Growth with moderation and uncertainty...Russia’s output – manufacturing and domestic demand-led...

Growth with moderation and uncertaintyRussian Economic Report 23November, 2010

THE WORLD BANK GROUP

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63752

The World Bank in Russia

Russian EconomicReport 1

№ 23November, 2010

With heightened uncertainties and moderating global and Western European growth and oil prices, and volatile capital fl ows, Russia is likely to grow by 4.2 percent in 2010, followed by 4.5 percent in 2011 and 3.5 percent in 2012 as domestic demand expands in line with gradual improvements in the labor and credit markets. Unemployment situation is likely to get worse before it gets better later in 2011. Fiscal risks have risen with likely expenditure pressures and downside risks to oil. While there is huge diversity across regions in the patterns of labor market recovery, smaller regions with a larger share of SMEs, better investment climate, more FDI, and stronger fi nancial sector presence tend to show a more robust recovery.

Growth with moderation and uncertainty

WORLD BANK

http://www.worldbank.org.ru

1 The report was prepared by a World Bank team consisting of Sergei Ulatov (Economist), Karlis Smits (Economist), Olga Emelyanova (Research Analyst), Victor Sulla (Economist), and Zeljko Bogetic (Lead Economist for Russia and the team leader). Annette de Kleine, and Shane Streifl er (Senior Economists) contributed on the international environment and the global oil market. Victor Sulla (economist) and Ken Simler (Senior Economist) authored the note in focus on unemploy-ment. The team expresses gratitude to the World Bank Global Economic Prospects team lead by Andrew Burns (Manager, DECPG) for close collaboration and discussions on global economic environment and its linkages with Russia.

C O N T E N T__________________

I. Recent Economic Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

II. Economic and Social Outlook for Russia 2010–2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

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

I. Recent Economic Developments | 3

IRecent Economic Developments

Summary. The global economy has returned to moderate growth amid uncertainty, but the feared ‘double dip’ recession remains unlikely. The Europe and Central Asia region—hardest hit by the crisis—is growing slower than the rest of the world. In Russia, growth is being led more by domestic demand–consumption and investment–and credit is beginning to fl ow. But the way Russian policymakers manage the short-term macroeconomic risks of fi scal spending and infl ation—and the long-term challenge of competitiveness and diversifi cation under tighter budget constraint—will determine the medium-term prospects.

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

months but growth has been moderate (fi gure 1.1). Industrial production has slowed world-wide (from 11.7 percent, annualized, in the fi rst quarter of 2010 to 8.7 percent in the second), and the bounce-back in global trade has ended (fi gures 1.2–1.3). Growth in the value of mer-chandise trade decelerated from 25 percent in the fi rst quarter to just 2.5 percent in the second, raising concerns about a double dip. While growth will be slower in the next few quarters, a double dip is unlikely. This moderate growth will not make big inroads into high unemploy-ment and spare capacity.

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

Non-bank capital fl ows to developing countries (such as bond issuance) continue to recover, but bank fl ows remain weak. CDS spreads for developing countries with good credit histories and conditions (including Russia) have not risen, while those of more vul-nerable developed countries have increased (fi gure 1.4). Since May 2010 bond spreads have narrowed, and bond issuance by sovereigns and emerging market corporations has picked up (fi gure 1.5). With large repayments and limited new fl ows, however, net bank fl ows to developing countries are likely to be negative this year. Equity fl ows to developing coun-tries reached USD 72 billion over the year to date, 50 percent above 2009 levels—mostly to China. FDI fl ows to developing countries so far remain close to the second half of 2009. They are expected, however, to reach USD 438 billion in 2010, up from USD 364 billion in 2009. But outward FDI from middle-income countries has remained more resilient that that from high-income countries.

4 | Russian Economic Report. № 23. November, 2010

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

Domestic demand growth

growth at seasonally-adjusted annualized rates

Foreign trade

contribution to growth a annualized rates

Source: World Bank, DEC Prospects Group.

Figure 1.2. Global Industrial production

Output momentum fading across

all developing regions industrial production,

% seasonally adjusted annualized rate

Figure 1.3. Global Trade

Global trade growth is slowing rapidly as

pre-crisis levels regained

Source: World Bank, DEC Prospects Group.

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

5-year sovereign credit-default swaps,

basis points (bps), 2010

Source: Global prospects, World Bank.

Most countries in the Europe and Central Asia (ECA) region–which was hardest hit by the crisis–returned to growth, albeit less robust than in other regions. Growth in the region is driven by the bounceback of external trade but domestic demand is also growing, especially


in the largest regional economies, Russia, Poland, and Turkey. Metals prices, important for exporters such as Russia, are back to pre-crisis levels, as are many food prices. Capital infl ows rose to about 10 percent of the region’s GDP (from just over 7 percent) on account of offi cial fl ows, FDIs, and other private fl ows. However, this moderate growth in most countries is unlikely to make a big dent in the high unemployment, especially in the Central and Eastern European countries, while in the CIS countries, unemployment is lower, but continues to rise in several countries.

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

(real GDP growth, %)

Source: WB staff estimates.

Figure 1.7. And most returned to growth in 2010

Source: WB staff projections.


