Report No. 26000-RU Russia Development Policy Review June 9, 2003 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank Currenn˘y ind EZqnvaeelnt 1unn (Exchange Rate as of March 01, 2003) Currency Unit = RUBL1E US$ 1.00 = 32 rubles nsesi˘ Year January 1 to December 3i Weng ants T.Z. aX. Metric System ACRONYM ANDs 1- 1., 7 , ._ NO AIDS Acquired Immune Deficiency Syndrome ALMP Active Labor Market Program CBR Central Bank of Russia CEFIR Center for Financial Research CPI Consumer Price Index ECU European Currency Unit EU European Union FDI Foreign direct investment FEL Federal Electricity Law GDP Gross Domestic Product HIV Human Immunodeficiency Virus EiF International Monetary Fund LCU Local Currency Unit LRMC Long-run marginal cost MDGs Millennium Development Goals MFN Most Favored Nation MHI Mandatory health insurance MOH Ministry of Health NDC Notionally Defined Contribution OECD Organization for Econornic Cooperation and Development PISA Program for International Student Assessment RAO-UES Unified Energy System RLMS Russian Longitudinal Monitoring Survey SDR Standardized Death Rate TIMSS Third International Mathematics and Science Study WTO World Trade Organisation Vice President: Johannes F. Linn Country Director: Julian Schweitzer Sector Director: Cheryl W. Gray Sector Manager: Deborah Wetzel Task Team Leader: Asad Alam PREFACE The objective of this report is to provide an assessment of the development challenges before the Russian Federation. To that end, this report assesses: (i) development outcomes and prospects, and (ii) the extent to which the Government has been able to implement its social and structural reform program. The analysis and recommendations herein draw on knowledge acquired through various World Bank activities in Russia as well as on sources external to the World Bank. The Bank team was comprised of: Asad Alam (Team Leader), Olusoji 0. Adeyi, Mary Canning, Thomas Laursen, Vera Matusevich, John D. Nash, Mansoora Rashid, David Tarr, Peter Thomson, Sergei Ulatov, and Mikhail Pryadilnikov (consultant). Others who provided comments and contributions included: Olga Antimonova, Harry Broadman, Yelena Dobrolyubova, Vladimir Drebentsov, Carlos Ferreira, Victor Gabor, Cheryl Gray, Agnieszka Grudzinska, Joel Hellman, Elena Ianchovichina, John Langenbrunner, Su Youne Lee, Eva Molnar, Allister Moon, Alexander Morozov, Helga Muller, Neil Parison, Friedrich Peloschek, Paula Perttunen, Christof Ruehl, Afsaneh Sedghi, Julian Schweitzer, Radwan Shaban, Louis Thompson, Tunc Uyanik, Vladislav Vucetic, and Ruslan Yemtsov. The Peer Reviewers were: Philippe Le Houerou and M. Zia Qureshi. The team also benefited from useful guidance and comments from Pradeep K. Mitra. The work was done under the overall supervision of Deborah Wetzel. Judy Wiltshire provided excellent support with document processing, Tatyana Alexandrova was instrumental with mission arrangements and Helena Makarenko assisted with the finalization of the translation of the document. The Bank team is grateful to all Government and non-Government officials who cooperated with the work of the team. These include the First Deputy Ministers of Economic Development and Trade, Ms. Elvira Nabiullina, and Mr. Michail Dmitriev and Deputy Minister of Economic Development and Trade, Mr. Arkady Dvorkovich. The team would also like to thank Professor Y. Yasin and the May 28, 2003, seminar participants at the Higher School of' Economics, the staff of the Institute for Economy in Transition, the Higher School of Economics, the New Economic School, the Federal Energy Commission, Gazprom, RAO-UES, the Agrarian Institute, Troika Dialog, Brunswick UBS Warburg, the Center for Fiscal Policy, the Center for Financial Research, Standard and Poors, and the Economic Expert Group. TABLE OF CONTENTS EXECUTIVE SUMMARY ....................I 1. DEVELOPMENT OUTCOMES AND PROSPECTS .1 A. From Crisis to Recovery. B. Social Outcomes .3 C. The Government's Social and Economic Reform Program .4 D. Medium-Term Prospects and Risks .5 E. Conclusions and Future Challenges .9 2. STRENGTHENING THE INVESTMENT CLIMATE . .11 I. THE INCENTIVES FOR ENTERPRISE RESTRUCTURING .1 A. Reducing Energy Subsidies .1 B. Strengthening Payments-Discipline .13 C. Strengthening Corporate Governance .14 II. THE INCENTIVES FOR NEW SMALL AND MEDIUM ENTERPRISE GROWTH.... 15 A. Improving the Business Environment .15 B. Reforming Tax Policy .17 C. Strengthening the Financial Sector .17 D. Reforming the Infrastructure Monopolies .19 E. Promoting Competition through Global Integration .23 F. Improving Labor Market Flexibility .25 G. Promoting Rural Investments .............................. 26 III. CONCLUSIONS .29 3. MANAGING MACROECONOMIC RISKS . . .30 A. Key Macroeconomic Challenges and Risks .30 B. Securing Fiscal and External Sustainability .31 C. Managing Macroeconomic Volatility and Avoiding Dutch Disease .34 D. Conclusions .36 4. ENHANCING HUMAN CAPABILITIES AND PROTECTING THE VULNERABLE..38 A.V Enhancing Educational Outcomes .38 B. Improving Health Outcomes .41 C. Ensuring Old Age Security .45 D. Targeting the Safety Net System .47 E. Conclusions .52 5. REFORMING PUBLIC SECTOR MANAGEMENT . . .53 A. Intergovernmental Fiscal Relations .53 B. Public Financial Management .54 C. Tax and Customs Administration. 55 D. Public Administration and the Civil Service .57 E. The Justice System .59 F. Conclusions ........: ; 61 Table 1.1: Key Macroeconomic Variables, 1995-2002 ................................................................2 Table 1.2: Medium Term Prospects, 2C03-205 ............................................................... ...6 Table 2.1: Estimate of the Implicit Subsidies in the Electricity and Gas Sectors, 202 ............. 13 Table 2.2: Payroll Taxes in Selected OECD Countries .............................................................. 17 Table 2.3 Financial Market Depth, 2001 ................................................................. 18 Table 2.4: Net Foreign Direct Investment lInlows- Russia and Other Selected Countries, 1995-2G1 ................................................................. 24 Table 2.5: Private Ownership in Agricultural Land (as of January 1, 2C02 .............. ................. 26 Table 2.6: Estimate of Agriculture Support, 1998-200 ............................................................. 28 Figure 1.1: Output Recovery Post-Crisis ..................................................................1 Figure 1.2 Poverty and Income Trends, 1997-2002 .................................................................. 3 Figure 1.3: Gini Index for Incomes Per Capita, 1992-2001 ........................................................... 3 Figure 1.4: Private Savings and Investment, % of GDP .................................................................7 Figure 1.5: Balance of Payment 2003-05, US$ ......................................... .........................7 Figure 2.1: Trends in Effective Subsidies, 1998-2O2 ................................................................. 12 Figure 2.2: Overdue Taxes Payable, 1998-202 ................................................................. 14 Figure 2.3: Obstacles to Business in Russia, 1999 and 2002 ........................................................ 15 Figure 3.1: Crude Oil Prices in 2001 Dollars ..................................... ............................ 34 Figure 4.1: Educational Outcomes for Selected Countries, 1999 ........................... ...................... 38 Figure 4.2: Trends in Teachers' Salaries, 1989-2C ................................................................. 40 Figure 4.3: The Share of Specific Social Benefits in the Toa Received Benefits ........... ........... 45 Bozes Box 2.1: Key Issues in Power Sector Reform in Russia .......................................................... 20 Box 2.2: Railways Restructuring Program ................................................................. 22 Box 3.1: Fiscal Sustainability Analysis .33 Statistical Annex Table 1: Gross Domestic Expenditure and Product (billions of rubles) ................. .................... 63 Table 2: Gross Domestic Expenditure and Product (percentage of GDP current priees) ........... 64 Table 3: Gross Domestic Product by Expenditure, National Income and Savings ..................... 65 Table 4: Annual Growth Rates of National Income and Product ........................... .................... 66 Table 5: Prices .............................................................. 67 Table 6: Consolidated Public Sector Finance .............................. ................................ 68 Table 7: Balance of Payments ............................. 69 Table 8: Trade ..........; . 70 Table 9: External Debt and Debt Service ............................. 71 Table 10: Financial Sector Indicators ............................. 72 Table 11: Investment Climate ............................. 73 Table 12: Vulnerability Indicators ............................. 