above the rational budget, 11,800 rubles a month.

44. The social safety net system in Russia continues to be highly expensive and ineffective despite a number o f reform attempts o f the

20

recent decade. Major portion o f non-contributory social support expenditures i s consumed by categorical in-kmd benefits. This system i s regressive (beneficiaries are often not poor, and besides that many non-eligible benefit f rom subsidized services), nontransparent and hinders the budget process. Delivery o f in-hnd benefits requires large scale allocation o f subsidies to service providers that results in strong negative impact on utility sector efficiency. However, leakages to non- poor groups o f population are also typical for targeted monetary social assistance programs in Russia. The recent Poverty Assessment Report for Russia has documented that only 30 percent o f funding for decentralized social protection programs go to the beneficiaries f rom the poorest quintile, while most international comparator programs succeed in transferring between 40 percent and 60 percent o f funds to this population group.

45. The current Kazan social support system i s facing challenges that are typical throughout Russia. The system includes a complex set o f in-kind benefits to various categories (groups) o f population. Provision o f these (city transportation services, pharmaceuticals, spa treatment, housing and communal services, communication services) requires highly distortionary producer subsidies to be allocated f rom the regional and municipal budget to various municipal companies. In the c i ty o f Kazan there are some 300,000 residents eligible for subsidies (I ’goti), representing almost one-third o f the population. “Double-dipping’’ i s also quite significant, i.e. recipients o f benefits under federal and regional mandates overlap. Also the benefits applicable to one household member are often extended to other non- eligible members (e.g. a WWII veteran’s 50 percent discount on the electricity tar i f f i s actually applied to the entire household electric bill). Provision o f in-kind benefi ts i s often imposed o n municipal companies without funding, thus eroding the principle o f hard budget constraints and undermining the possibilities o f systemic reform in the communal services sector.

46. The social protection reform program developed by the Kazan authorities includes decisive steps in transforming the social protection system in order to (i) improve efficiency o f public social support expenditures; (ii) increase effectiveness o f social assistance programs in reaching the poor households, and (iii) strengthen capacity o f the social protection system. The following institutional and policy reforms in three inter-related areas are critical to the success o f the program:

0 clarification o f the institutional responsibility and integration o f the social support implementation in the ci ty o f Kazan;

0 replacement o f in-kind social benefits with monetary payments to most vulnerable groups and improvement o f targeting for SA programs; improved efficiency and quality o f social service delivery, reduction o f administrative costs in provision o f social services to the vulnerable groups.

0

21

47. The Kazan authorities have started tightening eligibil i ty criteria for various benefits and improvements in targeting o f social assistance programs. In October 2003 a decision was taken on elimination o f duplicating in-kind benefits for various groups o f the population. As a result o f this measure the number o f recipients o f in-kind benefits f rom regionally established programs was reduced three times fkom 12.7 to 4.6 thousand people. In January 2004 broad subsidization o f producers o f catering services for schools in al l schools in the city was replaced with targeted food subsidies for children f rom poor families. The innovative targeting mechanism included participation o f parent councils and teachers (equivalent to PTAs) in decisions on eligibility. In March 2004 the Kazan mayor submitted to the Government o f Tatarstan a request to authorize replacement o f a l l in-kind benefits initiated by Federal authorities with monetary payments. Finally, in October 2004 the Republic o f Tatarstan approved a l a w that delegated to the c i ty o f Kazan responsibilities in the area o f social protection.

48. Institutional framework, legal base and capacity for effective social support policy. Social protection policies for the city o f Kazan are defined either by federal or regional legislation while actual program design i s formulated at the regional level. Program implementation i s split between five different departments o f the c i ty and regional administrations. Policy and program fragmentation was identified as one o f the core weaknesses in the system o f social protection in the city. According to the proposed program, the c i ty o f Kazan role in social support policies wi l l be strengthened. Second, implementation o f social support programs will be integrated in one department o f the c i ty administration, namely the Department o f Social Protection. This would ensure consistency o f policies, coordination o f programs and cost savings. Third, more effective methodologies for social support programs wil l be introduced based on improved implementation practices (to include verification o f well- being o f applicants, conditional “social contracting”, development o f integrated data base for SA, monitoring and program evaluation). Fourth, an intensive program o f capacity building wil l be undertaken for the Department o f Social Protection o f the c i ty administration in order to upgrade program implementation.

49. Replacement o f in-kind benefits with monetary payments. The program o f social support reform in Kazan includes a comprehensive set o f measures aimed at replacement o f in-kind benefits with monetary payments. The init ial legal foundation for these moves i s based o n Federal L a w #122 passed in August 22, 2004 that authorized monetization o f the transportation in-kind benefit, provision o f pharmaceutical and spa treatment. The Kazan ci ty program will monitor in i t ia l phases o f this transition (registration o f eligible recipients, estimate o f required budget allocation) and support adequate budgeting for this reform in 2005-2007. The program will also introduce replacement o f regionally initiated in-kind benefits that are offered to 4700 recipients through nonmonetary vouchers with monetary payments. Most importantly, under the program the whole set o f housing and communal services benefits will be replaced with

22

monetary payment allocated only to eligible groups. This reform would require organizational measures, adequate financing and careful monitoring. I t i s l ikely to be neutral in terms o f budget implications, but would require reallocation o f budget resources from housing and communal services l ine i tem o f the budget to population social support budget l ine item. There i s a probability that some additional budgetary resources would be needed during the f i rst year(s) o f reform implementation. Although strong incentives for savings wil l be generated o n the customer and service provider sides, and eventually the budgetary costs o f service provision will be reduced, this change will not happen during the init ial years o f reform implementation. On the contrary, during the init ial period there will be a need to provide full cash financing f rom the municipal budget for portion o f the services that i s currently provided by municipal companies without full compensation for their provision.

50. Targeted assistance to the poor. Current programs o f social support are structured around categories o f the population, rather than based o n any poverty criteria, irrespective o f any forms o f measurement. The only exceptions are the national chi ld (family) allowance and housing allowance, but it i s wel l known that these, in particular chi ld benefits, permit significant leakages to non-poor groups o f the population. Therefore, the Kazan ci ty reform program will introduce special cash poverty benefit that will be used as income support instrument for the most needy households in Kazan. Implementation o f this benefit wil l use several important innovations in order to eliminate the risk o f leakage o f program funds to non-poor. These innovations will include, inter alia, (i) regular verification o f the welfare status o f eligible household, (ii) involvement o f employment office if an applicant’s household includes non-working able-bodied adult, and (iii) introduction o f conditional “social contract”. The program will support introduction o f targeted supplemental payments to poor families with children in order to cover the costs o f kindergartens and summer rest for children. Important improvements will be introduced into the program o f targeted housing allowance that i s currently one o f the two means tested targeted programs in Kazan. The innovations will include verification o f income level. Payment mechanisms for the housing allowance will be modified in order to take into account the best national practice o f uti l ization o f “individual social accounts” for these purposes.

51. Improved efficiency and quality o f social service provision. The social services in Kazan (assistance to the aged, rehabilitation o f disabled, assistance to families in crisis, etc.) are currently provided by municipal enterprises that are financed through input-based budgets and operate primarily in house. There i s l i tt le incentive for reduction o f costs and improved quality o f services to the beneficiaries. The existing 83 social service enterprises accounted for 47 percent o f the entire budget for social pol icy in 2003. Kazan has not had previous experience in outsourcing the provision o f social services, however, the program will introduce innovations into institutional and budgetary framework €or social services delivery in

23

order to improve accountability o f municipal service providers and to permit the non-governmental providers to compete for budgetary funds to finance service provision. In particular, funding for provision o f services wi l l be allocated as block grants to service providers within the mechanism o f “municipal contract (order)” and competitive selection mechanism will be introduced for contract awards for provision o f specific services.

The Housing and Communal Services Sector

52. One o f the most significant challenges facing Kazan, together with the vast majority o f other Russian cities o f comparable size and status, i s the delayed reform o f the largely inefficient housing and communal services (HCS) sector.’ Used as a buffer to mitigate the impact o f the overall transition in Russia in the decade following the collapse o f the Soviet Union, the sector has suffered f rom a combination o f adverse factors that work against efforts to restore i t to viability. The importance o f the sector reform i s self-evident: improvements in the HCS will positively affect the lives o f the majority o f the c i ty population living in multi-apartment residential buildings and dependent on utility infrastructure and related housing services. Of the many sector challenges the following were identified as top priority in Kazan:

53. Inefficient uerformance o f the sector enterprises. Technical and economical inefficiencies manifest themselves in growing production costs and high levels o f losses in networks, higher consumption o f power and other resources. In 2003, the total volume o f water billed made up only about 65 percent o f the overall water production in Kazan while i t s estimated cost per cubic meter was some 15 percent higher than that in neighboring oblast capitals o f the Volga Region. Although costs o f the heat supply in Kazan are remarkably l o w (as it comes as a side product o f electricity production), the estimated volume o f the heat lost i s also beyond economically justifiable level.

54. A key factor behind these inefficiencies i s obsolete and wom-out sector infrastructure (facilitieshetworks) and equipment. The average depreciation o f the Kazan Vodokanal (municipal water company) fixed assets i s 61 percent, including 72 percent for water pipelines, 66 percent for sewer pipelines, and 65 percent for water supply structures. As a result, 454.4 km o f the water supply network and 232.1 km o f the sewer network need to be replaced.

55. Institutional and managerial weaknesses are yet another factor preventing the efficiency upgrade o f the sector. The bulk o f water and wastewater services, as wel l as over 30 percent o f the heat supply,

In Russia, the housing and communal services sector includes an array o f municipal services: provision o f state owned housing, building management o f state and privately owned apartment dwellings, water and waste-water provision, and district heating.

24

50 percent o f housing maintenance and almost al l housing stock management in Kazan are currently provided by the municipal unitary enterprises (MUEs), a special form o f publicly owned entities now broadly recognized to be an instrument o f l imited use. Complementary to MUEs, which pose identical problems for municipalities throughout the country, there are institutional challenges specific to Kazan. These stem from the lack, until very recently, o f a municipal status and the related and lasting uncertainty in the division o f responsibility between the Republic and the city.

56. Poor financial position o f the sector enterprises. As elsewhere in Russia, improving the financial position o f individual utilities and the sector at large i s prerequisite for the success o f the HCS reform in Kazan. Various aspects o f this challenge are wel l known; the cumbersome tariff-setting procedure i s among the most important ones.

57. A key element o f the HCS tariff-setting procedure in Russia i s the federally mandated, and regionally adjusted, maximum aggregate cost o f providing housing and communal services, also known as “economically justif ied HCS ta r i f f ’, in fact, an administratively imposed tar i f f ceiling. In Kazan, the maximum aggregate cost grew f rom RUR15.72 per square meter per month in 2004 to RUR 20.5 for 2005. Another federal standard establishes the maximum HCS tar i f f for population in the form o f percentage o f the economically justified tar i f f t o be assigned to and paid for by households. For 2005, the Government o f Russia has set i t at 100 percent, thus creating a situation conducive for the elimination o f the long-standing cross- subsidization practices when service consumers o f one category (manufacturers) compensate for the portion o f expenditures not covered by consumers o f another category (population). This year, the population o f Kazan paid in full for almost’ a l l services except heating and capital repair o f buildings. And finally, the third standard that contributes to the process o f tariff-setting and to distinguishing o f those in need o f housing subsidies, i s the maximum percentage o f the overall family income to be spent on HCS payments. At the country level i t i s now uniformly set at 22 percent o f the family income, but regions have the right o f lowering the threshold at their own expense.