Russia’s output – manufacturing and domestic demand-led growthWith stronger domestic demand, the Russian economy regained momentum in the

second quarter 2010 with the real GDP expanding by 5.2 percent, compared to 3.1 percent in the previous quarter (table 1.1). In the fi rst half of 2010, the Russian economy expanded by 4.2 percent, year-on-year, mostly due to the base effect, but seasonally adjusted quarter-to-quarter growth suggests that the growth momentum was regained in the second quarter. Tradable industries and manufacturing led this growth, supported by non-tradables, such as transport and communication. Retail and wholesale trade, by contrast, was fl at in the fi rst quarter and grew by 5.3 percent in the second, refl ecting the recovery of domestic demand. With limited access to long-term credit and bankruptcies of many construction companies, construction sector continued to contract although at a slower pace than during 2009. The fi nancial sector–another labor intensive industry–also failed to expand, beset by the large share of bad loans. In contrast to Russia, robust growth in Turkey has refl ected rapid recovery of the construction and fi nancial sectors, comparatively less vulnerable before the crisis.

Investment demand, particularly inventory restocking, was the main factor contribu-ting to output growth in second quarter 2010. According to Rosstat national account statis-tics, gross capital formation contributed about 5.6 percent to the aggregate GDP growth in Q2-2010 (fi gure 2.2), with as much as 3.8 percent accounted for by the inventory restocking. Household consumption was the second most important factor of GDP expansion, con-tributing 2.5 percentage points to aggregate growth. By contrast, net export’s contribution became negative as import volumes (especially of services) surged with rising real wages and incomes.

TABLE 1.1. GDP growth by main sectors (value added): 2006–2010

2006 2007 2008 2009 Q1-2010 Q2-2010

GDP growth ................................................................................... 8.2 8.5 5.2 -7.9 3.1 5.2

Tradable sector ............................................................................. 3.0 3.5 0.3 -10.1 11.9 10.3

Agriculture, forestry ...................................................................... 2.7 1.3 7.3 0.2 2.7 1.1

Extraction industries ..................................................................... -2.9 -2.2 1.7 -0.9 11.7 5.2

Manufacturing .............................................................................. 6.6 7.5 -2.2 -15.8 13.4 15.3

Non-tradable sector ....................................................................... 12.5 12.8 9.1 -7.2 -0.3 3.5

Electricity, gas, water production and distribution ........................ 4.5 -3.4 -0.3 -4.3 9.0 3.7

Construction ................................................................................. 12.8 13.0 11.2 -17.2 -8.9 -0.3

Whole sale and retail trade ........................................................... 14.1 11.7 9.4 -10.3 -0.1 3.7

Transport and communication ...................................................... 9.7 4.8 5.1 -3.0 9.5 9.6

Financial services ......................................................................... 25.4 29.1 13.5 2.4 -7.3 -1.2

Source: Rosstat; World Bank staff estimates.

Most recent output data for the third quarter suggest that domestic demand is beginning to replace external demand as the main growth engine. The industrial sector, supported by a gradual pickup in investment, and inventory restocking in particular, has continued healthy growth in the third quarter (6.4 percent) led by manufacturing (9.5 percent). Gradually recovering domestic demand has fi nally provided a welcome boost to non-tradable sectors, with retail trade growing in the third quarter by 5.9 percent and construction by 2.2 percent in Q3-2010. This is good news for the small and new businesses that often populate these sectors, but it is clear that they suffered considerably during the crisis (Box 1).


Labor market — a temporary decline in unemployment With the ongoing output recovery and a seasonal increase in employment, unemploy-

ment fell from January to June 2010 and has since remained broadly stable, if elevated. Unemployment in Russia fell from 9.2 percent in January 2010 to 6.6 percent (5.0 million people) in September, based on the ILO defi nition (table 1.3 and fi gure 1.8)), but it is likely to increase with the onset of the winter and remain high in 2011. Moreover, many long-term unemployed dropped out of the labor force. So, Russia’s labor market conditions remain dif-fi cult, mimicked in the sharp drop in net migration to Russia from Central Asia.

Box 1. The Impact of the Crisis on New Firm Entry

Like many upper-middle and high income countries, Russia experienced a sharp drop in new

firm registrations during the financial crisis. Between 2008 and 2009, new firm registrations dropped

37 percent. Even with this precipitous drop, new firm entry density – calculated as newly registered firms

as a percentage of the working age population, normalized by 1,000 – in Russia remained higher than

most upper-middle income countries.

According to an index of crisis turbulence calculated by Calderon and Didier (2009), the impact of the

crisis on the Russian economy was nontrivial – a value of –0.31 on a scale of –2(worst) to 2(best) – and

the drop in new firm registrations was broadly in line with the severity of the crisis (Box Figure 1). This

index of “financial turbulence” measures the degree to which a country has been affected by the crisis. It

is calculated as a principal component of three measures: (a) variation in the real effective exchange rate

in March 2009 (% year-on-year), (b) rate of change in the aggregate stock price index in March 2009 (%

year-on-year), and (c) change in the country credit rating from Institutional Investor (variation in March

2009 vis-а-vis March 2008). Higher values of the turbulence index indicate the country was less affected

by the crisis. It appears that this turbulence measure has a significant impact on new business registra-

tion across 95 countries in the sample, even while controlling for country fixed effects and economic and

financial development.