74 References EXECUTIVE SUMMARY Russia stands at an important crossroads in has' enabled fiscal discipline to be its path of economic transformation.' With maintained, reined in inflation from 86 aggressive reform implementation, the percent in 1999 to 15 percent in 2002, country can surge forward at higher growth ensured the timely payment of external rates over the medium term, improve social obligations, and strengthened foreign welfare, integrate with the global economy, exchange reserves. and move rapidly towards income convergence with the advanced economies. Since 2000, a spate of legislative enactments Alternatively, complacency with the current has taken place in a broad array of critical reform effort risks only modest growth and areas. These enactments seek to address the poverty reduction prospects, and inadequate macroeconomic, structural, and social attention to overcoming the factors behind problems through both policy and the uncertainties and economic volatilities institutional reforms. Some of the which have dogged Russia's transition past. pathbreaking reforms that are being implemented have been in 'the areas of Russia has emerged from the unprecedented business deregulation, tax, pension, and land economic collapse and social distress of the reforms. At the same time there are other no early transition years with rapid growth. less important areas, such as the energy The growth rebound since the 1998 financial sector, the financial sector, and public crisis has resulted in an average annual GDP administration, where less progress has been growth over 1999-2002 of 6.4 percent. This made, though reforms have been launched growth has led to a significant reduction in or are being developed in these areas too. poverty levels, from their peak of about 40 percent in 1999 to 27 percent in 2002 Notwithstanding the progress made, the (Goskomstat data) Many other social economy remains constrained by key indicators have also reversed their declining structural imbalances. Evidence suggests trends during this period. Nevertheless, the only limited enterprise restructuring and recent growth remains fragile, as the modest growth of new firms. Indeed, economic slowdown over 2001-02 economic reliance on natural resources has demonstrates. grown, and the economy is increasingly vulnerable to any sudden collapse in oil Post-crisis growth has been supported not prices. At the same time, large financial only by fortuitous external factors, but also industrial groups have grown, concentrating by good economic policies. Undoubtedly, economic assets and power in the hands of a growth has been driven in good part by the few, and-in the absence of effective 1998 devaluation (whose effects are now government enforcement of competitive waning), by the high prices of energy rules-undermining incentives for enterprise exports, and by the relatively low domestic restructuring and new firm entry and energy prices. Not surprisingly, growth has growth. It is particularly at the regional and been led by the natural resource sector while local levels that the nexus between these manufacturing has been sluggish. Growth large groups and the local political elite is has also been aided by the excess capacity in the strongest. Moreover, in the absence of the economy. But good economic policies timely investments, the deteriorating have also played a role. In particular, infrastructure risks economic dislocation and prudent macroeconomic management, which social hardships. All this is taking place in emerged as a key "learning" from the crisis, the context of growing regional inequalities in incomes and economnic performance, are unable to take advantage of these fueled by differences in initial conditions oppoAunities, or are adversely affected by and economic performance. the reforms, adequate social protection needs to be provided. All this, of course, ?Tuspecst. With the current pattems and requires an effective state which is able to trends in reform implementation, Russia can provide good governance and the necessary expect to grow at an annual average rate of public goods for private sector growth. about 4.8 percent per annum during 2003-05 with a gradual reduction in poverty levels. PITrcMOnng ta llmveKtnTnelit CThnnae Higher growth rates and greater poverty reduction are possible if reforms are The Government's reform program accords accelerated and income inequalities reduced. high priority to improving the investment Successful reforms, by continuing to impose climate. These efforts include measures to hard budget constraints on enterprises and enforce the restructuring of the existing communities, and by continuing to improve enterprises so as to release resources for new the investment climate, will attract increased activity and to encourage the growth of new investments and will promote higher small and medium-size enterprises, which productivity and growth. The investment have been engines of growth in the more needs for such a higher growth path are advanced transition economies. large but are affordable given the estimated US$250 billion of Russian capital that exited Financial discipline over the old sectors of the country during the past ten years. Even the economy is being strengthened through if half of this capital were to return to the hardening of budget constraints. The Russia, it would provide a quantum leap in tightening of payments discipline in the the availability of investible resources. budget sector has broken the past nexus between nonpayment of energy bills, TIHIE IRtU§AN IEVIEL0I71MENT budgetary tax arrears, and noncash POLNCY OCHALLENGIE§ settlements. Evidence also suggests a The fundaena creduction in the overall extent of energy The fundamental challenge for Russia IS to subsidies through tariff increases and accelerate and sustain broad-based economic improvements in cash collections. groweth. Russia's economy possesses unique However, the remaining subsidies in gas and strengths, primarily from its rich resource power remain high at 50-60 percent of base, itS high level of huran capital and economic prices. Barter and inter-enterprise scientific base, and its proxty to the arrears have fallen sharply but overdue marketsofWesternEurope and Asia. These debts, especially from large agricultural advantages provide lt wlth significant farms have been growing. The stock of tax opportunities in the global marketplace for arrears has fallen sharply but still remains trade and investment. large at 5 percent of GDP; the growth of Higher growth rates can be achieved only new tax arrears has slowed. Corporate through higher levels of efficient goverance is being strengthened. investments. This can be realized only by The Govermment's program also seeks to addressing the remaining weaknesses in the improve the business environment for new policy and institutional environment as well firm growth through business deregulation. as managing the risks to the Russian Recent evidence from business surveys economy. As economic opportunities grow, suggests significant improvements in the Russia needs to ensure that its peoples' overall business environment during 1999- human capabilities are enhanced so that they 2002. Businesses also report lower can take advantage of these opportunities. inspections and licensing costs since the For the poorest and the most vulnerable who implementation of the Government's deregulation program in mid-2002. But protection programs that provide cash problems remain.' Businesses are still compensations for the most vulnerable. constrained by the differential application of Without economic pricing and federal laws, anI uneveni playing field, complementary restructuring of the energy difficult access to land and construction sector, the country will be unable to meet permits, lack of access to finance, excessive the large investment needs in the energy administrative burdens, and inadequate sector. Meeting these needs is essential if regulatory framework. Payroll taxes remain Russia is to realize fully its higher growth quite high for social insurance schemes, potential. And without communal and creating incentives for tax evasion and housing services reform, it would prove under-reporting of wages, and undermining difficult to make real tariff increases socially competitiveness and formal activity. acceptable. However, tax reforms have reduced the overall burden, while banking sector Second, the financial intermediation regulation and supervision is being between the surplus energy sectors and the strengthened, albeit very gradually. deficit sectors in the rest-of-the-economy Progress towards World Trade Organization remains constrained by the shallowness of (WTO) accession is also critical in locking- financial savings. This reflects the overall in reforms and ensuring predictability in the lack of trust in the banking system which policy and institutional environment in will take time to develop. It also reflects the Russia, but important obstacles to a sector's domination by large and relatively successful conclusion of negotiations inefficient state banks and the overall lack of remain, especially in agricultural and energy bank competition. Banking sector reform tariff policy. also requires complementary reforms in the enterprise sector including improved The largest potential for new investments is corporate governance to strengthen banks' in the infrastructure sectors - power, gas, trust in borrowers. and railways - which remain dominated by monopolies and characterized by Last, but not least, the political economy uneconomic pricing. As a result, challenges to investment climate reforms investments have fallen short of the levels remain significant. It is crucial to promote a needed to maintain the various networks, rules-based system in which investors know leading to deteriorating services. The need their returns will not be eroded by a myriad for structural reforms in each of these of payments that are required by official and sectors is now recognized and there has been unofficial agents, in which profitable variable progress in developing such enterprises do not attract excessive and strategies. arbitrary taxation of an unofficial nature, and in which entrepreneurs can gain more The progress made in the investment climate from providing good products at low prices is still constrained by significant than they can by lobbying their Government. deficiencies. First, the extent of energy There are crucial challenges for reform subsidies in the economy remains large. Not implementation at the regional and local only are subsidies provided to large energy- levels where the nexus between the vested inefficient industries, but they also lock up interests in favor of the status quo and the scarce human and physical resources in low local political elite is the strongest. productivity sectors and prevent their more International evidence suggests that this can efficient use in new growth areas. While be overcome by improving transparency and these subsidies do help to soften the social accountability within subnational impact of economic restructuring, the social governments, ensuring a free media, objectives can be met through less costly mobilizing the potential winners and public interventions, such as effective social opinion by publicizing the costs of current accumulate reserves (possibly in the form of policies, and ensuring democratic rights. a formal stabilization fumd), or invest in priority physical and social infrastructure. Maimaginmg Mmcironaomkc IMaks Monetary policy should be geared to Achieving high and sustainable growth rates ensuring a steady decline in inflation over will also require securing fiscal and external the medium term, in the context of a less sustainability, managing macroeconomic managed floating exchange rate regime. volatility, and