58. There i s a body o f evidence to suggest that the tar i f f setting procedure in Kazan i s both non-transparent and politicized, a situation typical for Russia today. What i s special for Kazan i s that some services continue to be regulated by the Republic o f Tatarstan and n o explicit mechanism exists for tar i f f adjustments. Methodologically, the adopted procedure represents a modification of “cost-based pricing”, which normally provides l i t t le or n o incentives for cost efficient behavior on the part o f service suppliers as profits in this system are in direct proportion to costs.

59. Underdeveloped market environment in the housing management and maintenance. The housing privatization pol icy that was instituted in the early 1990s led to a fairly high level o f privatization o f

25

individual apartments (over 65 percent in Kazan, i.e. close to the Russia average), but failed to create the necessary conditions for adequate representation o f the demand-side o f the market, for which the relevant economic agent (in the case o f most services) i s the entire building, not the individual household consumer.

60. As a result o f this lingering institutional failure, most multi-unit residential buildings in Russia exist in a legal l imbo in which the unambiguous attribution o f ownership privileges and responsibilities for buildings’ common spaces, shells, land plots, etc. i s impossible.

61. The conflict o f property rights and interests o f individual apartment holders with the fact that i t i s the municipality that, through i t s management companies, continues to perform as the owner o f the common property inside and outside multi-unit buildings could be resolved with the creation o f homeowners associations (HOAs). Currently, the incidence o f registered homeowners associations i s l o w (206 in Kazan) and generally limited to wealthier people. For the vast majority o f the population, municipalities throughout Russia continue to assume responsibility for housing maintenance and management. This state o f affairs has led to two negative outcomes. First, expenditures on the housing complex represent a significant burden o n local budgets, which are typically not in a position to finance the huge costs o f capital refurbishment, with the result that a large part o f the urban housing stock i s slowly fall ing into disrepair. In Kazan, the accumulated backlog o f repairs i s estimated at RUR 6.5 b i l l ion rubles (USD 230 million), which, in physical terms, i s equivalent to 2650 buildings o f total area approaching 6 mi l l ion square meters (50 percent o f the total multi-apartment stock o f the city). Second, administrative methods continue to dominate housing maintenance and management, leading to suboptimal outcomes, including the determination o f prices by regional and local planners, imposition o f preferences on consumers, opportunities for patronage, etc.

62. In the past year Kazan completed the delineation o f functions o f the residential property management and o f the housing maintenance. A municipal system o f the housing stock management, comprising nine management companies, o f which eight belong to the city, was created. At present, they bear full responsibility for ensuring that residential property i s in good repair that actual comfort levels meet the established standards. For a c i ty o f the size o f Kazan, this business, however, appears to remain overly monopolized, i t s further improvement would depend o n the abil ity to assume more players f rom the private sector.

63. Similarly, there i s scope for a growing presence o f the private sector in the housing stock maintenance. In 2004, due to the relatively recent practice o f competitively tendered maintenance contracts, more than 50 private service suppliers were contracted. However, over 52 percent o f the city’s municipal stock continues to be serviced by 15 municipal enterprises (MUEs), whose cost to quality ratio i s less favorable than that o f their private competitors.

26

64. On September 30, 2004, the Ci ty Council o f Kazan approved a Program o f Reform o f the Housing and Communal Complex o f Kazan. The Reform Program developed by the ci ty reflects a comprehensive approach to the range o f interrelated problems in the sector, with a focus on three major areas: (i) reform o f utilities and other public enterprises workmg in the sector, (ii) restoration o f the sector's financial viability, including reform o f the tariff-setting process, (iii) support to the development o f market environment for housing maintenance and management, including provision o f economic incentives to the voluntary creation o f home-owners associations. The Program builds on the progress made in recent years in cost-recovery, social protection, and init ial efforts to develop a market for housing maintenance. I t sets clear short and medium term targets, suggests implementation indicators and assigns operational responsibilities to ensure successful outcome.

65. The following are the proposed reform actions in the respective areas:

66. Improvinp; the performance o f the sector enterprises. In making the HCS more efficient the c i ty wi l l seek to corporatize or privatize the c i ty utilities. Municipal unitary enterprises will give way to jo in t stock companies. The underlying concept presumes that whi le utility infrastructure remains in the public property the operations o f these enterprises are corporatized with 100 percent o f shares to be in i t ia l ly held by the city. For example, a new jo in t stock company for heat supply will be brought into being in early 2005. All district housing maintenance companies will be privatized i'n 2005.

67. Special programs devised for the involved sub-sectors guide the pace o f the reform. The majority o f these have already been approved by the Ci ty Council and therefore have the status o f an of f ic ia l policy. Along with institutional changes the programs lay out specific actions for technical and engineering improvement o f the services.

68. Installation o f water and heat supply meters and regulators i s also seen as part o f an effort to increase sector performance efficiency. In 2000, a plan was adopted to install in Kazan 4603 house water meters over a 5-year period. As o f now, 3622 meters or 79 percent o f the originally planned number i s already in place. Installation o f another 600 meters was due before the end o f 2004. The process i s linked to the capital repairs and i s paid by the city. I t i s planned to attract financing f rom residents, in particular when meters are installed in apartments.

69. Stabilize and improve the financial position o f the sector enterprises. F rom year 2004 onwards the majority o f HCS tariffs are being set by the ci ty (except those for electricity, gas and heat supply remaining the prerogative o f the Republic o f Tatarstan). Although administrative restrictions to tar i f f setting are s t i l l in place, the c i ty managed to make the process more realistic: the average increase o f

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tar i f f rates for population f rom 2003 to 2004, and from 2004 to 2005 (projected) and was about 1.5 times.

70. The ci ty considers the actions outlined below necessary to ensure strengthened operational and financial position o f the Kazan’s housing and communal services sector:

0 eliminate budget subsidies to producers o f heat (except housing subsidies offered to needy families through the system o f social protection); 0 eliminate debts o f budget organizations to HCS suppliers, and o f district housing maintenance companies (RZhU) to housing maintenance companies; delegate to the c i ty the right to set the heat tariffs or continue establishing them at the regional level provided tariffs are set at the level o f 100-percent cost recovery for a l l heating companies operating in the ci ty o f Kazan; 0 starting 2005, introduce two-tier tar i f f rate (fixed and variable) for the water and wastewater supply; 0 starting 2006, introduce two-tier tar i f f rates (fixed and variable) for heat supply; 0 eliminate cross-subsidization between categories o f water and wastewater consumers; 0 eliminate cross-subsidization between categories o f heat consumers ; 0 adopt ru les to regulate tariff-setting procedure for heat, water and wastewater supply; 0 change the existing practice o f subsidizing ut i l i t ies to financing individual consumers (via personalized social accounts); 0 in the ci ty budget, provide sufficient funding to compensate service suppliers for the lower tariffs o f budget organizations; 0 revenue generated from the lease o f municipal housing to be allocated for the capital repair o f the same.

71. Facilitate the development o f market environment in the housing management and maintenance. This section o f the Program deals with measures to promote market relations in housing stock management and servicing, extending public support to the emerging business o f property management, privatization and subsequent competitive selection o f companies to provide upkeep services, etc. The novelty o f the approach i s the emphasis on the development o f the demand side o f the housing market, which implies the transition f rom administratively determined housing management with imposed tastes and control o f prices, to a system o f housing management based on market principles and allowing for a range o f preferences.

72. The proposed actions include the following:

0 maintain 100 percent o f municipal housing stock by competitively selected contractors;

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0 introduce competitive tenders for private management o f municipally owned housing stock; 0 ensure a framework for a steady dialogue between the Ci ty Administration and local communities represented by HOA leaders (a special Coordinating Council under the auspices o f city administration has already been created; at the moment i t i s comprised only o f c i ty officials); 0 develop a package o f economic and other incentives to encourage the formation o f HOAs (the prospects for leasing common spaces, e.g. attics and basements, might be particularly attractive);

launch an awareness campaign to promote the H O A model among city residents;

facilitate the formation o f HOAs in newly completed housing and in buildings that have undergone comprehensive capital repairs;

prepare grounds for the introduction o f an individual building maintenance budgeting system including the development o f appropriate software.

111. BANK STRATEGY

Link to the Country Assistance Strategy

73. The Wor ld Bank Group’s Country Assistance Strategy (CAS) for the Russian Federation for the period 2003-05 calls for the Bank “to support the effective implementation o f the Govemment’s comprehensive reform program, to help mitigate the underlying r isks to the sustainability o f growth and to extend the opportunities arising f rom the reform process more widely across the r i ch diversity o f Russia’s p o p ~ l a t i o n ” . ~ The CAS identified three strategic pillars o f support to the Govemment’s reform program: (i) improving the business environment and enhancing competition; (ii) strengthening public sector management; and (iii) mitigating the social and environmental r isks o f reform. Each pi l lar consists o f several components, as detailed in the CAS. Whi le this CAS did not envision a need for federal budget support under the conditions that prevailed at the time o f i t s preparation in early 2002, it recognized that this lending instrument could be an option under future circumstances, and’ in particular noted the importance o f developing instruments to work effectively at the regional and municipal levels. Moreover, the CAS base case lending program included the St. Petersburg Economic Development Project that had a adjustment lending component. The KMDL was added to the program after the current CAS had been finalized. The Russia CAS Progress Update, scheduled to be distributed to the Board o f Directors around February 25, 2005, explicitly mentions the Kazan Municipal Development Loan as an

Russian Federation CAS, Report No. 24127-RU, M a y 14,2002.

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important element o f extending the Bank’s involvement in municipal reform in Russian cities.

74. The Bank’s current program o f assistance to GOR is structured around these strategic areas that remain appropriate. Whi le the budget surpluses o f recent years have led to a decline in the need for Wor ld Bank lending to Russia relative to expectations at the time that the CAS was developed in conjunction with GOR, the Bank Group continues to play an active role in providing advisory services in support o f the three strategic pillars, with targeted lending to reflect the evolving priorities and needs o f the Government. As demonstrated by the city’s reform programs that constitute the basis for Bank support and by the pol icy matrix (Annex 3), the proposed Kazan Municipal Development Loan directly supports, o n the municipal level, the three strategic pillars o f the CAS with particular reference to the components identified below:

Table 3. Links t CAS Strategic Pil lar Improving the business environment and enhancing competition

Strength en ing public sector management

Mitigating social and environmental risks

the Russia Country Assistance Strategy CAS strategic components embodied by the KMDL

0 upgrading infrastructure and restructuring natural monopolies; 0 increasing opportunities for entry and growth o f new f i rms.

