Russian Federation

The Russian Federation, the largest of the Commonwealth of Independent States with an area of 17 million square kilometers, has a 2000 population of 144.8 million people and a 1999 GDP per capita of US$2260 (latest available World Bank estimate using Atlas method).

In 1992, the Russian Federation embarked on the long and difficult path of transition towards a market economy. This process has resulted in a profound change in Russia's economy, even though the transition is far from complete and has often been accompanied by disappointment and setbacks. Recent economic developments have been encouraging, with a brisk recovery following the financial crisis of 1998. Although reforms appear to begin to bear fruit, the necessary restructuring is far from complete and, in particular with a worsening international economic climate, the risk of setbacks remains. The World Bank's will remain a partner of the Russian government and people in that difficult process of completing the transition to a market economy until the basis for sustain able growth is established in the years to come.

Historically, the economic situation appeared on the surface to have stabilized in 1997, with a substantial reduction in inflation and the first signs of positive GDP growth. However, there was no sustainable foundation for economic growth. The principal reason for the financial crisis in 1998 was unsustainable levels of fiscal and quasi fiscal debt, combined with continuing structural weakness. These fundamental problems reflected weak implementation of fiscal and structural reforms, and also insufficient involvement of legislative bodies in the design of reforms.

The trigger for the decline in Russia’s macroeconomic situation was provided by the financial crisis in East Asia. In addition, the terms-of-trade suffered from a world wide fall in commodity prices. The consequent rise in macro instability and interest rates contributed further to the rapidly worsening fiscal situation, characterized by an unsustainable accumulation of public debt with a large short-term component. The rise in real interest rates highlighted the Russian Federation's vulnerability to a changing sentiment in the international capital markets.

During this period, the Russian Federation experienced several episodes of exchange market instability as investors sought to flee from ruble-denominated assets, including government securities, into hard currency, depleting foreign exchange reserves in the process. Following the first episode in November 1997, two others soon followed in 1998. The first of these occurred in late January 1998, the second and decisive episode began in mid-May. Announcement of a US$22.6 billion dollar package from International Monetary Fund (IMF), World Bank, and Japanese on July 13,1998 could not stem the tide. The Ruble remained under attack until the August 17, 1998, meltdown.

This meltdown had three principle reasons: (i) an inability to systematically and effectively implement structural reforms which resulted in a lack of effective restructuring in the industrial and agricultural sectors, and low rates of new investment and growth; (ii) an inability to close the gap between available resources and public spending, resulting in incomplete stabilization, unsustainable debt accumulation, and finally ushering into financial collapse; and (iii) the absence of broad-based political support for state initiatives.

Accordingly, economic progress in 1998 was disappointing. Real GDP contracted by 4.9 percent, and industrial output decreased by 5.2 percent. December-on-December inflation reached 84.5 percent, compared to a target of 8 percent. The Ruble exchange rate fell to 20.65 rubles per U.S. dollar by year-end, compared to 5.96 at the beginning of the year. Real disposable income dropped 28 percent in the fourth quarter of 1998 relative to the same period of 1997, substantially increasing the number of people living below the poverty line.

The large real devaluation, the rise in oil prices, and the separation of the financial from the "real" sector which barter and other non cash settlements provided, led to much better short-run results than expected. Buoyed by the devaluation and a 40 percent increase in average oil export prices over 1999, real GDP grew by 3.5 percent. Likewise, fiscal performance was strong, with cash revenues of the federal budget increasing from 9 percent of GDP in 1998 to 13.5 percent in 1999. The extent to which this initial recovery can be explained almost entirely by devaluation and higher oil prices, and changes in tax-sharing rules with the regions becomes visible also by the fact that, despite of the sizable US$30 billion trade surplus, Central Bank reserves barely budged, indicating that exporters preferred to keep their money abroad.

The macroeconomic environment improved further in 2000. Real GDP, increasing by 7.7 percent, by now has surpassed its 1998 crisis level; industrial output grew by 9 percent. Increasingly, income substitution spread industrial recovery across light industry, pharmaceuticals, ferrous metallurgy, machine building, next to chemical & petrochemical sectors. Inflation continued to be moderate, declining from 36.5 percent in 1999 to 20.1 percent in 2000. Simultaneously, the nominal exchange rate depreciated by 30.8 percent in 1999 and by 4.1 percent in 2000. Taken together, this translates into a bilateral real appreciation of 1.3 percent in 1999 and 12 percent in 2000 (assuming 3 percent US inflation both in 1999 and 2000). However, the current account retained its large surplus and, although capital flight also reached record levels in 2000, the Central Bank managed to build significant foreign exchange reserves- from $12 bln. in August 1998 to $29 bln. by end 2000. This had its price, pushing the Ruble to appreciate in real terms, and thus reducing the competitiveness of domestic goods. On the fiscal side, federal revenues increased from 13.5 percent of GDP in 1999 to 16.3 percent in 2000, leading to the best fiscal position during the whole transition period. For the first time in a decade, an overall budget surplus was registered in the year 2000 (2.3 percent of GDP, with a primary surplus of 4.7 percent). All revenues collected to the federal budget since early 1999 have been in cash.