achieving low rates of While formal iflation targeting may be inflation. Current policies are unlikely to premate in Russia given the state of the generate growth rates substantially above 5 financial sector and uncertainty about the percent, and the budget is likely to come transnmission mechanism, the Central Bank under increasing pressures as elections of Russia (CBR) should aim for a more approach and as structural reforms are ambitious disinflation process based on implemented. Furthermore, while Russia "core" inflation (CPI inflation excluding should be able to manage the spike in debt administered prices). hI this context, it service payments in 2003-05, a sharp should allow for more flexibility in the decline in global oil prices could trigger foreign exchange market. renewed financing problems. Conversely, a prolonged period of very high oil prices, EU&.n%C IHtnnnianm CmaabiMles anmd especially if combined with a sharp reversal IPrVlacim Sie Vullnaembll of private capital outflows, could lead to excessive upward pressures on the real For Russian citizens to be able to take exchange rate, impair the competitiveness of advantage of the growing opportunities, domestic industries further (unless their human capital needs to be enhanced. productivity improves commensurately), and This has been eroded during the past ten undermine medium-term growth prospects years. Cf particular concern are declining (Dutch Disease). school enrollment; inadequate incentives for trained teachers, doctors, and nurses; the Fiscal policy should remain firm over the growing divide among regions in terms of medium term in order to ensure a continued access to educational and health facilities; decline in the debt burden, support the the deterioration in health outcomes such as disinflation process, help alleviate upward life expectancy and adult mortality; pressures on the real exchange rate inefficient allocation of public expenditures; stemming from the strong balance of inadequate financial management at payments, and support the implementation education and health facilities; and the of the social and structural reforms. To this general fragmentation of governance end, tax administration needs to be arrangements. strengthened further and expenditures rationalized and redirected towards In education, the Government's program mitigating the social and fiscal costs of aims to improve accessibility, quality, and reforms. Also, intergovernmental fiscal efficiency. Several measures are being relations require further strengthening to implemented including strengthening preserve financial stability at all levels of financial management through the pilot government. The fiscal stance should be implementation of the "money follows the assessed on the basis of the non-oil balance, student" principle, establishing standards for or the balance measured at a constant oil the certification of student achievement, price in line with some assessment of its rationalizing the school network in line with long-term average. As long as oil prices changing demographics, improving funding remain above this range, the surplus should for teachers' salaries and school costs, and be used to pay off expensive debt, using modern information technologies to iv introduce new approaches to teaching and redressed by increasing the retirement age learning. for pensioners and by linking the pension payout period to life expectancy at In health care, the Government's program retirement. Second, Russia lacks the main seeks to improve service efficiency by financial market requirements for successful rationalizing the structure of health services reform implementation. While the slow at all levels, improving resource pace of pension reforms, the proposed low management, and streiigthening sector-wide limits on private sector participation, and a governance.' These measures are important passive investment strategy mean that the to addressing systemic weaknesses in the absorptive capacity of financial markets is sector. But' they need to be co'mplemented not an immediate issue, this situation will by a large-scale program of disease control necessarily become a constraint over the and health promotion to attack the growing medium to long term unless capital market AI)S epidemic and the lifestyle problems development proceeds apace. And finally, associated with alcohol and tobacco use. administrative capacity needs to be strengthened in areas such as pension While enhancing human capabilities will databases, a modern financial management enable Russian citizens to take advantage of system, and coordination with tax and new opportunities, those who are most treasury agencies. vulnerable or poor need to be provided for. Old age security needs to be reliable and The challenge for the social safety net adequate, and social safety nets need to be system now is to move towards a system targeted towards the most vulnerable, such that provides adequate benefits to those most as those affected by the increase in utility in need. This requires phasing out prices and by the labor shedding of untargeted benefits and privileges, selecting downsizing industries. a fiscally affordable level of minimum subsistence, developing a modem family A major improvement in recent years has and child welfare system, and strengthening been the real increases in pensions and the the monitoring and evaluation systems. enforcement of generally timely payments. Significant structural changes have also Strengthening Public Sector been introduced that are aimed at putting Management pensions on a sound footing. The Government has introduced a multi-pillar The implementation of structural and social system. By separating efficiency and reforms, in tum, requires a Govemment that redistributive goals, the reforms seek to has the capacity to implement them and is improve worker incentives to contribute and able to provide the essential public goods to work longer, to improve the financial and services needed for private sector solvency of the pension systern, to ensure a growth. Accordingly, the Government basic minimum pension for all, and to reform program includes an appropriate contribute to the growth of a source of long- emphasis on the reform of term investible capital. intergovernmental fiscal relations, public financial management, tax and customs While it is too early to assess the success of administration, the civil service, and the pension reforms, several challenges are justice system. evident. First, the fiscal solvency of the proposed reforms can be achieved only at Intergovernmental fiscal reforms, essential very low and falling replacement rates (from to ensure proper incentives at the 36 percent to 24 percent in 2012), which subnational levels for the effective delivery puts in doubt the political sustainability of of public services, have been reinforced these reforms. This problem should be since 2001. The Government's current v reform program has already provided greater debt stock, consolidation of most clarity to the delineation of spending powers extrabudgetary and earmarked funds into the among the various levels of govemment and budget, and expansion of the federal to the reduction of "unfunded mandates." It Treasury to cover all federal transactions has also given improved predictability to tax and several regional level transactions as assignments (even though this has been at welL. Russia has also made progress in the cost of some centralization of tax instituting legislation on money laundering receipts), and has led to the piloting of an and in strengthening other safeguards. incentive-based system for fiscal transfers which rewards, on a competitive basis, However, additional institutional reforms regions that have successfully completed an are needed. Budget preparation systems agreed program of fiscal reforms. need to be strengthened. The transparency and the competitiveness of public However, problems remain. First, it has prMcurement needs to be improved. This is proven elusive to provide subnational a more importan issue at the regional levels spending authorities with real expenditure where the bulk of public procurement takes powers balanced with available financial place and where the necessary legislation resources. Indeed, recent federal increases and supporting regulations may not be in in public sector wages have imposed place. Systems for financial accountability additional fiscal burdens on subnational need to be strengthened in terms of both governments even as tax reforms have internal and external audit. Progress on Nhis eroded their own revenues. The challenge front needs to follow the development of for subnational governments is to meet these better budgetary classifications and data, new demands through expenditure along with the necessary capacity building. efficiency gains, higher cost recovery in housing and communal services, and Reforms in tax and customs administration privatization of subnational commercial have generally lagged behind reforms in tax assets. Second, the concentration of and customs policy. However, following revenues at the federal level and permanent upon various policy initiatives in recent changes in tax-sharing arrangements imply years to streamline and simplify tax policies, that subnational governments lack long-term and with the growing emphasis on business incentives for building their tax base and climate issues in order to boost slowing bringing all of their eamings on-budget. growth, attention has shifted to institutional These incentive problems need to be reform of tax and customs administation. addressed by extending the taxation powers The Government's program emphasizes of subnational governments and assigning organizational and business proess reforms major revenue sources to respective budgets that should precede the automation of tax on a long-term basis. In rural areas, the and customs administration and should devolution of social infirastructure to significantly reduce opporAunities for municipalities, which must be a component corrption. of the large farm restructuring process, should be accompanied by some assured The civil service has often been singled out means of funding operating costs and future in business surveys as lacking meritocracy investments at the municipal level. and being beset with corruption. Much of the problem stems from inadequate Evidence