0 improving fiscal management at the municipal level; 0 improving efficiency and quality o f public service delivery in areas critical for improving the investment climate and supporting long-term growth, particularly in provision o f basic infrastructure and communal services. 0 improving the design, targeting, administrative capacity and financing o f social protection programs.

75. The proposed KMDL i s within the base case lending scenario that envisages lending and guarantees o f up to U S D 600 mi l l ion per fiscal year. The base case i s contingent upon two sets o f triggers which both need to be met for lending activities to remain at the foreseen level. The f i rst refers to the share o f satisfactory projects in the portfolio and the average time to effectiveness. Currently, the share o f satisfactory projects in the portfolio i s 83 percent, above the benchmark figure o f not less than 70 percent. The processing time o f new operations f rom Board approval to effectiveness has been reduced f rom 12 to 9 months, not reaching the CAS trigger o f 8 month. This i s due to the delay in signing the St. Petersburg Economic Development Loan, which i t s e l f stemmed from changes in the local government that were entirely out o f the control o f the federal

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government (see para. 83). The second set o f triggers related to the continued implementation o f the Government’s structural reform agenda together with prudent macroeconomic policies; these continue to be met.

Analytical Underpinnings of the Proposed Loan

76. Specific analysis that was carried out in the course o f loan preparation has been complemented by major analytical undertakings carried out on the national level (notably the poverty assessment that was completed earlier in 2004) and by the country-level core diagnostic assessments made by the Bank in Russia. The specific analysis included an assessment o f the social impact o f the proposed reforms; a review of budget management practices, financial accountability systems and inter-budgetary relations in Kazan; and a review o f municipal procurement practices.

77. More generally over the past few years, the Bank has undertaken a variety o f cross-sectoral operational and analytical work, as we l l as lending, in Russia for a l l the themes addressed in the pol icy conditionality o f KMDL.

(I, intergovernmental and sub-nationalfinance

78. Economic and sector work which has been extensive producing a series o f reports and technical papers: Wallich, Russia and the Challenge of Fiscal Federalism, (1994); L e Houerou (1 995) Fiscal Management in the Russian Federation (1995); L e Houerou and Rutkowski: Federal Transfers in Russia: “Their Impact on Regional Revenues and Incomes ’’ Comparative Economic Studies (1998); Freinkman et al. Subnational Budgeting in Russia: Preempting a Potential Crisis (1999); and Freinkman and Yossifov (1 999) Decentralization in Regional fiscal systems in Russia: Trends and Links to Economic Performance (1 999); Martinez-Vazquez, Jorge, et a1 Russia’s Continuing Transition Towards a New Federalism: Subnational Finance in the Russian Federation (forthcoming) .

(ii) social protection

79. The Bank has long been supporting replacement o f the ineffective and inefficient system o f categorical in-kind benefits with primarily monetary targeted social assistance. Specific actions taken included piloting o f modern targeting techniques in three RF regions, introduction o f targeting for chi ld allowances, design . o f methodologies for provision o f regional social assistance and financing for national survey o f incomes and social assistance (NOBUS). Effectiveness o f safety nets in reaching the poor was assessed in several pieces o f work (see Child Welfare Outcomes during the 1990: The case of Russia; Non-income Dimensions of Poverty), but most recently this was undertaken by the Russia Poverty Assessment (2004, Chapter 8) that concluded that Russian safety net

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system continued to allocate large shares o f social assistance spending to non-poor population.

Project Date Amount Approved USD mln

(i i i) housing and communal sewices

Status

80. In February 2002, the Wor ld Bank launched work on housing and communal services reform in response to a request f rom the Russian Government. The a im was to analyze the Government’s HCS reform program and to investigate the main issues faced within the regions in moving forward with implementing reforms in the HCS sector. The Bank’s work on HCS reforms was presented at two regional conferences that were held in Samara and Novosibirsk in February 2003, with the ci ty o f Kazan participating in the Samara conference. The main objective o f the conferences was to discuss the implementation o f HCS reforms in detail with local pol icy makers, and a l l participating local authorities felt that they could benefit f rom federal government guidance in implementing HCS reforms.

Regional Fiscal TA 1999 30.0 Fiscal Federalism & Regional Fiscal 2002 120.0 Reform St. Petersburg Economic 2003 161.1 Development Loan

81. The Bank i s currently in the process o f assisting the federal government in implementing HCS reform at the local government level (regional and municipal). The federal government and Bank’s HCS reform program prioritizes and sequences reforms into: (i) those that seek to improve the sector’s financial condition and need to be pursued immediately; and (ii) reforms that will take longer to implement, and seek to alter the institutional and regulatory environment, especially with regard to municipal enterprises. In addition, the reform program needs to focus on the management and maintenance o f the existing housing stock in order to halt the depreciation o f housing assets, in addition to i t s current focus o n the importance o f utility reform.

Active Active

Active

Lessons learned from lending operations

Social Protection Implementation I 1998 28.6 Closed

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82. The Bank has gained valuable experience in subnational lending. The Regional Fiscal Technical Assistance Loan (Ln. 45280-RU) provided assistance to the Russian Federation in strengthening federal and regional fiscal legislation and monitoring capacity, and provided assistance to six regions to carry out diagnostic studies and prepare reform programs. The Fiscal Federalism and Regional Fiscal Reform Loan (Ln. 46470-RU) supports the regions in the development and implementation o f fiscal reform programs that will promote financial transparency, budgetary accountability, and strengthened fiscal management policies and practices. These loans demonstrated that a project focused on Russian regions can be highly effective in leveraging structural reforms when based on federal grants to regions, allocated competitively, to create an incentive for reform. This approach includes the following: (i) competitive selection o f regions, with the selection criteria l inked to demonstrated progress on reforms; (ii) Bank lending to the federal govemment in the form o f budget support and allocation o f loan proceeds among regions as grants through a budget transfer window as an award for good performance, (iii) provision o f technical assistance to support the federal government and regions in preparation and implementation o f the program; and (iv) full benefits o f accelerated regional reforms, triggered by regional competition, significantly exceed the costs o f additional debt burden that the Russian Federation has accumulated under the project.

83. In M a y 2003, the Bank’s Executive Directors approved the St. Petersburg Economic Development Loan (Ln. 46940-RU U S D 161.1 million), a hybrid loan that supports the city’s economic transformation through reforms in the business environment and the city’s financial management and investments in selected cultural sites that are critical to the city’s future development as an intemational cultural destination. In St. Petersburg, the key has been a committed c i ty govemment workmg in tandem with a federal counterpart. St. Petersburg also highlighted the r isks inherent in the polit ical cycle: signing was delayed almost a year due to the sudden resignation o f the Governor and the subsequent lengthy process o f electing a new one. Despite these problems, however, the reform program continued to move forward in this period due to the commitment o f both the local and federal authorities.

84. The Bank has also undertaken projects in social protection, namely the Employment Services and Social Protection (Ln. 35320- RU), Social Protection Adjustment Loan (Ln. 42030-RU) and Social Protection Implementation Loan ( Ln. 42340-RU). These loans assisted the establishment o f national institutions that were non- existent before the market reforms o f the 1990s (employment service) and the design o f national policies in the area o f income support, employment and pensions. Implementation o f these projects and o f the SPAL in particular, was affected by the financial crisis o f the 1998 and overall government instability. These factors prevented a breakthrough in social sector reforms except pensions, where three pil lar pension system has been introduced.

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However, through these projects the Government gained a significant experience in the design and piloting o f social protection programs, including targeted income support, employment and pension policies and equipped the Government with effective tools o f pol icy analysis (National Survey o f Households’ Welfare and Social Programs Participation - NOBUS).

85. In the housing and communal services, the Bank had extensive experience in the development o f housing markets and implementation o f HCS reform policies in receptive cities. For the most part, these efforts (which mainly took place in the mid-to-late 90s) had a mixed record because they were: (i) unrealistic in their objectives and assessments o f polit ical and economic realities, and (ii) designed as a traditional, br ick and mortar, investment project. Kazan took part in the Housing Project (Ln. 3850-RU) and had a relatively successful outcome. A considerable portion o f land in downtown Kazan was auctioned o f f to private developers by the ci ty administration, thus creating a model for the establishment o f market relationships in the city’s real estate. More recent projects are incorporating a broader institutional and policy agenda, whi le assessing the polit ical climate for reform. Kazan i s currently participating in the Municipal Heating Project (Ln. 4601 -RU), which follows a track broadly similar to the engaging o f the private sector for service delivery planned for the Vodokanal under the proposed KMDL.

IV. THE PROPOSED LOAN Objectives

86. The proposed KMDL will be the instrument through which the Wor ld Bank will support the Russian Federation’s effort to deliver technical and financial support to the Kazan Government’s reform program. The proceeds o f the loan will enable Kazan to strengthen i t s financi+A position and put in place the reforms needed to improve budget and financial management, the delivery o f social services and the condition o f the HCS sector.

87. The Russian Federation’s objectives in requesting this loan go beyond Kazan. The federal government i s eager to promote a sound policy framework and fiscal sustainability in the regions, and the proposed KMDL (as wel l as the St.Petersburg EDL, currently under implementation; see para. 104) are good vehicles for doing this. A partnership with the Wor ld Bank further ensures accountability and transparency. The loan thus carries a nation-wide externality, i.e. t o demonstrate good practice and foster it in the rest o f Russia.

Loan Amount and Tranches

88. It i s proposed that the Kazan Municipal Development Loan o f USD 125 mi l l ion equivalent be disbursed in two tranches. The f i rst tranche o f the loan in the proposed amount o f USD 50 m i l l i on would be disbursed upon effectiveness in early 2005. The second tranche in

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the amount o f U S D 75 mil l ion would be disbursed following IBRD’s review and determination that policy actions pertaining to the second tranche release have been undertaken and are satisfactory. This i s notionally planned for early 2006. The somewhat back-loaded disbursement schedule reflects the different financing requirements o f the city’s program, which are expected to be larger in 2006.

89. The options o f a single-tranche operation and multi-tranche (i.e. more than two) operation were considered but rejected. The reason for the choice o f the two-tranche option was that i t combines sufficient f lexibil i ty in designing the timing o f the pol icy reforms with a realistic approach to dealing with constraints o f the polit ical consultative process. In the case o f the proposed loan, where a sub- national entity i s the main beneficiary, a single-tranche operation was considered risky as it would not have provided the Federal Government any instrument or ability t o effectively leverage the actual implementation o f the reforms. A multi-tranche operation was considered equally r i s k y as it could provide incentives to delay decision-making and implementation.

Conditions

90. The support o f Tatarstan to the transformation o f the city o f Kazan into a full fledge municipality, as wel l as it ’s commitment to take the legal and organizational steps envisaged by the Program i s la id out Tatarstan’s Letter o f Development Policy (Annex 1). The City’s Letter o f Development Policy (Annex 2) lays out a reform program that i s both consistent with the federal program o f decentralization and addresses the actions needed to sustain i t s economic and financial transition. From that program a core subset o f pol icy actions, listed in bold face in Annex 3, have been selected as the legally agreed actions that would trigger the disbursement o f the f i rst tranche (conditions to be completed before the Board presentation) and the second tranche. The conditions are considered by the Bank and the Russian federal government as wel l as the city o f Kazan as key steps to achieve the loan objectives, namely to improve Kazan’s fiscal condition and its’ capacity to deliver efficient and effective services to the population.