However, a closer look still reveals substantial structural weakness. Investment in Russia’s economy, for example, grew 37 percent in 1999 and 17.7 percent in 2000, but these investments have largely been concentrated in a few sectors of the economy (most notably fuel and gas, as well as the state dominated transport sector). Next to the export proceeds from oil, gas, and metals, the present output rebound across industries reflects largely an increase in capacity utilization from very low levels stimulated by the expenditure switch towards domestic goods as a result of devaluation, rather than the result of investment growth.

The recent strong macroeconomic growth performance has helped to reduce unemployment, increase real wages, and as a result, reduce the share of the population living below the subsistence level (as defined by the government) from 35 percent by the middle 1999 to about 25 percent in the third quarter of 2000. However, wage arrears, although declining from 2.9 percent of GDP in 1998 to .77 percent in the first 9 months of 2000, have not been completely eliminated and for some benefits, such as child allowances, new arrears continue to be registered.

Overdue payables to suppliers and to the budget and EBFs declined by 6 and 4 percentage points of GDP respectively. They continue to represent a significant source of vulnerability for the economy, amounting to 28.5 percent of GDP in the first 9 months of 2000.

The economy’s re-monetization and improved discipline becomes visible also in a significant decrease of non-cash offsets in payments to the budgets and transactions between enterprises. Gazprom and RAO UES were allowed to disconnect consumers for nonpayments. Moreover, cash collection rates for RAO UES increased from 48 percent in the first quarter 2000 to 101 percent by the end of 2000 (although some cash receipts for past arrears are included in this figure). In 2000 the share of barter transaction declined from 30 percent to 20 percent in comparison to 1999. There are signs that subnational budgets’ non-cash execution declined drastically (from about 50 percent in 1998 to about 12 percent in the third quarter of 2000).

The ratio of public debt to GDP rose from 49 percent in 1997 to 142 percent in 1998 as a result of devaluation. In 1999 it declined to 105 percent as a result of inflation erosion of domestic debt, repayment of debt, strong growth, and 13 percent real appreciation of the ruble. In 2000 this ratio decreased even further to 65 percent of GDP due to continuing strong growth of the economy, 20 percent real appreciation of the ruble, and write off of $10.6 bln. because of the London Club restructuring agreement.

A balanced assessment overall has to recognize the great strides that have been made in particular in macroeconomic performance without being silent as to the fact that underlying structural reforms have not progressed to an extent which would allow for comfort. On the positive side, the economic outlook for Russia can now proceed from improved political stability, sound macroeconomic and in particular fiscal policies, and the expected effects of export-let growth on the current account, the accumulation of reserves, and investment. On the other hand, Russia’s economy remains vulnerable to external shocks, especially to a decline in oil and gas prices. This vulnerability reflects the need to increase the effectiveness of policies in hardening enterprise and public sector budget constraints, and to increase its credibility. In particular, tax collections from natural monopolies and energy bill payments exclusively in cash need to be improved. On the external side, the rise in the real exchange rate and inflation need to be carefully managed, to avoid loosing some of the competitiveness gained in the aftermath of the 1998 crisis. In the long run, however, these policies can not substitute for the need to accelerate enterprise reforms and, of particular relevance in Russia, to accelerate the growth of a segment of competitive, new private firms.

The new Russian government, formed after the major reorganization of ministries in May-June 2000, has embarked on a steady course of reforms, thus far with more determination than most since the initial launch of reforms in early 1992. Deregulation and increased transparency of the business environment; comprehensive administrative, judicial and public service reforms; hardening of budget constraints at the enterprise level: changing the nature of the social welfare system—these are just a few major components of the new, ten-year government program, and the program of priority measures for 2000 and 2001. This is a very challenging reform program, it would challenge any government. The World Bank has repeatedly urged the Government of RF to speed up reform process necessary for economic recovery after the 1998 crisis, by taking advantage of favorable external factors including high prices for oil and other raw materials exports, as the "window of opportunity" can close very quickly.

Russian Federation and the World Bank

Since the Russian Federation joined the World Bank in 1992, the Bank has approved more than US$12 billion in loans for 48 operations. As of today, 33 of these operations are under implementation, and due to some cancellations total commitments equal US$11.23 billion. Cumulative disbursements to the Russian Federation as of March 1, 2001, amounted to US$7.62 billion (US$2.67 billion for investment loans and US$4.95 billion for adjustment loans).

The Bank's assistance since 1992 initially emphasized the vital role of the emerging private sector and the importance of maintaining financial stability during the transition. The operational objectives (i.e., development of a market economy based on private sector initiative, institutional development, protection of the most vulnerable during transition) underpinning the Bank's program have not changed appreciably since 1992. During the early years, the lending program emphasized rehabilitation—particularly in energy— infrastructure and environment, and institutional development. A substantial technical assistance and training effort was also mounted to support institutional development in partnership with other donors. Because of the volatile economic, political, and administrative environment of the early-to-mid 1990's, policy reform was pursued largely through analytical work and dialogue: quick disbursing operations—apart from Rehabilitation I and II — did not feature in the Bank's program until 1996.