suggests that improved public incentives bcause of low salaries relative to financial management at both the federal the private sector, lack of accountability, and regional levels has contributed to weal transparency, and excessive scope for improvements in fiscal outcomes since discretionary behavior. At the same time, 1999. These improvements include there are few external pressures (e.g., from reductions in payments arrears and in the the private sector, NGOs, users) on the vi system to change. The problem is integrated approach to maximize the gains compounded by the multiple competing and from these reforms. overlapping structures of Govermment, which obfuscate the responsibility for The key reform priority is to improve the policymaking, fragment decision-making, investment climate. Among other things, and complicate internal coordination. this requires a further tightening of the financial discipline on enterprises through a The Government's civil service reform phased reduction in the effective subsidies program, adopted in November 2002, aims for energy. But this needs to be to build a modern, professional, and service- complemented by structural reforms in the oriented civil service. Significant pay gas and power sectors that would ensure reform is to be undertaken to redress the strengthened corporate governance, bring in imbalances with the private sector, and to new investments, and lead to improvements improve the incentives for service delivery. in service delivery. At the same time, Additional public administration reforms are adequate social mitigation measures need to being developed to rationalize the structure be put- in place to protect the poorest and and functions of Government and to most vulnerable from these tariff increases strengthen decision-making and (as well as the potentially adverse transparency. These reforms, if consequences of enterprise restructuring) implemented properly, can go a long way and housing and communal services toward strengthening public administration reforms. and establishing a meritocratic and professional civil service cadre. But this Measures to strengthen financial discipline will take time. Critical to their effective and need to be accompanied by measures to sustained implementation would be a promote the growth of new firms and communications strategy to mobilize public employment. To this end, priorities should opinion in favor of improved public service include the promotion of banking delivery and the measures needed to achieve competition and financial intermediation, it. gradual reduction in the burden of social taxes through a rational reduction of social And finally, reforms of the justice system benefits, and expediting WTO accession are needed to ensure that individuals and through an early resolution of remaining enterprises have equal opportunity to benefit issues. from the legal environment. Recent Government efforts have focused on the The effective implementation of reforms judicial system to strengthen systems of will likely test the ability of the public accountability, independence, administration. This needs to be supported professionalism, and fairness. Concerted through a careful review and rationalization and sustained reform implementation will be of government functions, and the needed to ensure an effective judiciary, implementation of civil service reforms. essential to the protection of property rights. Accelerating the implementation of PRIORITIES FOR ACTION integrated social and structural reforms is the best option for Russia, as it holds the Theunattacs thedkey matrix(sevementale 1 greatest promise for faster growth and summarizes the key achievements of the improvement in lving standards over the reform program over the past few years, the medium-term. remaining challenges, and the priorities for public action over the medium-term. Russia's developmental challenges remain huge and will continue to require an vii Table -: KEY AC˘IEVEMENPS (OUTCOMES), EPMAIE NG CHALLENGES, AND 1POLRCY P1fDOlRTffllIES Iinvestment Climate e Effective subsidies in power and gas reduced by Remaining subsides in energy still very high-50-60 Develop an energy tarff strategy for Inreasinng tariffs about 40-50 percent since 1999 primarily on account percent of economic levels. (reducing effective subidies) in a phased manner; integrate of improved cash collections and real tariff increases. . . strategy with structural reforms in the gas and power Payments discipline needs further Improvement; growing sectors anil wihE te development of7 a targeted soial safety Tax payments strengthened; stock of tax arrears fell inter-enterpuise debt in agriculture. neet, and housing aned cmemnlp services recorm s from over 9 percent of GDP in 1998 to about 5 percent of GDP in 2002; tax offsets eliminated. Businesses' perception of business environment Large inter-regional variation in perceptions of the Promote reform competition among regions through improved over 1999-2002. business environment and in the implementation of the competitive and conditional federal transfers. Inspections and licensing reduced by 26 percent and business deregulation measures. Periodically monitor implementation of deregulation reforms; 45 percent respectively 6 months after modify reform effort as appropriate; make information on implementation of deregulation measures; regional performance public. registration and certification requirements also cut (but results not available yet). Low level of FDI (about I percent of GDP); uncertainty Enpedite WTO accession n2gotiations thirough early over predictability of domestic policy environment resoluilon o? remaining issues, espcially with respect to energy tariffs, agricuRture subshides, and liberlization CY the hans and hinroneZ, Financial intermediation remains low; banking sector Undertake strategic review el lbwerbank wh˘th a view of underdeveloped. eventual nDvcntiturrestrucutg G a rl _ cr, aideraton of marrow lans so ); Intrzuce dep a t nasurance orly after necessary inrarstructre is in p˘e; cc;se/ restr!ct lIcenses of non-viable Ihonks. Infrastructure monopoly reform-necessary to attract new Finalize infrastructure monopoly reform program (esp. in domestic and foreign investment-still not fully developed power, gas, railways) and start phased implementation. and/or implemented. Overall reduction in corporate tax burden: corporate Payroll taxes at 36 percent 3 times higher than those in Gradualy redzte Current high level of payroll tazes, tax cut from 35 percent to 24 percent; social taxes advanced OECD countries; these raise the cost of formal trough a rtiona reductiom in socae henefis. reduced by 3 percent. sector employment. Create a flexible and enforceable Labor Code that would facilitate enforcement of contracts and protection of basic workers' rights. viii KEY ACIEVEMENTS (OUTCOMES)' ;R:Mi(ING CHALLENGES K.; EYPOLICYPRIO -TIES:-, a: Landmark law on agnculture land turnover passed, Large farms still mostly loss-making and unrestructured; Restructure large farms under market pnnciples and then subsidized credits in agriculture eliminated. inter-enterprise debts; private agriculture land ownership tighten financial discipline. still limited. Macroeconomic Risk Management Average GDP growth of about 6 percent over 1999- Achieving high and sustainable growth; growth has slowed 02 compared with -3 percent over 1995-98. down to 4.3 percent in 2002. Extemal debt to GDP ratio down from 90 percent at Falling growth rates of industrial output; growing end-1999 to 45 percent at end-2002. dependency on raw materials. Foreign reserves improved from about $12bn in Upward pressures on real exchange rate (out of line with Use windfall oil receipts for building reserves or paying off 1999 to about $48bn at end-2002. increases in productivity. Managing windfall oil revenues expensive external debt. Net private capital outflows have halved from about and avoiding Dutch Disease effects. Consider increasing taxation of windfall revenue gains in the $26bn in 1999 to $1 Ibn in 2002. Continued large net private capital outflows undercuts energy sector to lower taxation of non-energy sector and /or domestic investible surplus. spend on priority physical and social infrastructure. Inflation down from about 85 percent in 1999 to 16 Further reducing inflation gradually. Further reduce inflation; allow for increased exchange rate percent in 2002. flexibility. Tumaround in general govermment budget: from an Making room in the budget for significant potential costs Maintain primary fiscal surpluses of 2-3 percent of GDP per average deficit of 8 percent of GDP over 1995-98 to of structural reforms; risks of increases in non-interest annum based upon long-run average oil prices. a surplus of 0.8 percent over 1999-02. . expenditures. The fiscal accounts and balance of payments are very vulnerable to sharp fall in oil prices and fluctuations in private capital flows. Investing in People and Protecting the Vulnerable Headcount index of poverty reduced from 40 percent Income inequalities high (Gini of 0.45) and rising. at end-1999 to 27 percent at the end of Q3, 2002. Growing regional inequities in health and education Unemployment fell from 14 percent at end-1998 to 7 outcomes. Ensure adequate federal resources to poorest regions- percent at end-2002. Regional inequalities growing: share in GDP of richest consistent with macro stability-to improve educational and quintile of regions increased from 38 percent to 53 percent health services based upon sound sectoral strategies. while that of the poorest quintile fell from 6 to 4 percent over 1994-2000. ix AEV .