Table 5. Legally agreed actions I A. Budget and Financial Management

Strengthening I 1. Budget Planning

and Execution (a) The 2006 fiscal year budget with the concept and parameters satisfactory to the Bank has been approved by the City. (b) The Ci ty has demonstrated that there are n o new overdue payables of the c i ty budget and budgetary institutions f rom end-2004 to end 2005.

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2.Municipal Treasury

I 1 .Financial

cia1 Protection System 1. Implementation

Capacity for Social Protection Programs

The City has demonstrated

2. Transparency

3. Social Assistance Targeting

The City has demonstrated that a viable system o f Treasury-execution o f the municipal budget has been established based on a single account concept for budgetary funds, and funds are channeled solely through the Borrower’s Central Bank.

The Ci ty has demonstrated improvements, satisfactory to the Bank, in the implementation capacitj for social protection programs.

The City has demonstrated that: (a) payment o f monetized social and housing and communal service benefits using individual accounts has been introduced and i s under implementation; and (b) sufficient resources in the fo rm of subvention f rom the Republic of Tatarstan have been allocated in 2006 Ci ty budget for payment o f monetized benefit.

The targeted poverty benefit has been successfully implemented, and 2006 Ci ty budget allocates not less than 75 mil l ion Rubles for the City own social protection expenditures for i t s financing, and social contract practice i s utilized.

Conditions o f the Sector

2. Governance F Social impact

satisfactory improvements in the housing and communal sector.

The City’s water and wastewater facilities are managed by a competitively selected private operator.

91. The existing system o f social assistance in the ci ty o f Kazan has the benefit o f being managed by a department with good capacity and a strong client-orientation, and the disadvantage o f being constrained

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by a plethora o f Federal, regional and local laws and other acts that mandate excessively broad provision o f social assistance. The pol icy reform concern in this area i s to ensure the focus o f the existing resources o n the truly needy, i.e. to maximize coverage o f the poor while minimizing leakage to the non-poor. Means-tested programs o f social protection have been established in Kazan that are dynamically responsive to changes in a household’s income so that, for example, an increase in utility tariffs that results in a burden on the household that i s deemed to be excessive (as defined locally) immediately qualifies the household for receipt o f housing subsidies.

92. In order to gain a more robust empirical understanding o f the degree o f targeting and coverage o f social protection funds overall, as wel l as to model the potential social impact o f the various reforms proposed by the ci ty o f Kazan and supported by the Wor ld Bank under the KMDL, a social impact analysis was carried out in the course o f loan preparation. In this context, i t should be stressed that the need for adequate mitigation o f the possible social consequences o f the reforms supported under the KMDL i s built into the loan design i t s e l f (e.g. targeted poverty benefit), with a social protection dedicated to improving the effectiveness o f social assistance provided in Kazan.

93. The social impact assessment aimed to:

0 In the area o f housing and communal services: (i) evaluate the quality o f housing and communal services and to assess the level o f household customer satisfaction with the quality o f these services; (ii) provide a br ie f assessment o f h o w increased tariffs for centralized heating and water will affect the population, and especially people in lower income groups; (iii) evaluate the experience o f home-owners associations (HOAs) and to assess the response (interest) o f the population to a municipal policy o f stimulating voluntary reorganization o f residential buildings into the form o f home-owners associations.

0 In the area o f social protection: (i) prepare a br ie f assessment o f efficiency and targeting o f the existing social assistance system, (ii) assess the quality o f social assistance services.

94. The study included a survey o f the population and focus group discussions. A representative sample o f households residing in apartment buildings in Kazan was used for the housing and communal services part o f the survey. A representative sample o f Kazan’s population was used for the social protection part o f the survey. A quota o f social protection service recipients was added to this sample to evaluate quality o f services by recipients.

95. One o f the objectives o f the study was to understand how residential customers evaluate utility service quality. Overall, the quality o f gas, electricity and telephone service was perceived as very

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good, and the quality o f cold water, sewerage and central heating services as fairly good. Ho t water supply and housing services were not rated as good. Metering and billing for utility services was not considered perfect: respondents mentioned that the bills contained errors (electricity - 52 percent o f respondents; gas - 16 percent; heating - 28 percent), that they do not always reflect meter indications (electricity - 36 percent) and that meter readings are not fully reliable (electricity - 33 percent).

96. The district heating and water sector reforms discussed by the city government wi l l have impact on almost al l households in Kazan, as 98 percent o f households according to the survey have access to district heating and 96 percent have access to cold water. A few survey's questions were asked to understand potential response o f the population to key reform actions: metering o f cold water and tar i f f increases for cold water and district heating. The analysis has revealed that affordability i s unlikely to be a problem if water and district heating tariffs are increased as proposed. Metering o f cold water, according to the survey, would not cause resistance from the population, as almost ha l f o f the interviewed expressed preference for metered cold water service.

97. One o f the key elements o f the HCS reform in the ci ty would be strengthening incentives for voluntary reorganization o f residential buildings into homeowners associations (HOAs). The survey questionnaire included several questions to access potential response o f the population to this policy. In addition to the survey, seven focus group discussions were conducted: three with HOA heads and four with residents o f buildings organized as HOAs, including two with residents o f o ld buildings and two with residents o f new buildings. Overall, the analysis has demonstrated that the population believes that the system o f housing management in Kazan i s in crisis and that changes are needed. Many support the idea o f HOA creation in principle. At the same time, the population does not believe in the ci ty government readiness to start the HOA reform. The fear i s that the transition to HOAs will be forced and that the population wi l l not benefit f rom it. Also, Kazan' residents are concerned with potential problems if buildings requiring substantial renovation are transformed into HOAs. HOAs are expected to be more successful in more affluent areas o f the city, but less so in areas dominated by lower income groups. Heads o f existing HOAs, even in luxury buildings and in affluent parts o f the city, think that institutional environment i s not yet ready to support HOAs functioning.

98. One o f the main objectives o f the social protection r e f o m in Kazan i s increased efficiency and targeting o f social assistance. The survey included several questions to evaluate targeting and efficiency o f the existing system o f social protection and collect information on consumer satisfaction with social protection services. Overall, according to responses collected, targeting o f social protection i s perceived as satisfactory. The main problems are in the coverage (not al l poor are covered by the system) and access to services (many

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people find it diff icult to understand the system and to apply for asshtance). Based o n these outcomes, an awareness campaign to explain eligibil i ty criteria aimed at lower income households would be most useful. Such campaign would benefit lower quintiles and reduce possible inclusion and exclusion errors in the distribution o f benefits.

Environmental Aspects

99. N o direct negative environmental impact i s expected f rom the KMDL implementation. The Russian Federation has a we l l established framework for environmental assessments. The environmental assessment legislation i s based on the Federal L a w on Ecological Expertise, and includes a two stage procedure which includes Environmental Impact Assessment (EM) and obligatory State Environmental Review (SER) process. The Ministry o f Ecology and Natural Resources o f Tatarstan has traditionally been one o f the strongest institutions among the Russian environmental protection bodies and has managed to sustain i t s core expertise and institutional integrity over the last decade. In 2003, the Department o f SER o f the Ministry reviewed over 1100 projects and rejected (or requested to improve) about 40 percent o f them.

Outcomes

100. KMDL will result in: (i) a strengthened budgeting and financial management in the city; (ii) better access to social assistance and social protection services for the poor, and (iii) strengthened financial condition for the housing and communal services sector. Relevant policy actions and indicators are described in Annex 3 .

Monitoring and Evaluation

101. Country macroeconomic Performance will continue to be measured, in consultation with the Intemational Monetary Fund, throughout the loan period based on the fiscal and monetary stance, inflation, balance o f payments, and the extent to which the macroeconomic environment could affect the objectives o f the Program. Monitor ing o f the achievement o f performance targets wil l be ensured as part o f the regular loan implementation supervision by the Bank. In addition, a reputable consulting firm with a track record in monitoring Bank funded projects wil l be hired to provide the federal government with periodic monitoring reports and conduct additional surveys in case data underlying monitoring indicators i s not readily available through the Republic o f Tatarstan or Kazan authorities.

102. At the federal level, the Ministry o f Finance wil l allocate budget funds to finance activities related to monitoring, evaluation and

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dissemination o f achievements o f the Program. In addition, the MOF’s Fiscal Monitoring Div is ion (created under the Fiscal Federalism and Regional Fiscal Reform Project) will continue monitoring fiscal developments in Tatarstan as part o f i t s normal mandate. At the local level the overall monitoring o f the loan wil l be provided by the Tatarstan’s Interministerial Working Group (headed by an advisor on economic affairs to the Tatarstan President) and the ci ty o f Kazan Inter-departmental Working Group (headed by the f i rst deputy mayor in charge o f economics).

Implementation Arrangements

103. The overall responsibility for the implementation o f the proposed operation, including progress reports and coordination with parties concerned, will rest with the city’s mayor and the administration o f the c i ty o f Kazan, with support, as needed, f rom the Republic o f Tatarstan. Operational responsibility for implementation will be with the city’s f i r s t deputy mayor in charge o f economics.

104. Over the period o f loan implementation, the Bank team will carry out supervision missions to help ensure progress towards completion o f the tranche release conditions. Supervision o f the Program will be focused on the outcomes o f the Program with due account taken o f the latest country developments, stakeholder support, and feasible options for realizing the intended development goals. The review wil l be largely based on the monitoring indicators (benchmarks) and the goals o f the Program.

Fiduciary Aspects

105. In rapidly changing environment for inter-governmental relations in Russia, there i s some uncertainty regarding the medium-term inter- governmental fiscal relations, including Public Financial Management (PFM) arrangements for municipalities such as Kazan. As a result, the exact fiduciary environment o f this loan i s somewhat unpredictable.

The Kazan Municipal Development Loan embodies a few unique fiduciary features. Fiduciary aspects o f most adjustment loans to the Russian Federation so far have been concerned with the PFM performance o f the Federation (the Borrower). By contrast, the fiduciary environment for the KMDL will encompass a l l three levels o f government, the Russian Federation at the federal level, the Republic o f Tartastan IRT) at the regional level and the ci ty o f Kazan at the local level.

At present, Kazan has the responsibility for i t s budget preparation, while Kazan’s budget execution i s largely managed by a department o f the RT Treasury (KDRTT). Controls and internal audits are also managed by the RT institutions. Up to 2004, external audit had been

48

performed by the RT’s parliamentary commission”. Once Kazan’s new legal municipal framework i s fully enacted” prior to the release o f the second tranche o f the loan, budget execution functions, and particularly treasury, i s to be transferred from the KDRTT to a department in the regional branch o f the Federal Treasury in Tartastan. Precisely how this transfer will be managed and what wil l be the exact responsibilities and functions o f the new treasury arrangement, remains to be determined. The future internal and external audit arrangements for the Kazan budget are yet to be specified also.