Box Figure 1. The crisis turbulence in Russia was worse than average but the impact on new

firms much more pronounced

Source: Klapper, L. and Love, I. “The impact of the financial crisis on new firm registration,”

World Bank’s Policy Research Working Paper No. 5444, 2010/20/12, World Bank.


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

Source: Rosstat.

A more detailed look at the hiring and fi ring of workers suggest that only a few sectors resumed signifi cant hiring. These data and the replacement ratio of the number of hired and fi red workers in major sectors suggest that the economy is not absorbing enough labor to make a sustained dent in the unemployment rate. Finance is the only sector in which hiring rates now exceed the fi ring rate, after a period of large job losses. Manufacturing, energy and gas, transport, and communication are gradually improving, if still with fairly low replace-ment ratios (fi gure 1.9). Vacancy data also indicate that manufacturing is the only major sector looking for qualifi ed workers (fi gure 1.10). And the coming winter season is bound to result in seasonal increase in the overall unemployment.

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

Source: Rosstat, WB staff calculations.

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

Source: Rosstat.

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TABLE 1.3. Labor productivity, disposable income, wages, and unemployment, 2006–2010

2006 2007 2008 2009 2010

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

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

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

Employment growth, percent, year on year ........................ 0.8 2.4 0.5 -2.1 0.3a -0.1

Labor productivity growth, percent, year on year .............. 7.3 6.0 4.7 -5.9 3.9a n/a

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

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

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

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

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

Balance of payments – improved, but then deteriorating due to a rapid growth in imports

The external current account balance improved in the fi rst half of this year due to higher oil prices and sluggish imports, but deteriorated in the third quarter as imports picked up. According to the preliminary estimates from the Central Bank of Russia (CBR), the current account surplus amounted to USD 60.9 billion in the fi rst three quarters of 2010, up from only USD 33.3 billion in the corresponding period of 2009, mainly because of higher-than-expected oil and resource prices (fi gures 1.11–1.12). But in July-September, import growth accelerated, and the trade balance narrowed considerably despite relatively high oil prices. According to preliminary estimates, the current amount surplus narrowed to only USD 8.7 billion in the third quarter, compared with USD 33.5 billion and USD 18.7 billion in the fi rst two (table 1.4). The current account surplus is likely to narrow further in the last quarter of 2010, refl ecting further import growth supported by economic recovery.

TABLE 1.4. Balance of payments (USD billions), 2006–2010

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

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

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

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

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

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

Source: CBR a Preliminary estimates.

With a lower current account surplus and downside risks for capital account, the balance of payments position could deteriorate toward year-end. Net capital outfl ows from Russia fell during the fi rst nine months of 2010, allowing the balance of payments to strengthen and the CBR to accumulate USD 51 billion in international reserves. According to the CBR pre-liminary estimates, the capital account registered an outfl ow of only USD 6.7 billion during the fi rst nine months of 2010 compared to USD 56.3 billion in the corresponding period of 2009. But disaggregated data convey a more mixed picture: capital fl ows remained volatile, with net infl ows into the banking sector but sizeable outfl ows from non-banking corporations (table 1.5). With the uncertain global growth and capital fl ows to emerging markets, Russia’s balance of payments position could deteriorate further toward year-end, becoming more vul-nerable to a new terms-of-trade shock due to a drop in oil prices.


Figure 1.11. Oil prices and the trade balance Figure 1.12. Current account balances and the real

effective exchange rate

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

TABLE 1.5. Net capital fl ows (USD billions), 2006–2010

2006 2007 2008 2009 H1 2009 H1 2010 Q3 2010

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

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

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

Source: CBR.

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

slowed down. According to CBR, the outstanding external debt of the banking sector declined only marginally to USD 120.1 billion by end-June 2010, from USD 125.7 billion at end-December 2009 (in 2009 the banks’ total outstanding debt fell by almost USD 40 billion, or 24 percent). As expected, no major defaults on foreign debt obligations by banks were reported in this period. Although the banks’ aggregate rollover capacity might have improved, the banks seem to have restarted short-term borrowing. Their outstanding short-term liabilities increased to USD 30.3 billon by end-June 2010, up from USD 27 billion at the end of 2009 and USD 24 billion at the end of Q3-2009. It is likely that the banks are using (at least partly) short-term borrowings to pay off their long-term liabilities. In the second half of 2010 the banks have to pay about USD 24.3 billion (including interest payments), most in the third quarter.

The external debt exposure of private nonfi nancial corporations fell in the fi rst half of 2010, likely refl ecting limited rollover capacity. According to the CBR, the outstanding ex-ternal liability of private non-fi nancial corporations fell to USD 234 billion at the end of June 2010, from USD 249 billion at the end of 2009. So, many companies were forced to delever-age their balance sheets. Thus the aggregate external debt exposure might fall further by year-end. According to the CBR, private non-fi nancial corporations have to pay almost USD 50.3 billion in the second half of 2010 (including interest), with USD 24 billion falling due in the last quarter of the year.