- L i_ F.,I "';1M2 I q OU7C Vii ' A U , _ 7tAi .L.. .ES KEY Li. L)L ACY PRIORITIES z' Lifestyle problems undermine health outcomes- Initiate large-scale program of disease control to attack the alcoholism, rapid growth of HIV/AIDS, growing growing AIDS epidemic and lifestyle problems. differences in male and female adult mortalities. Introduction of a multi-pillar pension system. Serious design issues in the pension system, which Strengthen fiscal sustainability of pension reforms by Improved financing and payment discipline with undermine the fiscal, financial, and political sustainability increasing the retirement age of pensioners and linking pension respect to social safety net transfers. of the reforms. payout period to life expectancy at retirement. Pro-poor targeting of social safety net transfers needs to be ]Phase out untarget social benefits/ privileges; strengthen strengthened. and coordinate targeted tranfers to protect the poor againt energy tariff inmreases and ther economic re-orms (including restructuring, unemployment), and abject poverty. Public Sector Mangement Implementation of fiscal federalism reforms have Imbalance remains between subnational spending Extend greater fiscal autonomy to subnational govemments reduced unfunded mandates, clarified spending obligations and revenue means. consistent with the requirements of macro stability and inter- powers among levels of government, centralizedreinlqut some revenues, and introduced incentive-baszd Federally mnandated public sector wage increases and regional equity. intergovernmental transfers. centralization/elimination of some revenues increase fiscal pressures on regions. The Federal Treasury system progressively extended Budget preparation reforms lagging; competitiveness and Accelerate implementation of program to improve efficiency of to now cover all of the federal government; growing transparency of procurement needs to be strengthened. public expenditures through institutional reforms in budgeting, number of regions have either their own treasuries or Interal and exteral audit needs to be strengtiened. procurement, and audit. access to services by the federal treasury. Effective implementation of expenditure control; Efficiency of public expenditures needs to be improved. extensions in budget coverage, consolidation of most extrabudgetary and earmarked funds. Tax and customs administration weak. Strengthen tax and customs administration through business process and organization reforms. .nitiate revaeev c? overasl government structure and Capacity of civil service weak to implement reforms and rationalize government unctions; acceRerate ensure effective provision of public goods. lnmpuemenition of civl servAce reforms. Weak judicial enforcement of property rights. Accelerate development/implementation of reforms of the justice systen. oal EDigher order proraIty measures are in bold. x 1. DEVELOPMENT OUTCOMES AND PROSPECTS 1.1 Russia experienced improved economic performance over 1999-2002, during which time the country showed strong growth with falling inflation levels. Much of this growth has been due to the large devaluation in the wake of the financial crisis of 1998, though high energy export prices and prudent economic management have also helped. Higher growth has also been accompanied by a reduction in poverty levels and a general improvement in many indicators of human welfare. However, the growth slowdown in 2001-02 raises questions about the sustainability of this growth rebound and the constraints imposed by the structural imbalances and growing inequalities in the economy. This highlights the importance of effective implementation of the social and structural reform program to promote growth with adequate social protection. This chapter discusses the recent development outcomes and assesses the prospects over 2003-05. A. From Crisis to Recovery 1.2 The economic and political developments leading to the 1998 financial crisis have been well documented.! The crisis culminated in August 1998 with a collapse of the fixed exchange rate and the Government's default on its debt obligations. This, in turn, resulted in a meltdown of the banking system. The Central Bank (CBR) stepped in, providing massive liquidity support. These developments led to a surge in inflation, a sharp contraction in output, and a further worsening of the fiscal position. 1.3 However, predictions of hyperinflation and a severe economic contraction proved unfounded. The impact of the crisis was less severe and the recovery more .rapid than in most other recent crisis Figure 1.1: Output Recovery Post-Crisis countries (see Figure 1.1). Inflation (GDP per capita In constant LCU Indexed relative peaked in September 1998 to pre-crlsis year) (although it remained relatively high throughout the year), and 120 output bottomed out in the last isX quarter of the year. Macroeconomic 110 ,Ko1999 policies were relatively quickly Brazl IS98 brought under control through a IO significant tightening of fiscal *0 +' naU1997 policy in the context of the 1999 Thand1e budget while rising global energy so prices from early 1999 helped 85 provide external liquidity. A floating exchange rate regime was Source:WorldBankdatabase;staffestimates maintained. 1.4 Indeed, most macroeconomic indicators show a sharp improvement between the four years leading to the 1998 crisis and the four years since then (see Table 1.1). After contracting at almost 3 percent per year during 1995-98, growth rebounded to an average of 6.4 percent per year during 1999- 2002. The recovery was initially led by import substitution, reflecting the large real depreciation, and gained further momentum in 2000 as investment responded to the improved profitability from the exchange rate depreciation, high global energy prices, compressed real wages, and low domestic energy See, for example, Kharas et al. (2001), Pinto et al (2000), Slay (1999), Blejer and Skreb (2001), Schleifer and Treisman (2000) and Gaidar (2002). 1 costs. Output growth slowed somewhat in 2001-02, as rising real wages and the real appreciation of the ruble combined with a progressive weakening of global activity slowed the growth of aggregate demand. 1.5 The balance of payments position is much stronger post-crisis than it has ever been, largely on account of the weaker ruble and high global energy prices. The cunfent account shifted from small surpluses during 1995-98 to record-high surpluses. In 2M2, the current account was estimated at US$32 billion. Net private capital outflows has also ebbed, down to an estimated US$ 11 billion in 2002 from around US$25-30 billion in the late 1990s. As a result, gross reserves have tripled since the crisis, reaching US$ 48 billion by the end of 2002. 1.6 The fiscal position also improved dramatically, assisted by the economic recovery, high energy prices, and improved tax collections. With expenditures being curtailed, the overall balance of the enlarged Government turned around from an average deficit of 8 percent of GDP in 1995-98 to a surplus of 3 percent of GDP in 2000-01, and almost 1 percent of GDP in 2032. The fiscal surpluses were instrumental in helping to sterilize the large foreign exchange inflows and to avoid an excessive real appreciation of the exchange rate. However, with monetary policy geared to rebuilding reserves and resisting the appreciation of the nominal exchange rate-and with inadequate instrments and concerns about its income position preventing the CBR from undertaking any significant sterilization operations- inflation remained relatively high at around 20 percent in 2000-1 and 16 percent in 2002, despite a sharp recovery in money demand. As a result, the real effective exchange rate appreciated by about 45 percent during 2000-02 but still remained well below its pre-devaluation level. Trble Mi: Key Macroeconomic Vsrlalbesn, 09502 Annual Averages 1995-98 1999-02 1999 2080 2001 2002 (est.) Real GDP (% change) -2.9 6.4 6.4 10.0 5.0 4.3 Investment Growth -11.3 8.5 5.3 17.4 8.7 2.6 Consumption Growth -1.3 5.1 -3.5 12.8 5.9 6.95 Export Growth (% change) 5.8 2.8 -1.7 9.1 1.3 2.6 Import Growth (% change) 0.5 5.7 -28.5 20.2 14.2 12.0 CPI (% annual change) 69.3 36.0 85.6 20.7 21.5 16.0 Real Exchange Rate Depreciation (%) -27.2 -2.2 34.8 -25.5 -15.3 -2.9 Real Wage (% change) -7.7 19.7 -22.0 20.9 20.6 16.2 General Governrment Budget Surplus (% of GDP) -7.9 0.8 -3.6 2.9 3.0 0.9 Revenues (% of GDP) 34.1 36.1 34.0 38.1 37.8 36.0 Terms of Trade Index (% change) 0.7 5.4 -0.6 30.9 -2.7 -6.2 Current Account Surplus (US$ bln) 4.5 34.5 24.6 46.8 34.8 31.7 Gross Reserves e.o.p (US$ bln) 15.6 31.2 12.5 28.0 36.6 47.8 Net Private Capital Flows (US$ bln) -23.1 -20.1 -25.8 -26.5 -17.6 -10.6 External Debt (% of GDP) 41.4 61.9 90.4 62.4 49.8 45.1 Debt Service (% of exports) 7.9 12.7 11.5 10.0 12.9 16.4 Sources: World Bank data; staff calculations; Goskomstat. 1.7 The strong external and fiscal positions allowed for a gradual normalization of relations with external creditors and a sharp reduction in the debt burden. A debt and debt service reduction agreement was reached with commnercial bank creditors in 2000, and was followed by a similar agreement with suppliers in 2001. Full debt service to the Paris Club was resumed in early 2001. Bilateral negotiations were also pursued with non Paris Club creditors and agreements were reached with several of these (including Germany on the debt of the former Soviet Union (lFSU) to the former East Germany). By end- 2002, the total debt of the federal Government had been halved to 45 percent of GDP from its peak of almost 90 percent in 1999.2 2 The peak in 1999 reflected in part the real exchange rate overshooting after the crisis. 2 1.8 The improved liquidity conditions in the economiy-including from an expansion of banking sector credit to the private sector-and the strengthened financial discipline on the part of both the Government and the energy companies also led to a sharp reduction in non-payments. The use of tax offsets was abandoned by the federal Government in 1999, while full funding for the energy consumption of budgetary organizations was ensured in 2001, and cash collections by the energy companies rose to nearly 100 percent during 2001 (as discussed in Chapter 2). Meanwhile, the share of barter in industrial sales declined to less than 20 percent. B. Social Outcomes 1.9 The measurement of poverty levels in Russia differs depending on the data source and variable used. However, there is consensus that since 1999, the headcount index of poverty has fallen sharply. Goskomstat data indicate that poverty fell from a peak of about 40 percent at the beginning of 1999 to 27 percent at the end of the third quarter of 2002 (see Figure 1.2).3 These measures are very sensitive to the choice of the poverty line, as much of the poverty is quite shallow. Figure 1.2: Poverty and Income Trends, 1997 9--2 incorne poverty line 99 income poverty line 6 HBS, '92 poverty line - -*Z--GDP Index 60.0% - 130 50.0% 120 x. x 40.0% I 1 30.0%- 110 * 20.0% - 10.0% - ~ ~~~~~~100w 0.0% 90 1997 1998 1999 2000 2001 2002 Source: Goskomstat. 