106. At the federal level, substantial diagnostic work has been carried out. Since January 2001 the Bank carried out a CFAA, a CIFA, a CPAR and several sectoral PERs (federal capital expenditure and sub- national PERs for the following sectors: health, education, housing and utilities, public transportation, industry, construction and agriculture, law enforcement, culture and state governance).

In 2001, the C F A A concluded that the public financial accountability framework in Russia required considerable strengthening. The country’s control framework was fairly comprehensive but inefficient. Since the CFAA’s completion, substantial reforms have taken place in the public financial management. These have been noted in the recent IMF Fiscal Transparency Module o f the Report on the Observance o f Standards and Codes (ROSC)I2. The report notes that the legal framework o f the budget and tax system as wel l as for intergovernmental relations has been reformed. Macroeconomic pol icy forecasts are soundly based and open for scrutiny. Budget preparation has become sophisticated with considerable transparency in the process and in the availability o f information. The treasury system has strengthened budget execution, control, and monitoring. Reliable data i s increasingly available on a timely basis for most levels o f the government. Many quasi-fiscal activities (QFAs) have been removed. Tax policy has been modernized, and the scope for administrative discretion has significantly reduced. A stabilization fund was created as part o f the federal budget in January 2004. The authorities have a clear sense o f direction for needed reform, are engaged in a transparent process o f developing medium-term plans o f action and, in many cases, are already engaged in implementing these plans.

However, remaining challenges need to be addressed, including the following:

0 narrowing the opaqueness in the boundaries between the general government, the public enterprise sector, and the private sector;

lo In 2004 the commission has been replaced by the RT Accounts Chamber. The Accounts Chamber will, on an exceptional basis, audit Kazan’s 2004 accounts.

l2 IMF, Country Report No. 04/288,3 September 2004, Expected in January 2006.

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0 addressing remaining weaknesses in intergovernmental relations, particularly establishing stable ru les for expenditure and revenue assignments; assuring the stability o f fiscal policies, liberalizing the energy market and further reducing QFAs; further strengthening the budget formulation and execution process; and

0

0 enhancing debt management.

107. At the regional level, n o fiduciary assessment o f the Republic o f Tatarstan (RT) has been performed. At the level o f the municipality, an assessment o f the financial management arrangements o f the Ci ty o f Kazan has been carried out by the Bank with the assistance o f local Russian PFM consultants. The main findings o f the assessment were as follows13:

0 Although Kazan has acquired the municipal status, the legal framework i s s t i l l to be completed. A detailed annual budget i s prepared by the city’s Finance Department (FD) through a well-regulated bottom-up process, and i s approved by the City Council. The FD i s in charge o f the accounting and reporting. There i s only one Chart o f Accounts and accounting i s done on a cash basis. Accounting rules are based on the federal Budget Code and o n accounting provisions issued by the federal MOF. As mentioned above, the process o f budget execution i s shared between Kazan and the RT. Whi le Kazan FD i s largely responsible for legal and financial commitments o f the budget resources, the treasury system i s managed by the Kazan Department within the RT Treasury (KDRTT) that reports to both the RT Treasury and the FD. The KDRTT uses the same payment system as the RT Treasury. Whi le treasury regulations are in l ine with the federal Budget Code whereby a single budget account o f RT i s opened in the National Bank o f RTI4, funds are usually transferred from the National Bank o f RT to a commercial bank (Ak Bars Bank)Is. This bank i s used for a l l payments by the RT Treasury. RT directly owns around 6% o f Ak Bars BankI6. The internal audit i s performed by RT KRU”, a part o f the RT Treasury. Quality and effectiveness o f internal audits (compliance audits) has not been assessed. After January 1, 2005, the RF KRU i s t o become a federal agency (Federal

.

l3 Fiduciary Review Report for the KMDL. l4 Which i s the local branch o f the federal Central Bank. .

day. Only the Federal fhds that are transferred to the republic or the municipality remain in the Central Bank. l6 llwww.akbars.ru

Republican and municipal funds remain in the Central Bank account, usually, n o more than one 15

Russian abbreviation for Control and Revision Department

42

Controls Agency), but the exact functions o f the Agency are s t i l l to be defined. Until the establishment o f the RT Accounts Chamber in June 2004, the external audit o f the execution o f the Kazan budget was carried out by the RT Parliamentary Control Committee. With the new legislation’*, the RT Accounts Chamber i s now in charge o f external audit. Owing to the recent changes, quality and effectiveness o f external audits could not be assessed.

0

108. Fast changing conditions for inter-government relations usually generate fiduciary risks, at least during a transition period. In addition, as shown above, the assessment o f financial accountability for the purpose o f this loan i s incomplete and partly outdated. Based on the above, the fiduciary r isks o f the KMDL are considered high. T o mitigate these risks, the following actions will be completed under this loan:

0 T o clarify roles, responsibilities and accountability in Kazan’s budget management, municipal regulations defining the P F M system (budget management, treasury, accounting and reporting, internal and external audit) for Kazan wil l be approved prior to the second tranche release. Such regulations will need to meet standards acceptable to the Bank;

0 T o secure an effective municipal treasury after existing treasury arrangements have been transferred to the Federal Treasury, the city will demonstrate (as a core condition o f the second tranche) that a viable system o f treasury-execution o f the municipal budget has been established based on a single account concept for budgetary funds, and funds are channeled solely through the Central Bank o f the Russian Federation”. The specifics o f the arrangements for treasury management between Kazan and the RF will be embodied in an agreement between the RF and Kazan, acceptable to the Bank.

0 T o secure continuity o f the external audit function during the transitional arrangements, i t has been agreed that before the second tranche the RT Accounts Chamber will audit the 2004 financial statements (budget execution report) o f Kazan. The audited financial statements will be discussed and approved by the City Council and published.

Other risk mitigation measures are described in the section below.

RT Law Nr, 37 - ZRT o f June 3,2004, approved by the RT State Council. In the law, neither the RF nor the RT Accounts Chambers have the authority t o audit the execution o f the budget o f municipal bodies. An amendment to the RT L a w al lowing the RT AC to carry out audits o f municipal budgets has been submitted to the RT State Counci l and i s expected to be adopted in early 2005.

In accordance with RT Budget Code (art.75)

43

Disbursements and audits

109. The proposed loan will be disbursed against satisfactory implementation o f the adjustment program and wil l not be tied to any specific purchases, therefore n o procurement requirements wil l be needed. Because the treasury arrangements for the city wil l be transferred, as a second tranche condition, to a city department under the Federal Treasury, the transfer o f funds for the two tranches wil l have a slightly different f low. The funds o f the second tranche will be disbursed directly f rom the Federal Treasury to a sub-account within the Federal Treasury without going through the Republic o f Tatarstan Treasury.

110. At the request o f the Borrower, the proceeds in foreign currency will be deposited by the Wor ld Bank in a Deposit Account at the Central Bank o f Russia or another Bank acceptable to the Bank. The Deposit Account managed by the Ministry o f Finance o f the Russian Federation will have n o other funds. The proceeds o f the second tranche wil l be deposited in the same Deposit Account after a l l the conditions o f the second tranche release are met. If, after depositing in the Deposit Account, the proceeds o f the loan are used for ineligible purposes as defined in the Loan Agreement, the Wor ld Bank wil l require the Borrower to either: (a) return the amount to the account for use for eligible purposes, or (b) refund the amount directly t o the Wor ld Bank. To further mitigate the r isks discussed above, the following fiduciary arrangements for the loan have been agreed:

0 an audit o f the use made by the City o f the ruble equivalent o f the f i rst tranche o f the loan will be carried out by an auditor and o n terms o f reference acceptable to the Bank, and for that purpose a respective provision will be included in the Grant Agreement;

0 the f low o f funds o f this operation (from the Deposit Account to the c i ty o f Kazan account) will be channeled solely through the RF Central Bank system;

0 since there i s n o safeguard assessment o f the Central Bank o f the Russian Federation, the Bank will request an audit o f the Deposit Account and o f the whole f low o f funds until it reaches the Kazan’s account. The audit will be carried out by an auditor acceptable to the Bank within four months after the disbursement o f each tranche and the report wi l l need to be provided to the Wor ld Bank immediately upon completion;

0 for the f i r s t tranche, the RT Treasury (which currently manages the Kazan treasury) will report to the Wor ld Bank the receipt o f the grant funds within five business days. For the second tranche, the Federal Treasury will report t o the Wor ld Bank the receipt o f the grant funds within five business days. The RF Treasury wi l l report, within five business days,

44

to the Wor ld Bank the transfer o f the loan funds f rom the Deposit Account to the Kazan Treasury Account;

as a condition o f effectiveness, a Grant Agreement between RF, RT and Kazan, regulating the f l ow o f funds, the timeliness o f their transfer and their use, will be put in place; and

the 2005 and 2006 budgets o f the Russian Federation, the Republic o f Tatarstan, and Kazan will include the loadgrant funds as demonstrated by budget documentation.

V. R I S K S

Federal Level

1 1 1. Unquestionably, the Russian Federation presents a relatively l o w risk at this point in time for the Wor ld Bank’s portfolio and the proposed loan. Significant economic growth should continue in Russia over the medium term, although the pace o f this growth will depend on o i l and gas prices. If o i l prices should fa l l t o 20-25 dollars a barrel, annual GDP growth would most l ikely slow to 3-5 percent. Although exceptionally high o i l prices may generate a record current account in 2004 (already over US4 22 b i l l ion for the f i rst ha l f o f the year), rapid import growth should narrow the current account surplus in the medium term. An improvement in the investment climate would simultaneously strengthen the capital account, leaving the overall balance o f payments in surplus.

112. The r isks to economic growth and stability in Russia are nevertheless non-trivial. If o i l prices were to fa l l wel l below U S D 20 dollars a barrel, and remain at such levels for a number o f years, Russia could begin to experience serious financial problems. Even a smaller shock to o i l and gas prices could cause some ripples in the enterprise and financial sectors. Lower profits and tax revenues would cut into economic growth rates and eliminate the budgetary surpluses (close to 30 percent o f federal revenues come f rom o i l and gas). Lower o i l prices would put downward pressure on the exchange rate, thereby causing potential problems for a number o f enterprises that have borrowed considerable amounts in foreign currency in recent years. Russian non-financial enterprises held an estimated USD 42 b i l l ion in foreign credit in the beginning o f 2004, and gross foreign borrowing by the non-financial sector amounted to another U S D 14 b i l l ion during the first ha l f o f the year. The Russian banking sector also remains weak and potentially vulnerable to shocks. Due to these concerns, the IMF has urged caution in macroeconomic pol icy in order to maintain the considerable cushion that has been built in recent years against a potential external shock.