Monetary policy and credits—in search of a fi ne balance Monetary conditions remained loose in the third quarter as the CBR kept its key policy

rates unchanged despite an infl ation scare from rising food prices. Gradual loosening of mon-etary conditions in 2009 and 2010 resulted in a 33 percent increase in money supply (M2) by


August 2010 (y-o-y). Given the recovery in money demand, the observed rapid monetization of the economy could have been excessive and led to a buildup in infl ationary pressures. The situation was complicated by rising food prices in August-September 2010 due to a severe drought in the European part of Russia. According to Rosstat, the declining infl ation trend reversed in August, with 12-month CPI infl ation rising to 7.0 percent in September, up from 5.5 percent in July (fi gure 1.18). Also, in September 2010, producer prices increased by 8.2 per-cent relative to December 2009 (by 10.5 percent in manufacturing). But despite rising infl a-tionary pressure the monetary authorities kept the refi nancing rate unchanged, but revised its end-year infl ation target up by 1 percentage point to 7.5 percent—to account for a one-off effect of food prices.

The CBR is currently facing a diffi cult trade-off between keeping the main policy rates low and a potential buildup of infl ationary pressure. The problem with the currently low rate is that even with the rapid monetization of the economy (M2 increased by 33 percent in August 2010, year-on-year) and considerably improved liquidity in the banking sector, credit activities remained very weak during 2010. Net credit to the private sector increased slightly in April-August 2010 (fi gure 1.14). But most of this increase is due to new credits to enterprises, while net credits to households remained limited. With real policy rates now in negative territory, the observed marginal recovery in credits suggests supply constraints in the banking sector.

Banks have been keeping wide spreads between the refi nancing rates and effective lend-ing rates (fi gure 1.13). This suggests that most banks still perceive credit risks of potential borrowers (especially households) as very high. Given the slow economic recovery and low profi tability, prevailing interest rates on new loans for fi rms and households remain high (ef-fective rate for consumer loans may vary from 18 to 40 percent). Under these conditions, some monetary tightening might not affect credit, but may limit infl ationary pressure.

The recovery in credits depends, among others, on strengthening of bank balance sheets and increases in borrower profi tability—and this will take time. Data from the CBR suggest little or no improvement in the share of non-performing loans during 2010, although their rise has slowed substantially. On October 12 Moody’s Investors Service raised the outlook for Russia’s banking sector to “stable” from “negative,” citing its “improved liquidity” and “loan-loss provisioning buffers.” Interestingly, many banks restructured a large share of de facto non-performing loans during 2009 and 2010 although the nature of such restructuring varies widely. The Russian banking system is relatively well provisioned (18 percent of total loans), but the long term performance of many restructured loans remains uncertain, which means that such banks may be under-provisioned and some under-capitalized.

Figure 1.13. Lending rates and inflation in Russia

2006–2010

Figure 1.14. Stock of credits to companies and

households in 2007–2010

Source: CBR; World Bank staff estimates.


Faced with balance of payments pressures and remaining volatility in oil prices, CBR has further widened the exchange rate corridor. In March 2010 the CBR, moved to a more fl exible exchange rate management, smoothing volatility but not defending the absolute levels of the targeted corridor for the Euro/USD currency basket. This made the CBR policy more effective in avoiding a possible carry-trade and destabilizing speculation against the ruble. However, with deteriorating balance of payments and capital account volatility, CBR prudently decided in October to widen the exchange rate corridor and further reduce the size of interventions in a move to make the exchange rate more fl exible and less predictable in the face of volatile external conditions.

Fiscal policy – rising fi scal risks The fi scal outcome for 2010 is likely to be better than expected as a result of favorable

oil prices. According to preliminary Minfi n estimates for the fi rst nine months of 2010, the Federal budget was executed with a defi cit of only 2.2 percent of GDP, down from 4.0 per-cent of GDP in the same period in 2009 and a budgeted defi cit level of 5.4 percent of GDP for 2010. This is mainly due to higher revenues from oil: in Jan-Sep of 2010 revenues amounted to 18.3 percent of GDP, up from the budgeted 17.3 percent for 2010. Similarly, expenditures in the fi rst nine months of this year were only 20.5 percent of GDP, down from 22.7 percent of GDP in the budget. But budget execution will accelerate in the fi nal quarter of the year, resulting in the higher defi cit than so far in the year, but lower than budgeted.

The Government is now planning a gradual fi scal adjustment to eliminate the federal defi cit by 2015. The draft Federal budget law for 2011–2013 indicates a commitment to reduce the federal budget defi cit from 5.4 percent of GDP in 2010 to 2.9 percent in 2013 (table 1.6).

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

2009 2010 2011* 2012* 2013*

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

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

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

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

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

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

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

* Draft Budget.