1.10 The sharp reduction in poverty levels follows the trends in economic growth. The potential impact of growth on poverty reduction has been undermined by an increase in income inequality during this period. Official data show Figure 1.3: Gini Index for Incomes Per Capita, 1992-2001 that the 1998 crisis led to rising inequality, although alternative estimates of inequality which tak int aco n ego a Officially Published, omrinal per caPila incoDleS take into account regional - Estimate,basedonagresationof(lopor)regionldistibutions differences in prices suggest 0.50 that income inequality fell in 1998 before rising again (see 0.45 A Figure 1.3). 0.40 1.11 Other dimensions of 0.35 inequality have also shown deterioration. While poverty 0.30 levels have fallen for both rural 0.25 and urban households, rural 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 households have benefited proportionately less than urban 3 The estimates are based on 1999 poverty line. Goskomstat is currently revising its poverty measures. 3 households from the post-crisis economic recovery, As a result, regional divergences are also growing. Over 1994-2C00, the share in GDP of the richest quintile of regions increased from 38 percent to 53 percent, while that of the poorest quintile fell from 6 percent to 4 percent.4 Indeed, estimates attribute one-third of the overall national inequality to inter-regional differences.5 The incidence of poverty in the poorest regions can be four times as high as in the richest regions.6 1.12 These regional differences in key outcomes are reflected in various other social indicators such as life expectancy, morality, and access to public service delivery, although, in the aggregate, Russia shows improvement in many of the non-income dimensions of poverty. Enrollment rates are high, providing almost universal access to education at all levels. There is little gender bias. Maternal and infant mortality rates also improved in 2000, but they remain higher in rural areas, with considerable regional variation. Unemployment has fallen from 14 percent at end-1998 to 8 percent by end-2002. For other indicators of social stress-such as divorce rates, non-marital births, deprivation of parental care, family violence, and homelessness-recent data are not available to assess improvements since 1998, if any, which may have reversed the dramatic deterioration in these indicators that occurred during the earlier years of transition.7 1.13 The sharp rise in adult mortality rates during the tansition years in the face of declining fertility rates has speeded up Russia's population decline. Increased mortality rates for adults, primarily males, are driven by the increased rates of cardiovascular diseases, circulatory problems, alcohol-related causes, and violence (see Chapter 4 for further discussion). As a result, Russia's population is projected to fall from 144 million in 2002 to 104 million in 2050.8 This declining population has implications for future growth prospects while the changing demographics have implications for social policies.9 Over the next 50 years, Russia will see a growth in its elderly population and a contaction in its working-age and youth populations. This is likely to place its health and social protection systems increasingly under stress. Given the enormous size of Russia and the regional variations in population density, there will probably be large regional variations in the effects of these changes. Nonetheless, the decline in male life expectancy-from 64 years in 1990 to 59 years in 2000-has further accentuated the mle disadvantage in life expectancy, relative to females, from 10.5 years in 1993 to 13.2 years in 200 and is a growing source of social pressures and vulnerabilities. C. The Govermenl's $Ocz&d amid Ecolm cic hT ' anmm 1.14 The way forward for the Govermment has been to embark on a serious program of social and structural reforms encompassing wide segments of the economy. At the beginning of 2000, the new Government of President Putin adopted a wide-ranging program of economic and scial reform to be implemented over 10 years.10 Following this announcement, a 3-year medium term program was developed and is currently being implemented." At the samne time, work began on developing a comprehensive set of state reforms (covering the public administration, the civil service, and the judiciary). 1.15 The Medium-Term Program identifies five structural reform priorities which have been driving the legislative agenda: 4 See World Bank (2002b). 5 Yemtsov (2002). 6 For instance, poverty levels in the poor Tuva region are around 60 percent compared with 15 percent in the richer Moscow and St. Petersburg region (Goskomstat data). 7 See Rashid and Posarac (2002) for a detailed discussion of the non-income dimensions of poverty. 8 U.S. Census. 9 See, for instance, Bloom et al (2003). DaVanzo and Grammich (2001). 1° Russian Federation, "Basic Trends in Social and Economic Policy of the Government of the Russian Federation over the Long Term," adopted by the Govemment in July 2000. t' Russian Federation, "Medium-Term Program of Social and Economic Development for 2002-04," adopted by the Govemment in July 2001. The Government is in the process of developing a revised program for 2033-05. 4 (a) Reducing poverty levels and income differentials by providing incentives for wage and employment growth and by improving the targeting of social assistance. (b) Achieving economic modernization and improvement in enterprise efficiency through: (i) elimninating implicit subsidies embedded in low tariffs; (ii) increasing the efficiency of the infrastructure monopolies and housing and communal services; and (iii) improving the innovative and technical potential of the economy. (c) Creating an institutional environment favorable to investments in the real sector through: (i) developing effective financial intermediation; (ii) ensuring property rights protection; (iii) developing competitive markets; and (iv) increasing the role of small and medium- size businesses. (d) Improving fiscal efficiency by focusing budget expenditures on the priority expenditure areas and improving control over state assets and liabilities; by strengthening the budget management process; and by maintaining an efficient tax system. (e) Reducing regional inequalities in social and economic development and ensuring economic consolidation by ensuring the conformity of federal and subnational legislation, and by introducing clear functional divisions of authority and financial resources between the federal and subnational levels of Government. 1.16 The period 2001-02 was particularly important in the accelerated enactment of a host of legislations in diverse areas which enhanced the Government's credibility and improved investor perception of the investment climnate in Russia. This included a spate of laws to deregulate the business environment, reduce and simplify taxation, and initiate reforms in pensions, land, and judicial systems. The enactment of new legislation slowed down in 2002 as the Government focused more on implementing reforms already passed. Even so, new initiatives are under way in several areas, including civil service reform, the reform of infrastructure monopolies, banking reform, and harmonization with the WTO accession requirements. D. Medium-Term Prospects and Risks 1.17 After three years of high growth and high oil prices, the growth rate of fixed capital investment has slowed and much of the economy is now operating at full capacity utilization. Based upon current trends, the Government is projected to maintain sound macroeconomic management and to continue to implement reforms in the key areas of the business environment, public sector management, and social risk mitigation. At the same time, world oil prices are projected to stay in line in future years with the international consensus forecast of about US$20-22 per barrel of Urals (though for 2003, it is projected at a higher level consistent with current trends). Under such a scenario, the growth rate is projected to remain at an average of 4.8 percent in 2003-05, as the economy can no longer rely on spare capacity and surplus labor to grow (see Table 1.2). Fiscal policy is assumed to support sterilization of the large balance of payments surplus. Continued good macroeconomic management thus results in preserving a small fiscal surplus, and a mild appreciation of the real exchange rate helps to sustain the sizable trade surpluses and to bolster reserves as the net capital outflows reduce considerably. 5 11ae b 2a Medumlun Te rm opecĥsta 2=33Al 2833 22 38S Real GDP Growth, % 5.5 4.5 4.5 Export Volume Growth, % 2.7 2.7 2.7 Import Volume Growth, % 10.0 8.0 6.0 Investment Growth, % 8.0 7.0 7.0 Gross Domestic Fixed Investment, % of GDP 20.1 20.9 21.6 Gross Private Savings, % of GDP 19.9 17.8 17.6 CPI Inflation, average 12.8 11.5 10.4 Terms of Trade (% change) -7.0 -2.9 -2.6 General Government Balance, % of GDP 1.0 1.0 1.0 Trade Balance, US$ billion 45.3 40.2 33.9 Gross Reserves, US$ billion 65.0 71.0 75.0 Net Private Capital Flows, US$ billion -10.5 -7.9 -3.6 External Debt (US$bn) - long term, public+private 120.0 115.3 108.3 External Debt (% of GDP) 28.8 24.5 20.5 Debt Servicing (US$bn) 19.4 16.1 17.7 MEMO Nominal GDP (US$) 417 470 527 Oil Price, US$ per barrel (Brent) 26.0 21.0 20.0 Real Effective Exchange Rate, 2002=100 102.9 104.3 105.7 Source: Staff calculations, LDB. 1.18 lPotendal Sounrces oi Girowth. Domestic demand is likely to continue to be the main source of growth for Russia in the medium term. Specifically, the growth will be mostly driven by an increase in consumer demand, as the growth of real disposable income is fueled by both economic growth and the real appreciation of the ruble. It is unlikely, in the absence of major improvements in the investment climate, that investment demand-which was the major factor in growth in 200-will resume that role in the medium ternL According to our forecast, the growth rate of fixed capital investment might increase from an estimated 2.6 percent in 2C02, but the increase will only be enough to bring the level of gross investment to 21.6 percent of GDP by 2005, which is still less than in other transition economiies. On the supply side, the aggregate data suggest that the ceiling for capacity utilization is being approached. Indeed, cost increases (labor, real energy and real exchange rate) have been a multiple of productivity increases. And the growth slowdown follows a slowdown in net investments. Consequently, future growth will become ever more dependent upon the effects of new investments on new capacity generation and, through embodied technological change, on productivity.12 Given the modest growth rates of investments, growth rates significantly above 5 percent appear unlikcely to materialize in the medium term as they require much larger investment flows-which can only be realized if accelerated reforms succeed in reversing capital outflows and Russia's current negative foreign investment position. 