45

113. The new decentralization framework also carries some risks. The new legislation certainly clarifies the roles and responsibilities o f the various levels o f govemment, and makes an enormous contribution by focusing the responsibilities o f local governments o n functions as opposed to maintenance o f institutions. However, there are a number o f important issues that arise:

implementation o f new expenditure assignments may be diff icult as coordination mechanisms are unclear in areas for which more than one level o f government has responsibility; the responsibilities assigned to the settlement level may overload them; the new expenditure assignments may also require a significant reallocation o f state property among levels o f government that could be contentious; assignment o f key social welfare provisions to the regional level may exacerbate inequalities among r i ch and poor regions.

114. There i s also an imbalance in the Government’s approach to fiscal federalism, assigning responsibility and accountability on the expenditure side but providing l i t t le or n o autonomy or control on the revenue side. Although expenditure responsibilities continue to increase at local govemment levels, they have less and less control over their sources o f revenue. This breaks the relationship between service delivery at lower levels o f government and the taxes provided to pay for those services. Continuous monitoring and oversight will be required to assess how revenue assignments match up with expenditure assignments.

115. Potential risks with respect t o the relations between federal and subnational governments also include recent move by President Putin to appoint govemors o f the Russian regions (effectively, although formally President nominates a candidate to be approved by a regional parliament), possibility o f appointment o f mayors o f Russian municipalities (either by RF President or by a regional govemor), changes in the composition o f the upper chamber o f the RF Parliament (President Putin’s proposal i s to include govemors and heads o f regional parliaments instead o f regions’ representatives into this body). Although this i s clearly a setback with respect to decentralization process in the Russian Federation it i s highly unlikely that such possible changes may lead to turnarounds in the Kazan reform program, as this program i s mimicking to a large degree federal reforms program, it i s supported by the federal center and i t i s also endorsed at the level o f the Republic o f Tatarstan.

116. Risks associated with the predictability o f the resource transfer f rom the federal govemment and potential r isks arising f rom resource volatility are quite limited. I t seems, significant amount o f federal transfers to the Republic o f Tatarstan and Kazan i s quite predictable. First, Republic o f Tatarstan i s not entitled to the federal equalization grants as a relatively r i ch region. Second, Republic o f Tatarstan wil l

46

not get federal funds under the Federal Targeted Program from the year 2006. These two sources o f funds could have been the major sources o f revenue volatility and o f potential risk for the consolidated budget o f the republic. Federal Compensation Fund i s based on per capita estimates and as a result i s rather predictable. All other transfers are o f a minor nature (e.g. federal investment grants to regions). The Wor ld Bank loan i s to be incorporated into annual budget laws o f the Russian Federation, Republic o f Tatarstan, and Kazan and thus i t s amount i s also relatively fixed (minor risks are related to exchange rate fluctuations).

Kazan

117. As a newly constituted municipal entity undertaking a diff icult reform agenda, there i s substantial risk with respect to the Kazan administration’s capacity carry out this reform agenda and the potential for a lagging commitment over the longer term. The significant pr ior actions that have been taken, however, suggest that the Bank-Federal Government-Kazan partnership i s working and that continued collaboration will have a mitigating effect on this risk. T o further manage this risk, the loan i s structured with two-tranches, with a greater weight assigned to the second tranche. Finally, there i s also a risk o f backlash to the reform program by the city’s inhabitants. T o date, however, the Kazan administration has shown significant sk i l l in explaining i t s aims and objectives, building consensus and maintaining broad based support. In addition, the federal authorities are committed to provide funds to build monitoring and evaluation capacity for the Program.

118. In accordance with the framework for municipal reform in Russia, Kazan i s supposed to receive equalization transfers f rom the Republic o f Tatarstan that will affect the city’s overall fiscal balance. Though the concept o f such transfers i s inscribed in the Russian legislation, the precise amount o f each annual transfer i s not known (and can only be predicted with relative accuracy) in advance. Thus, the sustainability o f Kazan’s fiscal position i s in some measure dependent on actions o f the government o f the Republic o f Tatarstan that cannot be known in advance. Nevertheless, the reforms supported under the KMDL that assist in fiscal strengthening, improved planning and monitoring, and the increased flexibility wil l enhance the city’s abil ity t o manage and adjust to these equalization transfers.

119. Overall, the context for the KMDL implementation i s complex: i t involves actions by the federal government to implement a decentralization framework across eighty nine sub-federal entities, a transfer o f power by a once strongly independent region (the Republic o f Tatarstan) and the implementation o f a c i ty strategy and reform program by a newly created municipality. Each o f the tiers o f government involved in this process has already demonstrated i ts commitment to the overall goals and objectives, and the ci ty o f Kazan has already undertaken significant reforms. As the KMDL i s implemented, however, it wi l l be essential to maintain a close

47

worlung relationship with the federal Ministry o f Finance, the Republic o f Tatarstan and the ci ty administration, to provide extensive advice and just-in-time support. This wil l be done as part o f loan implementation support and will be greatly facilitated by the Bank’s Moscow office.

48

49

ANNEX 2: KAZAN LETTER OF DEVELOPMENT POLICY

50

51

52

53

54

55

56

57

58

December 13,2004 N g 4097

Mr. James Wolfensohn President The International Bank for Reconstruction and Development

Dear Mr. Wolfensohn,

Kazan - the capital city o f the Republic o f Tatarstan - has a population of 1.1 mi l l ion people which makes it the seventh largest c i ty in Russia and the largest c i ty in Tatarstan. In 2003, the City o f Kazan accounted for about 40% o f the Republic's Gross Regional Product (GRP) which was equal to USD 7 b i l l ion (about 1.6% o f the Russian Federation GDP). The ci ty i s an important industrial center wel l known for i t s developed manufacturing base including machine building, aircraft construction, chemical and petrochemical industries. Kazan i s an important transport center with developed transport infrastructure and communication facilities. The ci ty has a significant intellectual and cultural potential being an important center o f research, education and healthcare.

Along with Tatarstan, Kazan i s home to a large number o f nationalities, including most significantly Tatars and Russians. The ci ty that would mark i t s mil lennium next year, enjoys a well deserved reputation for the multi-ethnical and multi-confessional amity, based on equal rights o f a l l ethnical groups represented in the ci ty and r i ch cultural exchange between them.

Since 1991 as a result o f reforms Kazan has undergone significant structural economic changes. The share o f machine-building reduced, while chemical and petrochemical industries, power industry and production o f construction materials gained importance. The highest growth was registered in the service sector. Employment in the industry and construction has shrank from 45% in 1995 to 33% in 2003, while the share of those employed in the service sector (healthcare, education, culture, trade and catering) out o f the total employment has increased f rom 34% in 1995 to 40% in 2003. It i s expected that the economic growth in the future will be secured through both the increased export potential o f existing highly technological industries, and most o f a l l the

59

rapid development o f the service sector, mainly transport, financial services, trade, culture and tourism.

In view o f major structural changes that have taken place in Kazan since 1991 and recognizing the need to define the program for city future development, the Administration o f Kazan prepared and approved in April o f 2003 a Strategy for the Development o f the Ci ty o f Kazan to 2015. Prior to i t s adoption the Strategy was broadly discussed with representatives o f government and c iv i l society.

The strategy has identified several groups o f Challenges that the city i s facing in the medium to long term. These are: Economic development challenges, Urban Development Challenges and Social Challenges. The Strategy proposed a logical “List o f Objectives, Tasks and Activities intended for Implementing the Kazan Development Strategy” that wil l drive the reform process intended to improve economic sustainability o f the city and i t s social situation. The array o f reforms envisaged by the Strategic Plan coincide with the main national reform priorities fostered by the Govemment o f Russia. Their implementation i s intended to help the c i ty to j o i n the mainstream o f social, economic and polit ical reforms as they are currently carried out in Russia.

The ci ty Administration, supported by the Republic o f Tatarstan government, has been working with staff o f the Wor ld Bank for over a year in order to define the concise set o f priority reforms and actions that would be essential for successful implementation o f the Kazan Strategy and indeed for the future economic prospects o f the city. These f i rs t priority set o f actions and reforms were identified to include: strengthening budget and financial management o f Kazan municipality (including municipal procurement and municipal assets management), social support reform in the ci ty and financial and institutional strengthening o f housing and communal services. These are currently included into the proposed Kazan Municipal Development Loan.

With this letter the Kazan ci ty administration i s requesting the Wor ld Bank to provide support for implementation o f the set o f ambitious and challenging reforms in the ci ty within the framework o f Kazan Municipal Development Loan (KMDL). These will lay foundation for future improved economic and fiscal sustainability o f the city, improved efficiency of social support pol icy and more effective and efficient housing and communal services sector. The reforms will include the fol lowing main actions in the respective priority areas.

STRENGTHENING BUDGET AND FINANCIAL MANAGEMENT

The city received i t s legal status o f municipality in September 2004 and this leads to a need to upgrade and strengthen budget management, public procurement and asset management practices. The budget management, treasury and auditing functions have to be streamlined and integrated, because now different functions stay with different entities both in the city or in the Republic o f Tatarstan administrations. In order to strengthen municipal budget and financial management under KMDL we plan the following:

60

Development o f a municipal public finance regulations. This wil l allows to create a wel l governed, transparent and accountable structures and procedures for the city budget execution. A comprehensive legal framework for modem municipal public finance management would ensure transformation o f the c i ty o f Kazan from de jure to de facto effectively and efficiently managed municipality.

Introduction o f municipal medium term (three year) financial plan on a rol l ing basis, This will enhance medium term budget planning and will increase the ability to evaluate choices o f different developmental scenarios to be made within overall resource constraints. In particular, better forecasts o f aggregate revenue and expenditure (according to both economic and functional classification) categories will help the c i ty to incorporate into the budget major reforms envisaged in social protection, housing and communal services, asset management. In addition i t i s planned to consolidate formerly independent rayon budgets into the c i ty budget. Development o f a borrowing strategy and o f a medium term capital investment program will also become key elements o f improved budget planning.

Strengthening creditworthiness o f municipality. It i s planned to gradually phase out and eventually eliminate arrears o f the city budget and o f budgetary organizations. Towards this end inventory o f the city overdue payables for capital construction i s under way and wil l be completed by the end o f 2004, adequate budget funds are allocated to budget organizations to help them to stay in compliance with restructuring agreements with the federal social funds (e.g. federal Pension Fund) and to facilitate inclusion into this legal framework o f those budgetary organizations which were expelled f rom such agreements.

Upgrade o f Public Procurement. A number of reforms are now underway in this area, including establishment o f an Expert Commission headed by the First Deputy Mayor that (i) i s clearing a l l cases of direct contracting, closed bidding and price quotations, and (ii) reviews complaints f rom bidders. The ci ty will continues strengthening public procurement with the following measures: (i) independent assessment o f current c i ty procurement practices to establish a baseline quantifiable data against which agreed improvements will be evaluated; (ii) introduction o f transparent contractors complaints processing mechanism, conflict resolution and sanctions against municipal purchasers violating the rules; (iii) increasing the proportion o f contracts awarded and ci ty budget used under open bidding (iv) carrying out independent audit o f city procurement conducted in 2004 and 2005; (v) creating o f a unified contract registry for the c i ty that includes a l l contracts financed through the ci ty budget.