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

On the expenditure side, despite sizable changes in expenditure priorities, Russia faces additional expenditures to close the infrastructure gap, support diversifi cation, and imple-ment military reform. According to the draft federal budget for 2011–2013 aggregate expendi-ture reductions total 3.7 percent of GDP. And the federal government has an ambitious plan to increase fi scal space to almost 6 percent of GDP over the next three years by reprioritizing and optimizing existing expenditure structure. Although this is ambitious, it might not be enough to address additional spending pressures likely to emerge over the medium term. Russia’s well documented demographic trends—declining population, aging, and increasing demand for pension and health services and the changing structure of demand for educa-tion—will increase social expenditures by 3.5 percent of GDP in 2016–2020.21 2 Bogetic, Zeljko, Karlis Smits, Nina Budina and Sweder van Wijnbergen (2010). “Long-Term Fiscal Risks and Sustainability in

an Oil-Rich Country: The Case of Russia,” World Bank Policy Research Paper No. 5240, 2010/03/17, World Bank, Washington D.C. Available at the World Bank’s external website www.worldbank.org.


TAB LE 1.7. Preliminary estimates of additional funding needs in 2011–2013 (as a share of GDP)

2011 2012 2013 Total

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

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

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

Military ..................................................................................................................... 0.1% 0.0% 0.4% 0.5%

International events* ................................................................................................ 0.0% 0.3% 0.4% 0.7%

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

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

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

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

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

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

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

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

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

Figure 1.15. Initial oil price assumed in the draft budgets vs. actual price and

World Bank forecast

Source: State Duma database, Bloomberg, WB


Box 2. A sizeable but temporary grain shock

In 2010, Russia has experienced the worst drought in decades, contributing to higher food

prices. The lack of rainfall in Central Russia and in the West along the Volga river caused a massive

drought affecting many food items. The harsh weather has destroyed close to 40 percent of crops in the

affected regions producing grains, meat and potato. Bloomberg noted that the drought led to the biggest

jump in the price of wheat since 1973, affecting a range of food prices (e.g., meat and dairy products).

So prices of grains and related products have been soaring since July, 2010. During June-October, buck-

wheat prices more than doubled and potato prices rose by 30 percent. Prices of meat, eggs and cereals

have increased more than typical during the summer period (Figures 1-2.). As the world’s third largest

grain exporter, the drought also played a role in global food developments, but less than feared.

Figure 1. Changes in prices of selected

food prices

Figure 2. Domestic buckwheat price shock:

Ten most affected regions

Source: ROSSTAT. Weighted by share of household

consumption for each item.

Source: ROSSTAT, June 4 – October 7th period.

Figure 3. Poverty increase due to changes

in grain pricesTwenty seven (out of 88) regions in Russia have

declared emergency at the onset of the drought.

The prices increases spread all over the country, but

regions in Central and Western Russia were particularly

affected. The largest increases in buckwheat prices

were observed in the Moscow oblast (149 percent),

Vladimirskaya oblast (148 percent), and in Kostroma

oblast (147 percent). In Russia, one-time increases in

food prices are somewhat confused by the public as

a return of sustained inflation and this “inflation scare”

was no exception. So for this reason and for reasons

of policy, it is useful to understand just how deep and

sustained was the impact on household welfare?

Source: World Bank staff estimates using household

survey data.

To this end, we use a micro-macro simulation method to estimate the impact of the food

price shocks on the household consumption and poverty. The net effect of the price shocks on the

households’ consumption has been estimated as a loss in real household income due to an increase in

expenditures as result of higher food prices. Figure 3 illustrates the impact of the drought on selected

population groups, categorized by the sector of employment. It appears that the net direct and indirect

effect of the drought will result in 1.0 percentage point increase in poverty rate in the entire country – more

than 1.4 million people may have temporarily fallen into poverty (on top of the 13.6 percent of the Russian

population in poverty in 2010), holding all other factors constant, including any increases in wages and

salaries that may take place since the beginning of the shock. This is not a marginal impact even though

it is a one-time shock likely to dissipate over time with increases in household incomes. Pensioners and

others on fixed incomes are the most vulnerable group with a 2.6 percentage point increase in poverty.

In sum, the household income loss and the impact on poverty was sizeable but temporary. This is an

important finding in a debate to formulate appropriate policy (Box 3).


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

On August 5, in response to the escalating grain prices, the Russian government imposed a

temporary export ban on wheat, barley, rye, maize, wheat and wheat-and-rye flour from August

15 to December 31 2010; on October 20 the Russian government extended export ban on grain

till the end of June 2011 yet flour export ban was not extended. The export ban is a response

to the drought induced shortfall in the grain harvest and the associated rapid grain price increases.

According to the preliminary official estimate for October 20 farmers harvested 62.3 mln tons of grain,

a decline of 36.8% compared to 2009, resulting in sharp increases in grain prices in domestic as well

as in international markets.

The export ban is aimed to insulate Russia from highly volatile world grain prices by reducing

exports in 2010-11 to the 3 million tons already shipped, resulting in a drop of nearly 12 million

tons compared to initial projections for the year. Nevertheless, given the current production estimates,

and domestic consumption estimated at 78m tons, it is likely that Russia will become a net importer of

grain, depending on the use of reserve stocks1.

In these circumstances, the export ban will be largely ineffective in reducing domestic prices

as they will continue to be influenced by world grain prices. For Russia, an export ban could also

have unintended and often undesirable side effects such as undermining Russia’s long-term policy goal of

becoming an important player in the global grain market; encouraging hoarding in expectation of the ban’s

removal; distorting prices and affecting the investment and production responses.