1.19 Private svi!ngs and tlenvestmeimn BU3nces. The growth in the investment to GDP ratio observed since 1999 is projected to continue in 2003-05 (see Figure 1.4). The dynamics of private savings shows the opposite trend: with the private savings ratio declining from 25 percent in 2000 to 21 percent in 2002. Future consumption growth is projected to lower domestic savings to 17.8 percent of GDP by 2004 before stabilizing.- 12 See, for instance, Mitra and Ruehl (2002) and Yasin (2002). 13 Savings range between 18-22 percent of GDP in other emerging markets and advanced transition economies. 6 Figure 1.4: Private Savings and Investment, % of GDP 26- 24- 22 - 20- 18 _ YR99 YROO YROI YR02 YR03 YR04 YR05 - Gross Fixed Investment Gross Private Savings Source: WB staff estimates. 1.20 Balance of Payments. The balance of payments position is projected to remain stable in the medium term, with the Central Bank continuing to build up reserves. The trade balance is projected to shrink gradually with the real exchange rate appreciating but is still projected at more than US$34 billion by 2005 (see Figure 1.5). These levels, however, are substantially higher than in 1998 (US$17 billion) even though the real exchange rate is projected to surpass its 1998 level in 2004. Figure 1.5: Balance of Payments, 2003-05 US$ 50.0 40.0 2003 2004 2cos | Trade surplus * Foreign Debt Payments ONet Capital Outflows Source: WB staff estimates 1.21 Net private capital outflows will continue to diminish as a result of an improvement in the invesiment climate and the continuation of the Government reforms, though only gradually. Net outflows are projected to fall to US$4 billion by 2005. As a share of the trade surplus, capital outflows are projected to fall from about 25 percent in 2003 to about 10 percent in 2005. The sharp reduction in capital outflows and an improvement in capital accounts will allow Russia to honor its foreign debt servicing obligations-with a peak of US$19.4 billion in 2003-without undermining the viability of its balance of payments position. 1.22 Fiscal Balance. Given its recent track record of sound fiscal management, the Government is projected to maintain conservative fiscal policies and target small surpluses. The fiscal 'accounts will remain sustainable in the medium term even if the price of oil goes below US$18 per barrel (see Chapter 3). Fiscal vulnerability will also diminish with reductions in the stock of foreign debt and with sustained growth, even if at a modest rate. The stock of long-term foreign debt is expected to decline to US$108.3 billion by the end of 2005. This stock reduction will be accompanied by a substantial decline in the ratio of long-term foreign debt to GDP, from 29.8 percent in 2003 to 20.5 percent in 2005. 7 1.23 mlpHatfioms Tor IFoveut Reducdon0. If income distribution does not change during this period, poverty levels would continue to fall. With a poverty-growth elasticity of 1.3,'4 a cumulative GDP growth of 14 percent over 2003-05 would lead to a reduction in the national headcount index by one-fifth or about 5 percentage points. This suggests that poverty would fall from about 27 percent in 2002 to about 22 percent in 2005. This means that potentially about 7 million Russians would emerge out of poverty. ff growth were to be higher and if the social and economic reforms should lead to a contemporaneous improvement in income distribution, then that would provide futher salutary gains in poverty reduction. Conversely, in the absence of reforms and with slower growth, the distribution of income could worsen and even more of the population could risk slipping into poverty. 1.24 Hls E]igeinr Growth and Havtmvesanet 1posasblle? For the above projected growth rates of 4.8 percent per year on average, investment growth is projected at about 7.3 percent per year. But if Russia were to achieve faster growth, higher investments would be needed along with an aggressive implementation of economic reforms. But can higher investment rates materialize? The answer is yes. The potentially largest sources of finance are the huge capital outflows from Russia which averaged US$21 billion per year in 1999-2002 and were even higher in earlier years. Total fixed capital investment amounted to approximately US$55 billion in 2001. Thus, a reversal of only 50 percent (or US$10 billion) of a single year's capital outflows, if directed into investment, would increase domestic capital investment by 18 percent in dollar terms. Similarly, the net foreign investment position of Russia was still negative in 2002. Investment outflows exceeded inflows by US$6.8 billion from 2000 to 2G01. Had this money been used to finance domestic capital investment, it would have increased investment over both years by 7 percent in dollar terms. Thus, a return of Russian money and inflows of foreign money into financing Russia's investment needs is the key to achieving high rates of growth in the future. If the goal of reforms is to increase economic growth, then the domestic investment climate is the one area in which improvements matter most. 1.25 Medunn°nTarm Risks. The medium-term risks for the Russian economy are significant. Most important among them are the lack of economic diversification and the strong reliance on energy exports which make the economy particularly vulnerable to changes in oil prices. With prudent fiscal management, the budget could presumably be kept in balance (with some necessary expenditure retrenchment) even if oil prices were to fall to US$15 per barrel (Urals). However, growth would suffer. As discussed in Chapter 3, every dollar change in oil prices translates into about US$1.5 billion change in GDP. This means that, in the extreme situation, if oil prices were to fall by US$10 per barrel, this would imply a loss in output of US$15 billion or about 5 percent of current GDP. This would seriously constrain Russian growth prospects. However, given the current international environment, the risk of a large fall in global oil prices is deemed low. There is also the converse risk that if oil prices remain high, it would not only create pressures towards Dutch Disease, but mnight also induce a sense of complacency among policymakers, leading to deferral of key reforms in the expectation that the windfall gains from higher oil prices would lift the economy permanently. 1.26 Second, the implementation of reforms may become bogged down by a waning of political will in the run-up to the Duma and Presidential elections in 2003 and 2004. Regional interests may also grow to impede some of the more important reforms, particularly in the energy sector. This "reform hiatus" combined with "reform fatigue" could also produce a more populist and fiscally expensive economic program and encourage backsliding on reforms. Indeed, new and difficult policy measures, particularly with respect to the liberalization of the energy sectors, appear to have been put on hold. While this necessarily defers much needed reforms that are essential if Russia is to achieve its potential in the world economy, they also provide a window for assessing the impact of reforms to date and for thinking through and carefully planning the next phase of reforms. 14 The elasticity estimate of poverty to GDP growth may overestimate the poverty impact of growth given that official poverty figures were constructed to reflect trends in macro aggregates. 8 1.27 Third, the uniformity of reform implementation at the regional level is a serious risk.'5 While the recent centralization of political power has resulted in a greater alignment of regional economic policies with the directions provided by the federal Government, the challenge for reform implementation remains at the regional level. It is at the regional level that the nexus between the vested interests of the large financial industrial groups and regional politics may be the strongest, and it is at that level that the incentives for new entry and competition are the weakest. For this reason, the monitoring and enforcement of reforn legislation is important so that federal initiatives-for instance, on business deregulation-do actually result in an improved investment climate at the regional level. In this context, there are only limited incentives for regions to engage in reform competition, which can be a vital instrument for promoting economic and social reforms. 1.28 Fourth, as with most other countries, there is always the risk that poor economic management may undermine the gains made to date. Among other problems, failure to maintain fiscal discipline, to keep inflation low, to manage public debt prudently, to maintain an open and liberal trade regime, and to desist from activist industrial policy, may well lead to a loss of economic management and a return to the past days of financial indiscipline and uncertainty. However, there is a strong sense in the country that the lessons of the past have been learned and that Russia is unlikely to repeat past mistakes. E. Conclusions and Future Challenges 1.29 The Russian economy stands at an important crossroads. With aggressive reform implementation, the economy can surge forward at higher growth rates over the medium term, diversify its economy, integrate effectively with the global economy, improve social welfare, and move towards rapid income convergence with the advanced OECD countries. Alternatively, complacency in relation to the current reform effort risks only modest growth and poverty reduction prospects, with inadequate attention to the factors behind the uncertainties and economic volatilities which have dogged Russia's transition past. 1.30 For the present, Russia still lags behind the more advanced transition economies in terms of progress, particularly in the areas of financial institutions, infrastructure, competition, and governance and enterprise restructuring.16 This is also reflected in the low share of employment in the new small and medium enterprises which is much smaller than in other advanced transition economies.'7 However, there is evidence that budget constraints on the enterprise sector have hardened and are fostering some restructuring.'8 The investment climate, particularly for new enterprises, has improved with the passage of legislation reducing the requirements for licensing and registration, with tax reform and the reduction of the statutory tax burden on individuals and firns, with the strengthening of property rights, and with greater macroeconomic and fiscal stability. Social protection reforns have also been started with the objective of improving the affordability of the system and ensuring adequate coverage. Improved fiscal management has ensured the timely payment of pensions and other social assistance transfers and the reduction in arrears. The quality of investments in human capital is also being enhanced through various sectoral reforms in health and education. 