Improved Municipal assets management. In order to improve efficiency o f the municipal asset management the Asset Management Strategy i s approved to be implemented over the next year. It includes strengthened market principles in asset management, support market infrastructure by creating comprehensive legal framework and determining the rules o f interaction between market participants. Continued inventory and monitoring o f municipal assets will be introduced, and existing Asset Register will be transformed into an advanced database with embedded analytical capacity.

Specifically, the fo l lowing policies wi l l be introduced and actions will be undertaken in the area o f municipal asset management:

61

Publication as a matter o f routine practice o f notices o f auctions for sale or rent o f municipal property, information on property to be auctioned, including land, information on auctions’ procedures and results;

Preemptive plan for land subdivision (land plotting plan) wi l l be developed, and published;

The review o f a l l land allocations will be completed, a l i s t o f plots currently under design and construction will be compiled; extension periods for design and construction wi l l be restricted (one extension not more than 6 months long);

A legal regulation will be passed accepting competitive bidding as the only possible procedure for transfer or acquisition o f rights to municipal property a l l categories o f municipal assets, including real estate property;

Property rent rates for municipal assets will be established minimally at 90% o f commercial rates; previous land allocations will be revised and those expired will be terminated.

Reforms of Social Protection

The objectives o f the Republic o f Tatarstan in the area o f social support include improved outreach to the poorest groups o f population, and higher efficiency and transparency in the use o f budget resources allocated for social support o f the population. The Tatarstan Republican Government and the Kazan City administration have adopted a program o f improvement o f the social support o f the population, introduced targeted school lunches in the school system of Kazan, eliminated duplication o f in-kind benefits for regionally established social programs. KMDL program includes the fol lowing main actions:

Clarification of institutional responsibilities for social support programs in the ci ty o f Kazan and integration of program implementation within one department. State responsibilities for social support programs for Kazan population will b e delegated to the c i ty Administration, programs will be financed by targeted subvension from Republican budget and municipal budget. Capacity o f the department o f social protection wi l l be strengthened.

Monetary payments wi l l be introduced to replace the current complex system o f in-kind benefits for different groups o f population authorized by various levels o f government. The monetary benefits will be transferred to individual bank accounts o f the beneficiaries. Monetization will also include housing and communal services benefits. Thus transparency in social support system wil l be improved, and the foundation for most important moves for reform in the housing and communal services sector, as well as in social support wil l be developed.

Specific targeted poverty benefit wil l be introduced in the ci ty o f Kazan, and explicit targeting mechanism will be used for social support to pensioners, budget sector employees and households in need financed f rom RT budget.

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Targeting in Kazan wil l use well-being verification methodologies, social contracts with beneficiaries, incentives for reintegration in the labor market.

Provision o f social services for the vulnerable groups in the ci ty o f Kazan will use “municipal contracting” for a l l public service providers and competitive selection for selected social services.

Reforms of Housing and Communal Services

O n September 30, 2004, the Ci ty Council o f Kazan approved a Program o f Reform o f the Housing and Communal Sector o f Kazan. The Program i s focusing o n three main areas: (i) reform o f public utilities and unitary enterprises working in the sector, (ii) restoration o f the sector’s financial viability, including reform o f the tariff- setting process, (iii) development o f market environment for housing maintenance and management, including provision o f economic incentives to the voluntary creation o f home-owners associations. The Program i s setting quantifiable short and medium term targets, suggests implementation indicators and assigns operational responsibilities to ensure successful outcome.

Within the KMDL the ci ty will take the following steps in the area o f housing and communal services reform:

Direct budget producer subsidies to heat producers will be eliminated and budget support will be provided to eligible families and families in need through the system o f social protection; Debts o f budget organizations to HCS suppliers wi l l be eliminated, as wel l as debts district housing maintenance companies (RZhU) to housing maintenance companies; The ci ty wil l become responsible for setting the tariffs that will be set at the level o f loo-% cost recovery for a l l heating companies operating in the ci ty o f Kazan; Cross-subsidization between categories o f water and wastewater consumers and heat consumers wil l be eliminated; Optimization and leveling o f heating tariffs will be ensured, inter alia, through creation o f a single sales and distribution company; 100% o f municipal housing stock will be maintained by competitively selected contractors; Competitive tenders will be introduced for private management o f municipally owned housing stock; A package o f economic and other incentives to encourage the formation o f HOAs ( leasing rights for common spaces) will be introduced; Formation o f H O A s in newly complete housing and in buildings that have undergone comprehensive capital repairs will be facilitated;

These reforms constitute a major undertalung for the city, and I hope that we can count on continued Wor ld Bank technical support in the design and implementation. Though very significant steps have already been taken with respect to each o f these reforms we look forward to continued interaction with the Wor ld Bank as we move forward.

63

I hope that upon review o f the submitted program, the Wor ld Bank wil l find it possible to extend a loan for Kazan, which would enable the Ci ty to attain i ts institutional and economic development objectives and thus ensure steady and sustainable growth o f i t s economy necessary to improve the standards o f living o f i t s population.

K. Iskhakov Mayor o f Kazan

64

a 8

W W

cc 0

ANNEX 4: COUNTRY AT A GLANCE

RUSSIAN FEDERATION: KAZAN MUNICIPAL DEVELOPMENT PROJECT

POVERTY and SOCIAL

2003 Population, mid-year (millions) GNI per capita (Atlas method, US$) GNI (Atlas method, US$ billions) 1

Average annual growth, 1997-03

Population (%) Labor force (%)

Most recent estimate (latest year available, 1997-03)

Poverty (% of population below national poverty line) Urban population (% of total population) Life expectancy at birth (years) Infant mortality (per 7,000 live births) Child malnutrition (% of children under 5) Access to an improved water source (% of population) Illiteracy (% of population age 15+) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1983

GDP (US$ billions) Gross domestic investmenffGDP Exports of goods and servicedGDP Gross domestic savingdGDP Gross national savingslGDP

Current account balancelGDP Interest paymentslGDP Total debffGDP Total debt servicelexports Present value of debffGDP Present value of debffexports

1983-93 1993-03 (average annual growth) GDP 1.4 GDP per capita 1.8 Exports of goods and services 6.6

Russian Federation

143.4 2,610 374.8

-0.4 0.9

21 73 65 12 6

99 0

114 114 113

1993

435.1 27.0 38.2 34.7 33.7

0.6 0.3

26.0 4.3

18.0 119.1

2002

4.7 5.2 9.6

Europe B Central

Asia

473 2,160 1,023

0.0 0.5

64 69 31

91 3

103 104 102

2002

345.6 20.2 35.0 30.7 28.6

8.4 2.7

43.2 24.2 43.0

117.2

2003

7.3 7.8

13.7

Lower- middie- income

2,408 1,400 3,372

0.9 1.2

49 69 32 9

81 13

112 113 111

2003

432.9 20.6 35.0 32.0 28.9

8.3 2.4

38.8 18.2 41.7

110.5

2003-07

5.5 6.1 2.5

Development diamond'

Life expectancy

-

I

GNI Gross Per primary capita nrollment

1 Access to improved water source

~ -Russian Federation , _ _ Lower-middle-income group

Economic ratios'

Trade

T

1 Investment Domestic __ savings

I 1

Indebtedness

-Russian Federation Lower-middle-income aroiin

STRUCTURE of the ECONOMY

(% of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services

Private consumption General government consumption Gross domestic investment Imports of goods and services

Manufacturing

1983 1993

8.3 .. 44.6

.. 47.1

.. 45.2

.. 20.0

.. 30.5

1983-93 1993-03

0.8 1.4

1.7

2.1 0.8

-4.6 4.3

2002 2003

5.7 5.2 34.0 34.3

60.3 60.5

51.6 51.1 17.7 16.9 24.4 23.6

2002 2003

2.9 2.7 3.8 8.5

5.5 7.1

8.7 7.8 2.6 2.2

-2.2 13.5 14.6 19.5

I Growth of investment and GDP (%) 100

0

-50

I -100 - -GDI +GDP

I of exports and imports (%)

30 - 20 -

Note: 2003 data are preliminary estimates. Group data are for 2002.

"The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will ha inrnmnlmtn

Russian Federation

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplusldeficit

TRADE

(US$ millions) Total exports (fob)

Crude oil Natural gas Manufactures

Total imports (ci9 Food Fuel and energy Capital goods

Export price index (1995=100) Import price index (1995=100) Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net reserves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, /oca//US$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Official grants Official creditors Private creditors Foreign direct investment Portfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

1983 1993

.. 874.6

.. 887.8

., 38.6

.. -4.1

.. -8.7

1983 1993

.. 58,422

.. 10,621

.. 10,347

.. 3,100

1983 1993

.. 65,244

.. 58,110

.. 7,134

.. -4,459

.. 2,675

.. 202

.. -2,877

.. 8,914

.. 0.4

1983 1993

.. 112,940

.. 367 0

.. 2,800 11 0

.. 2,497

.. 1,038

.. 1,069 0

.. 700

.. 371 0

.. 371 11

.. 360

2002 2003

15.8 13.7 15.7 14.2

37.9 37.2 2.5 4.6 0.0 2.1

2002 2003

107,301 135,929 28,772 38,843 15,897 19,981 10,900 12,800 63,828 78,539 10,300 12,100 1,000 1,300

16,700 21,400

118 138 126 117 94 118

2002 2003

120,912 151,959 84,463 102,558 36,449 49,401

-6,583 -13,171 -750 -364

29,116 35,868

-16,450 -4,823 -12,666 -31,043

47,790 76,936 31.4 30.7

2002 2003

149,362 167,746 6,599 6,269

0 0

30,734 29,791 764 894

0 0

-4,075 -3,807 1,291 20,500

2,947 -5,045 398 -2,408

608 320 229 233 526 719

-296 -486 238 175

-535 -661

I 1 Inflation 100

98 99 00 01 02

-GDP deflator ' O I C P I

I 1 Export and Import levels (US$ mill.)