Alternatively, domestic inflationary pressures and food security could be addressed in the

short term by

• Using global markets to fill any temporary grain shortfalls.

• Protecting the poor through reducing taxes and tariffs on key food products.

• Making full use of the grain intervention fund to reduce pressures in the domestic market.

And in the medium to long run by:

• Targeting cash transfers to vulnerable groups. Various kinds of cash transfer programs are currently

used in many countries including Brazil, China, Mexico, and South Africa. Cash transfers are effective

in ensuring income transfers to vulnerable population segments and, unlike export restrictions, do not

reduce farm-gate prices and induce a negative supply response.

• Improving transport and logistics. In many countries, transport and logistics costs are a key com-

ponent of food prices and are generally far higher than OECD benchmarks of around 9 percent.

While countries can do little to reduce ocean shipping costs, they can act to lower the overall cost of

domestic distribution. Severe difficulties with exporting the 2008 bumper crop in Russia highlight the

importance of sufficient and efficient transport and distribution infrastructure.

• Encouraging a more robust agricultural insurance framework. Russian farmers have keen perceptions

of risk, but they are concerned about high premium costs and inadequate claims settlements; on the

whole, they remain seriously underinsured. It would also boost investment in infrastructure such as

on-farm storage, making natural disasters somewhat more manageable.

• Increasing priority to public investment programs to support (a) agricultural productivity improvements

(b) national irrigation development and rehabilitation program and (c) nation-wide price market price

information services.

• Strengthening capacity for food policy formulation.

1 Grain stocks are estimated at 26.3m tones as of July 1, 2010, of which 9.6 m is part of government’s grain intervention fund.

The federal budget defi cit is planned to be fi nanced mainly from domestic borrowing supplemented by a modest amount of external borrowing. In 2011 part of the defi cit will be fi nanced by a drawdown of the reserve fund, but in 2012–2013 the defi cit will be fi nanced mainly from domestic sources. The domestic fi nancing sources include the privatization revenues from the sale of state assets, about 0.5 percent of GDP a year, and the issue of domestic bonds.


TABLE 1.8. Preliminary estimates of additional funding needs in 2011–2013 (as a share of GDP)

2008 2009 2010

Draft Federal budget law2011–2013

Actual Actual

Original law

Revisedlaw

Actual (Jan-June)

2011 2012 2013

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

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

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

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

Source: World Bank staff estimates.

Reliance on domestic fi nancing of the defi cit presents at least two sets of challenges. First, although there is enough liquidity in the domestic market to fi nance an overall fi scal defi cit below 3 percent of GDP, even if the 2011–2012 budgets are implemented as planned, there is a real risk that interest rates will rise and crowd out bond issues by SOEs or large enterprises. Second, the fi scal adjustment on the expenditure side could become slower and the defi cit higher in the election cycle in 2011–2012, putting further pressure on the domestic market, aggravating the interest rate and crowding out effects.

Given the fi scal constraints, some post crisis priorities might be fi nanced by off-budget vehicles, increasing contingent liabilities. The budget code limits the government’s ability to lend directly to commercial entities, so the Vneshekonombank (VEB) has become a de facto source of long-term fi nancing for large investment projects in infrastructure and other strategic sectors. It is expected in the medium-term that the VEB will support government’s priorities in fostering innovation, modernization, and diversifi cation (including addressing the monotowns). The VEB is also supporting preparations for Sochi Olympic Games in 2014. In recent years it has benefi ted from capital injections fi nanced by the federal budget.32

Overall, fi scal risks have increased, suggesting the need to rethink the fi scal strategy in the face of heightened uncertainty and downside risks in the oil market. First, the pace of fi s-cal adjustment in the 2011–2013 budgets is slower than initially envisaged, pushing the hard decisions on expenditure adjustments into the future. As discussed in the RER22, a more rapid adjustment would lead to a faster convergence of the non-oil fi scal defi cit to a long-term sustainable level of about 4.3 percent of GDP. Second, as in other countries, expenditure pressures may increase in the election cycle 2011–2012 leading to further weakening of fi scal adjustment. Third, with high budgeted price of oil close to the current forecast, Russia’s bud-get has lost the cushion it had in previous years, becoming more vulnerable than in the past to sudden drops in the price of oil. A sustained USD20 dollar drop from the current levels could raise Russia’s fi scal defi cit in 2011 by two percentage points of GDP.

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

II. Economic and Social Outlook for Russia 2010–2011 | 17

IIEconomic and Social Outlook for Russia,

2010–2012

Summary: With moderating global and Western European growth, uncertain oil prices and capital fl ows, Russia is likely to grow by 4.2 percent in 2010, followed by 4.5 percent in 2011 and 3.5 percent in 2012 as domestic demand expands in line with gradual improvements in the labor and credit markets. With such moderate growth prospects, unemployment situation is likely to get worse before it gets better later in 2011.

Preliminary updates to the World Bank’s forecast suggest global GDP growth of about 3.5 percent this year, slowing to 3.2 percent in 2011 before recovering to around 3.6 percent in 2012. Developing countries are expected to continue outperforming high-income countries by a wide margin, with GDP growth of about 6.6 percent in 2010 and just less-than 6 percent in 2011 before fi rming somewhat in 2012 (table 2.1). This compares favorably with the 2.5, 2.3 and 2.8 percent anticipated for high-income countries. Excluding China and India, developing countries are projected to grow at 5.2, 4.5 and 4.8 percent, with average growth above 4 percent in all regions (except Sub-Saharan Africa), and above 7 percent in East- and South Asia.