Following the elections of July 1996 and the political and economic developments of the ensuing twelve months, the Bank believed that the conditions for a concerted reform effort — while far from the assured — were as favorable as could be envisaged. At the policy level, support for reforms appeared particularly strong, The Bank's fiscal (Fiscal year is from July 1 to June 30) 1998-99 strategy took advantage of this perceived "window of opportunity" to support a comprehensive, accelerated program of structural reform. The strategy envisaged — and delivered — a substantial volume of adjustment lending in support of a comprehensive program of structural reform.

In February 2001, the Bank's Board of Executive Directors approved the Country Assistance Strategy Progress Report (CAS Update). The last full Joint Bank/IFC Country Assistance Strategy (CAS) for the Russian Federation was discussed by the Board of Executive Directors on December 23, 1999. It was the first full articulation of a Bank Group strategy for Russia following the August 1998 crisis. While it was developed in an atmosphere of increasing economic stabilization, it remained influenced by significant economic and political uncertainty. As a result, the CAS covered a shorter, 18-month time horizon.

Since the Board of Executive Directors discussed the last Country Assistance Strategy for the Russian Federation, the Bank Group focused on (i) making strong progress in improving the portfolio performance a pre-condition for new lending, (ii) taking on incremental exposure through adjustment loans only when fully warranted by commensurate progress in reforms, and (iii) and making selective new commitments with primary focus on improved public resource management. Relative progress has also been made towards improving the portfolio performance (including selected cancellations of outstanding commitments), advancing project preparation, and taking steps to re-build the Bank's knowledge-base with particular focus on poverty reduction and institutional barriers to growth.

However, the positive developments in Russia over the past year, particularly with respect to economic and political stability, ownership of the economic reform program, and improvement in the performance of Bank-supported projects, provide the basis for a stronger operational engagement by the Bank Group than has been the case since the August 1998 crisis. CAS Update indicates that the Bank Group assistance program will continue to focus on systemic and institutional reforms, while pursuing related efforts at the regional and local levels to inform the overall policy dialogue and support the development of a consistent policy environment at all levels of government. Within this framework, the emphasis remains on strengthening public sector institutions and accountability, advancing enterprise restructuring, improving the investment environment, and strengthening the social safety net. While much of the IBRD support will be aimed at improving the policy environment and public institutions, IFC will complement these efforts with direct support to the real sector. Synergies are particularly important in supporting the creation of an improved investment climate.

The CAS progress report sets out a change in the criteria for scaling-up the World Bank’s financial support to Russia. As most of the significant reforms that had been agreed to as part of the now-cancelled Third Structural Adjustment Loan are incorporated into the Government’s own program, the relevant criterion has changed from implementation of adjustment loan conditions to the implementation of the Government’s program – thus providing a broader base for assessing progress. Similarly, the Bank’s approach towards supporting further structural reforms is now centered around the Government’s program, whose implementation will be monitored by the Bank and may be supported, depending on financing needs and reform implementation, by future adjustment lending.

The August 1998 financial crisis had a devastating impact on the quality of the Bank Group's portfolio. By July 1999, after a thorough review of the portfolio, only 33 percent of IBRD projects were rated as satisfactory. The Russia portfolio accounted for one third of the Bank’s commitments-at-risk. The July 1999 Country Portfolio Performance Review (CPPR) set out a clear road map to address generic implementation issues, as well as specific implementation issues on a project-by-project basis.

The February 2001 CPPR confirmed that the portfolio is largely back on track. As of February, 80% of projects are satisfactory overall, up from 76% at the conclusion of the July 2000 CPPR. The portfolio quality now exceeds the peak levels recorded prior to the August 1998 crisis. This remarkable achievement was the outcome of (i) restructuring and cancellations of components in investment projects amounting to nearly $1 billion since July of 1999; (ii) an extraordinary effort by the Government to satisfy conditions to upgrade a total of 12 projects, and (iii) the closing of four unsatisfactory projects. The Bank proposed to the Government to have a brainstorming session during the Spring Meetings with the participation of the Russian delegation and the Bank’s country and sector staff on the agenda and mechanisms of the next thorough review of the portfolio that has been scheduled for June 2001.

In the course of the current financial year (2001 fiscal year is from July 1, 2000 to June 30, 2001) Russia could receive from the World Bank up to USD 600 million under six projects. Four projects have already been approved by the Board of Directors, including improvement of traffic management in Moscow(USD 60 million) and municipal heating in the Russian Federation (USD 85 million), USD 200 million guarantee to help Russian coal and forest industries upgrade their economic performance in environmentally and sustainable way, as well as USD 122.5 million project in support of the most critical and immediate investments needed to improve operation of the water and wastewater systems of 14 Russian cities. The Northern Restructuring project (USD 80 million) to help voluntary resettlement of Russians leaving in the Far North to other regions and education reform project (USD 50 million) to test at the federal and regional levels of models and mechanisms to establish organizational and economic conditions for improving the quality of general secondary and primary vocational education could be considered by the Board of Directors till the end of the 2001 financial year.

April 2001

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