~140.000 120 000 - 100 000 80 000 60 000 40 000

0 1 20000

I Exports Imports 97 98 99 00 01

I

~~~~

I Current account balance to GDP (%)

I20 -

1-2 97 98 99 00 01 02 03 I

Composltlon of 2003 debt (US$ mill.)

G 21,000 A 6.28C 5,082

E 54900

A - IBRD B ~ IDA D - Other multilateral F - Private C - IMF G -Short-term

E - Bilateral

DeveloDment Economics

80

Annex 5 Page 1 o f 5

Public Information Notice (PIN) No. 04/112 September 30,2004

International Monetary Fund 700 19th Street, NW Washington, D.C. 2043 1 U S A

IMF Concludes 2004 Article IV Consultation with the Russian Federation I

Public Information Notices (PINS) are issued, (i) at the request o f a member country, fo l lowing the conclusion o f the Art ic le 1V consultation for countries seeking t o make known the views o f the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies o f member countries by increasing the transparency o f the IMF's assessment o f these policies; and (ii) fol lowing po l i cy discussions in the Executive Board at the decision o f the Board. The staff report (use the free Adobe Acrobat Reader t o v iew this p d f file) for the 2004 Art ic le IV consultation with the Russian Federation is also available.

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O n September 1 , 2004, the Executive Board o f the International Monetary Fund (IMF) concluded the Article IV consultation with the Russian Federati0n.l Background The macroeconomic environment continues to be favorable, with strong GDP growth, moderate inflation and large current account and fiscal surpluses. The oil-driven boom is, however, leading to growing macroeconomic tensions. While the near-term outlook i s strong, based on current projections for o i l prices, and external vulnerabilities are generally low, recent nervousness in the banking sector and uncertainty related to the Yukos affair highlight the fragility o f confidence. GDP growth rose to 7-7% percent in 2003 and the first half of 2004, and became better balanced. The acceleration was mainly due to higher investment, but also to increased o i l export volumes. Growth continued to depend heavily o n the favorable external environment, in particular high o i l prices, but recent increases in investment were also related to political stability, generally sound macroeconomic policies, and some structural reforms, suggesting that GDP i s increasingly deriving strength from domestic factors as well. Macroeconomic tensions have increased, however, as growth has risen and the balance of payments strengthened. While headline inflation declined to 12 percent at end-2003 and further during the first ha l f o f 2004, this was mainly due to administered price restraint; core inflation has become entrenched at 10-1 1 percent over the past two years. Tightening labor markets have added to inflationary pressures. With inflation s t i l l high relative to competitors and the ruble broadly stable in nominal effective terms, the pace o f real ruble appreciation has increased to nearly 10 percent over the past year. The balance of payments has strengthened further. Despite higher imports related to rapid demand growth and real appreciation, the external current account surplus has remained at 8-9 percent o f GDP during the past two years, supported by high world commodity prices. Meanwhile, net private capital outflows declined substantially in 2003, reflecting higher corporate and banking sector borrowing as we l l as some reversal o f foreign currency substitution. In the f i rs t half o f 2004, net outflows increased, with volatility reflecting periodic uncertainty l inked to the Yukos affair, prospects for global interest rates, and perceived changes in the central bank's intervention and exchange rate strategy. Nonetheless, reserves accumulation continued, even as the banking system was hit by turmoil in July. Gross international reserves stood at about $88.5 b i l l ion (over seven months o f imports) at end-July. Public external debt, net o f reserves, has fallen close to zero, compared with $140 b i l l ion in 1998. The Central Bank of Russia (CBR) has intervened heavily to slow ruble appreciation over the past 18 months. The interventions were largely unsterilized,

Annex 5 Page 2 o f 5

causing a surge in money growth during 2003. Rapid broad money growth, partly reflecting conversion o f cash foreign currency holdings into ruble deposits, fuelled growth in credit to the economy o f around 44 percent in the year to June 2004. The trend toward fiscal relaxation i s continuing, notwithstanding some tightening in the 2004 budget. Despite higher o i l prices and strong economic growth, the general government surplus increased by only % percent o f GDP, to 1 percent o f GDP, in 2003. Th is represents an underlying loosening o f the fiscal stance at constant o i l prices o f about 1 percent o f GDP. The 2004 budget envisions a moderate tightening, to be achieved through postponement o f non-interest expenditure increases, but plans for the 2005 budget suggest that this wil l be reversed, in response to growing pressures to spend more o f the o i l revenue windfall on tax cuts and expenditure reforms. Progress on structural reform has been limited. The two major reforms in 2003 relate to the financial system. The law on foreign exchange regulation introduced a far- reaching liberalization of capital flows. It allows the imposition o f unremunerated deposit requirements on capital flows, and the CBR decided to introduce such requirements from August 2004. Additionally, legislation was passed to introduce mandatory insurance o f household deposits. Increased regulatory vigilance in recent months has triggered nervousness in the private banking sector. The CBR has begun to assess applications by banks for entry into the deposit insurance system and has strengthened enforcement o f prudential standards and Anti-Money LaunderingKombating Financing o f Terrorism (AMLKFT) legislation. Confidence was shaken when the CBR withdrew the license o f a bank in May 2004 for AMLKFT violations, leading to a liquidity squeeze and deposit runs at some banks. Although the situation has since calmed down, reflecting prompt actions by the CBR, confidence remains fragile. Executive Board Assessment Directors commended the authorities' good management o f the economy, and the strengthening o f GDP growth and the balance o f payments, driven by high o i l prices, increasing o i l export volumes, and strong domestic demand. They were pleased that growth was becoming broader based and better balanced, and that key social indicators were improving. However, Directors advised that, with a buoyant economy, fiscal policies should not be eased and monetary policy should focus more o n controlling inflation than on resisting nominal appreciation. To maintain competitiveness and diversify the economy, they also saw a need to invigorate the pace o f structural reforms. Given the strong o i l price outlook, and Russia's large international reserves and l o w public debt, Directors expected that growth would remain robust over the near term and that external vulnerabilities would l ikely remain low. They cautioned, however, that further turmoil in the banking system could damage confidence. Directors commended the achievement o f a fiscal surplus in recent years and the establishment o f an o i l stabilization fund. They cautioned, however, that fiscal policy should not provide additional stimulus at this point in the economic cycle, and viewed the authorities' plans to relax fiscal policy in 2005 as exacerbating pressures for real ruble appreciation, arising from the exceptionally strong balance o f payments, and increasing inflationary pressures. They recommended increasing the cap on the collection o f windfall o i l revenues in the o i l stabilization fund and considering the use o f some revenues in the fund to reduce debt. Directors recognized, however that, once cyclical pressures eased, there could be a case for spending more on carefully elaborated long-term fiscal structural reforms, including on health care and pension reform, and on public infrastructure. They welcomed the authorities' plans to restructure and monetize the system o f in-kind benefits, and to judiciously reduce the social tax rate, accompanied by any necessary measures to ensure achievement o f the broader fiscal objectives. They

Annex 5 Page 3 o f 5

concurred on the importance o f further development o f regional and local fiscal capacity. Directors agreed that the central bank needed to clarify the two competing objectives o f controlling inflation and managing the exchange rate. They highlighted their concern over the emphasis on stemming real ruble appreciation, because, in their view, monetary policy could not target the real exchange rate, except in the short run, and the efforts to resist appreciation had resulted in inflation becoming entrenched at a relatively high level. Most Directors fel t that the cost to the economy o f high inflation was not sufficiently recognized, while the cost o f ruble appreciation was exaggerated. They urged the central bank to allow more nominal exchange rate flexibility, to facilitate a reduction o f interest spreads and discourage speculative capital inflows, and to take advantage o f the disinflationary impact o f nominal appreciation. They also highlighted the need to strengthen the independence o f the central bank. Directors welcomed steps to liberalize the capital account. Most Directors saw unremunerated deposit requirements as, at best, a temporary measure to stem capital inflows and advised the authorities to consider the experience o f other countries where such requirements have raised the cost o f capital, especially for small- and medium-sized enterprises. It was fel t that deposit requirements could help limit large inflows o f volatile short-term capital to weak banks. However, Directors took the view that deposit requirements should be temporary, reserved to deal with exceptionally large and volatile inflows, and should not be used to stem sustained pressure for ruble appreciation. Directors stressed that recent turmoil in the banking sector demonstrated the urgency o f strengthening prudential supervision and crisis management tools, while pressing ahead with closing unsound banks. They commended the central bank for taking prompt actions to calm the situation, including halving reserve requirements and extending interim household deposit insurance to al l banks. However, they noted that extension o f deposit insurance could increase moral hazard, and encouraged the central bank to be unwavering in enforcing sound prudential standards. Directors urged the authorities to give the central bank strong polit ical support and facilitate the development o f more effective instruments for further strengthening banking supervision and weeding out problem banks. In this regard, Directors welcomed the prompt action by the Duma to strengthen the bank bankruptcy law. They also encouraged further development o f a private banking sector and stronger action to counter money laundering. Directors noted that the authorities' structural reform plans were well focused and progress had been made in some areas, including pension reform. However they thought that these plans would benefit from more emphasis on specifics, as overall implementation had slowed. They encouraged the authorities not to view high o i l prices and strong growth as grounds for complacency but, rather, as a unique opportunity to carry out the structural reforms needed to sustain growth over the medium term. They emphasized the importance o f diversifying the economy and reducing reliance on natural resources, and in this regard, welcomed the priority given to encouraging domestic and foreign direct investment and improving the investment climate for small- and medium- sized enterprises. They also supported the focus on public administration reform, banking reform, and housing reform, and underscored the benefits o f liberalizing trade and early WTO accession. They underscored the need to improve governance and the rule o f law, and to resolve successfully the Yukos affair. They also emphasized the importance o f reforming the energy sector, breaking up inefficient monopolies, and improving labor market flexibility. Directors welcomed the findings o f recently conducted Reports on the Observance o f Standards and Codes modules on data and fiscal transparency, and the authorities' decision to publish these reports. They noted that Russia's statistical database i s mostly adequate for surveillance and that dissemination practices meet most o f the Special Data

Annex 5 Page 4 o f 5

Dissemination Standard requirements, and welcomed the authorities’ intention to subscribe to the SDDS. They also commended the progress made in strengthening fiscal transparency and financial management.

T h e Russian Federation: Selected Economic Indicators

2001 2002 2003 2004

Est. Proj .

Production and prices

Real GDP

Consumer prices

Annual average

End o f period

GDP deflator

Public sector

General govemment overall balance”

Revenue

Expenditure

Interest

Non-interest

Primary balance

Federal govemment overall balance”

External sector-

Total exports

Total imports

External current account (deficit -)

Stock o f public extemal debt

(Annual percent change)

5.1 4.7 7.3 7.3

21.5 15.8 13.7

18.6 15.1 12.0

16.5 15.7 14.2

(In percent of GDP)

2.7 0.6 1.1

37.3 37.6 36.6

34.6 37.0 35.5

2.7 2.1 1.7

31.9 34.9 33.8

5.4 2.7 2.7

2.7 1.3 1.5

(In billions o f U.S. dollars)

102 107 136

54 61 75

33 31 36

112 103 94

10.3

10.0

12.9

3.1

37.0

33.9

1.3

32.6

4.4

3.0

174

96

47

88

Annex 5 Page 5 o f 5

Gross reserves coverage (in months o f imports o f GNFS) 5.0 5.6 7.1 7.6

Memorandum items:

Nominal GDP (in billions o f rubles) 8,944 10,834 13,285 16,090

29.2 31.3 30.7 ... Exchange rate (rubles per U.S. dollar, period average)

Russian o i l price (U.S. dollars per barrel, c.i.f.) 22.9 23.6 27.3 30.1

Sources: Russian authorities; and IMF staff estimates and projections.

1/ Commitment basis.

LUnder Art ic le I V o f the IMF 's Articles o f Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On re tum to headquarters, the staff prepares a report, wh ich forms the basis for discussion by the Executive Board. At the conclusion o f the discussion, the Managing Director, as Chairman o f the Board, summarizes the views of Executive Directors, and this summary is transmitted t o the country's authorities. This PIN summarizes the views o f the Executive Board as expressed during the Executive Board discussion based on the staff report.

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