TABLE 2.1. The summary of the global outlook

2009 (actual) 2010 2011 2012

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

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

Developing countries ............................................................ 1.8 6.6 5.9 6.1

China .................................................................................... 8.7 9.5 8.5 8.2

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

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

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

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

Source: Global Economic Prospects, The World Bank.

The global transition from today’s very loose macro policies to a more neutral stance is a key challenge for all countries. Too abrupt a tightening could cut into the recovery—too slow a response could see demand outstripping supply. The latter point is of special concern given uncertainty over potential output—especially in high-income countries at the heart of the fi nancial crisis. If recent research suggesting that fi nancial crises tend to reduce potential output by between 4 and 6 percent of GDP is correct, then the U.S. and European economies could be close to their potential, with high structural unemployment. If so, an excessive de-mand stimulus and low interest rates could be counterproductive, leaking out imports and recreating earlier imbalances. For developing countries, many of them already at or closing in on potential GDP, tightening may attract unwanted and potentially destabilizing capital infl ows, as the difference between their interest rates and the low interest rates in high-income countries widen.


Box 2.1. World Oil Market: Recent Developments and Prospects

Developments. Oil prices (WB average) have been relatively stable over the past 13 months,

averaging around $77/bbl. Prices have been supported by strong demand in China and the U.S., and large

production restraint by OPEC producers. However, prices have been unable to rise sustainably higher

because of large stocks, substantial surplus capacity of oil production and refining, strong increases in

non-OPEC supply, and concerns about the outlook for the global economy. In October, prices rose above

$83/bbl, partly due to a weak dollar and tight distillate market. A strike at the large French Mediterranean

port of Fos-Lavera began September 27th, and spreading strikes closed most of France’s refineries, while

protestors blocked oil product depots resulting in fuel shortages at many of France’s petrol stations. So

far the impact has been local and had limited impact on global crude and product markets, a reminder

that supply is plentiful. Crude stocks on-land remain high, especially in the U.S., while much of the large

floating storage earlier in the year has been brought ashore. Product inventories remain high on-land and

at-sea, particularly middle distillates, but a lengthy strike in France could pull product stocks lower.

The price of Urals crude has fallen dramatically relative to Brent from its recent highs because of the

French strikes. With millions of barrels blocked at the French Fos-Lavera terminal, refiners are limiting

their spot purchases, and Urals sellers have to find alternative buyers.

World oil demand growth has been strong this year, with OECD demand turning positive in 2Q 2009

and joining very strong gains in non-OECD countries, particularly China. Global oil demand is projected

to increase by 2.1 mb/d or 2.5% in 2010, topping the pre-crisis peak in 2007, and recording the largest

volumetric increase in more than 30 years with the sole exception of 2004. Meanwhile, non-OPEC sup-

plies have recorded very strong growth, with output up more than 1 mb/d in the first three quarters of

year. Russia’s oil production has risen by 0.2 mb/d in each of 2009 and 2010 due to new fields coming on

stream, such as Rosneft’s Vankor field in East Siberia, and TNK-BPs Uvat project in West Siberia

OPEC producers have largely maintained their production cuts in an effort to keep prices within a

$70–80/bbl range, which they deem acceptable. OPEC’s spare capacity is around 6 mb/d, with about

5 mb/d of the surplus is in the Gulf, and nearly two-thirds of the total in Saudi Arabia.

Prospects. Oil prices are expected to remain relatively constant in real terms over the forecast period,

with the WB average currently projected at $76.4/bbl for 2010. Nominal prices are projected to drop to

$73.2/bbl, owing to a large drop in the WB MUV index. The market is expected to remain well supplied

going forward with large spare capacity in OPEC production and global refining. Oil demand is expected

to increase by 1.2 m/bd or 1.4% in 2011, with all of the growth in developing countries. Non-OPEC

supply is projected to grow by at least 0.5 mb/d, and OPEC NGLs are expected to increase by more than

0.6 mb/d. This leaves a very modest call on OPEC crude oil production, and thus the oil market balance

is not expected to change materially. This suggests that oil prices will continue trading around levels

of the past year. Downside risks would be slower growth in oil demand, a further climb in inventories,

and leakage of OPEC oil onto the market. Upside risks would include stronger demand in developing

countries—including emergency stock building in China when its new strategic petroleum tank capacity

comes online in the middle of next year—disappointing non-OPEC supply, further depreciation of the

dollar, and lack of an OPEC response should prices rise above the $70-80/bbl range.

Figure 2.1. World Bank oil price forecast; Average crude

(Brent, Dubai and WTI), simple average, $/bbl

Source: World Bank Staff

II. Economic and Social Outlook for Russia 2010–2011 | 19

With a slower-than-expected recovery in the fi rst quarter of 2010 and remaining downside risks to global economic recovery, we revised our real GDP projection to 4.2 percent in 2010, followed by a 4.5 percent growth in 2011, and 3.5 percent in 2012 (table 2.2). After a disappointing fi rst quarter in 2010, the growth momentum has been regained throughout Q2 and Q3, supported by recovery in household consumption and inventory restocking. In the second half of 2010, the sources of growth are likely remain the same, while net exports are expected to be a drag on growth, as import volumes pick up in line with economic recovery (fi gure 2.2). We expect that the pace of economic growth in 2011 and 2012 will be constrained, and will depend on sustained gains in consumption and the pace of recovery in longer term credit to the private sector, needed to facilitate growth in fi xed investment.

TABLE 2.2. Outlook for Russia, 2010–2012

2010 2011 2012

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

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

Russia

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

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

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

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

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

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

An increase in fi scal revenues due to higher oil prices is likely to be partly offset by new pressures from additional spending on infrastructure and modernizing the economy. We project the fi scal defi cit at 4.4 percent of GDP in 2010, 4.0 percent in 2011, and 3.1 percent in 2012, given the global oil price projections. With the reserve fund down to less than 3 percent of GDP by the end of 2010 (fi gure 2.4) the expected budget defi cit in 2011 and 2012 will have to be also fi nanced by domestic and (larger than planned) external borrowing. The downside risks associated with highly volatile oil prices and global demand will remain.

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


Figure 2.2. Demand sources of Russia’s

real growth, by quarter, 2008–2010

(percent change year to year)

Figure 2.3. Sectoral sources of Russia’s

real GDP growth by quarter, 2008–2010

(percent change year to year )


Figure 2.4. Balances of the National Welfare and Reserve

funds in billions of USD (end of period)

Source: Ministry of Finance.

* End of the year estimate

Figure 2.5. Monthly Unemployment Rate Dynamics

in Russia, 1999–2010

Source: World Bank estimates based on Rosstat data.

Although borrowing conditions are likely to remain fairly tight in the short term, we do not expect any major default by larger banks or corporations on their external debt obliga-tions in 2010 or 2011. Banks and non-bank corporations will continue reducing their long-term exposure while the net short-term debt might increase both in 2010 and 2011. The current debt payment profi le does not look worrisome. But if the private sector considerably increases its short-term exposure, the refi nancing risk would also increase, pushing up the cost of new borrowings in the medium term. According to the CBR, banks will have to repay about USD 57 billion in principal and interest and corporations about USD 98.1 billion in 2010, but much less–USD 29.4 billion and USD 54.9 billion respectively in 2011 (table 2.3).

TABLE 2.3. External debt service, including interest payments (USD billion)

20102010

20112011

Iq* II**q IIIq IVq Iq IIq IIIq IVq

All sectors ............................... 39.6 43.2 43.0 34.1 160.0 20.0 27.2 18.8 24.1 90.1

Government ............................. 1.6 0.5 1.6 1.1 4.8 1.6 1.0 2.0 1.2 5.8

Banks ...................................... 14.7 18.1 14.9 9.4 57.0 4.8 10.8 5.5 8.1 29.4

Other sectors ........................... 23.3 24.6 26.6 23.7 98.1 13.6 15.3 11.3 14.8 54.9

Source: CBR, schedule of payments as of July 1, 2010.

* – schedule of payments as of January 1 2010.

** – schedule of payments as of April 1 2010.

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

IIIIn Focus: Unemployment and Recovery

Across Russia’s Regions

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

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

Figure 3.1. Unemployment changes across Russia’s regions, 2010* over 2008

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

Charting regional employment and unemployment trends before and after the crisis reveals interesting patterns. Figure 3.2 shows the impact of the crisis on regional employ-ment and unemployment during the crisis (left hand chart) and emerging results following the recovery (right hand side chart). The bubbles represent Russian regions (with size of the bubble proportional to the size of the population). The top-left quadrant contains regions with worse outcomes, the lower-right regions where indicators have improved. Most regions have experienced adverse effects, but the recovery process across regions (in the right chart) is differentiated.

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


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


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

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


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

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


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

Similarly, FDI fl ows to Russia (especially some of the larger regions) were signifi cantly affected during the crisis, but the recovery seems related to FDI and investment climate in regions. During the crisis, FDI dropped everywhere. Regions with higher FDI in 2010 also had higher industrial production. More developed regions that were more exposed to foreign trade and foreign investments were most affected in terms of the loss of FDI. But some of these same regions are only slowly recovering. Interestingly, some of the smaller regions with a larger share of foreign direct investment and better investment climate show less unemployment in the recovery (fi gure 3.5).

Figure 3.5. Foreign direct investment in Russia’s crisis and recovery


In sum, regions that suffered most are the most developed, but they are not necessarily leading the recovery. Preliminary regressions of regional unemployment (explained vari-able) on a number of correlates (explanatory variables) suggests important roles for higher investment rates, higher GDP, openness, and the share of non-tradables in facilitating the labor market recovery. But diversity is huge during the recovery. One tentative result is that regions with a larger share of SMEs, better investment climate, more FDI, and stronger fi nan-cial sector presence tend to show a more robust recovery. The crisis may have provided an opportunity for reform and an impetus to rethink and accelerate public sector, fi nancial, and diversifi cation reforms at the regional levels.

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