1.31 Russia's economy possesses unique opportunities, primarily thanks to its rich natural resource base, its high level of human capital and scientific base, and its proxirnity to the markets of Western Europe. and Asia, in addition to its traditional trading partners. These provide it with significant opportunities in the global marketplace for trade and investment. These opportunities can be realized by directly addressing some of the serious weaknesses in the country's policy and institutional environment, as well as insuring against the risks and threats to the economy, primarily from its excessive dependence on its natural resource endowments (with its attendant implications for lack of economic diversification, 15 See Chapter 2 for more on regional variability and challenges to reform. 16 See, for instance, EBRD (2002), transition indicators. 17 See, for instance, World Bank (2002a). 18 World Bank (2001). 9 vulnerability to oil price shocks, and weak governance), and its deteriorating human and physical infrastructure. 1.32 The primary challenge for Russia is one of accelerating and sustaining high growth rates. Hligher growth rates-essential if Russia is to catch up with the advanced OECD countries and substantively improve the welfare of its people-can be achieved by ensuring an investment climate that seeks to enforce discipline over the old sectors of the economy and encourages the growth of new businesses. But as economic opportunities grow, Russia needs to ensure that its peoples' human capabilities have been enhanced so that they can take advantage of these opportunities. And for the poorest and the most vulnerable, who may be unable to take advantage of these opposunities or may be adversely affected by the economic restructuring, adequate protection needs to be provided. All this, of course, requires an effective state which is able to provide good governance and the necessary public goods for private sector growth. 1.33 The following chapters assess each of these challenges in the context of the design and implementation of the Government's reform program. 10 2. STRENGTHENING THE NVESTMENT CLIMATE 2.1 The Government's program accords high priority to promoting sustained higher growth rates. But prospects for higher growth are still constrained by a production system that is not fully adapted to the needs of a competitive economy. As a result, continued efforts need to be made to impose market discipline on the inherited enterprises so that they face appropriate incentives for restructuring and become productive or close down. This approach needs to be complemented by efforts to encourage the growth of new small and medium-size enterprises, which have been' the engine of growth in the more advanced transition economies. Progress along both of these' dimensions is essential to ensure a level competitive playing field across economic activity, but it requires different policy initiatives.'9 This chapter assesses the progress being made in strengthening the investment climate along these two dimensions. I. THE INCENTIVES FOR ENTERPRISE RESTRUCTURING 2.2 Key policies that would harden budget constraints on enterprises and promote incentives for the efficient use of existing assets and for the restructuring of existing firms and farms include: reducing utility subsidies, elirninating tax exemptions and enforcing tax collections, strengthening financial discipline on large agricultural enterprises, and improving corporate governance. These policies are discussed below. A. Reducing Energy Subsidies 2.3 Implicit subsidies embedded in non-payments and in low prices for domestic consumption of electricity and gas have, in the past, generated unsustainable economic trends which were partly responsible for the 1998 financial crisis. These subsidies undermine the investment climate in several ways. First, the low effective prices for energy delay much needed restructuring of the old enterprises by effectively subsidizing them, encourage inefficient energy consumption by both firms and households-making Russia 15-20 times more energy-intensive (energy use as a share of GDP) than advanced energy-efficient economies such as Japan and Germany)-and impede economic diversification. Second, smaller financial surpluses in the energy sector have led to under-investment (relative to needs) in the long-term productive and generative capacity of the sector. Third, these price reforms are essential for improving the quality and lowering the cost of housing and communal services to the public.20 2.4 The effective energy subsidy - defined as the difference between the statutory tariff, adjusted for cash collections, and the true economic cost of service provision - remains high though declining over 1999-2002 (see Figure 2.1 and Table 2.1). The 1998 ruble devaluation had pushed these subsidies to their 1999 peaks. Since then, however, the subsidy has gradually declined. At the beginning of 2002, the effective subsidy for electricity was 50 percent, down from 95 percent in 1999; similarly for gas, the effective subsidy was 58 percent, down from 92 percent in 1999. The reduction of these subsidies reflects an active program by the Government and the service providers which included the tightening of financial discipline to strengthen cash collections, phased increases in real tariffs, and the establishment of mechanisms for better budgeting for energy use by budget entities. The past practice whereby oblast governors and large incumbent enterprises devised schemes of mutual non-cash offsets in which the enterprises 19 See World Bank (2002 a) for a fuller discussion of these measures. 20 Experience from other advanced transition economies (especially the Baltics) suggests that raising prices to cost recovery levels is not only feasible but is an essential component in moderating consumption, financing service upgrades, and engaging private investors in the sector. were forgiven a part of their tax debt in return for political complacency and social protection is now widely discredited. Cash collections are now at around 10 percent for both power and gas. Consequently, the main component of the subsidy now is the difference between current prices for power and gas in Russia and the true economic cost of service provision. 2.5 The recent economic lFiurea lLO ĥ'redin ' On recovery is owed in part to the 1lower maintenance of lower prices for electricity and gas; but this is at the 120_ _ _ _ _- cost of the longer-term productive - . - capacity and growth of the 100%- .!- economy. Both Gazprom and ~ . RAO-UES have effectively l subsidized domestic energy [ h.n - consumers by deferring investments. It is becoming - increasingly clear that investments , r cannot be deferred indefinitely, 20 which has created a growing 0 imperative to bring tariffs up to full 2S08 0g 2X01 2002 economic cost recovery levels. The potential for additional investible (GMs surpluses from raising tariffs in electricity and gas is large (see Table 2.1). 2.6 While tariff reform needs to be guided by the objective of rebalancing tariffs, complementary 0 .. policies are also needed. Structural reforms of the power and gas 3'%i monopolies (see paras. 2.25-2.33) are needed to strengthen corporate governance. The latter is especially I . _ ___ P important to ensure that the ma9 22 financial surpluses generated do Sources: Gazprom, RAO-UES, Ministry of Economic indeed lead to increased Development and Trade; World Bank staff calculations. investments and improvements inn service provision. At the same time, if the efficiency of communal and housing services provision is improved, this would help to soften the social costs of tariff increases. In any case, tariff increases also need to be accompanied by appropriate social mitigation measures to protect the poorest and most vulnerable groups in society, and this, in tum, raises a number of issues. For instance, as electricity and gas tariffs increase, the ability of the regions to adjust housing allowances for low-income families will be severely tested. lHospitals and schools already use a significant portion of their budgets to pay for energy. As tariffs increase, these problems will be exacerbated. Tariff increases may also have an inflationary impact, though as tariff increases are phased in over time, the increase in the price level can also be spread over time.21 21 Moreover, given the small weight of utility prices in the consumer price basket, the price increase is likely to be small. 12 Table 2.1: Estimate of the Implicit Subsidies in the Electricity and Gas Sectors, 2002 Projected Average Economic Implicit Consumption Tariff Value" Subsidy Gas 390 BCM $16/MCM $35/MCM $ 7.4 billion Cash shortfall (10%) $ 0.6 billion Electricity 775 TWh 1.5 c/kWh 3.0 cfkWh 2t $11.6 billion Cash shortfall (10%) $ 1.2 billion Total $20.8 billion " Estimated at long-run marginal cost. 2The impact of under-pricing gas is covered in the gas line. Source: World Bank estimates. 2.7 Given these challenges, the Government needs to develop a medium-term tariff policy and communal services reform program that is designed to bring utility tariffs up to full economic levels. All of these measures will have to be complemented by greater transparency and improved governance in the operations of the energy firms to ensure that surpluses will indeed be utilized for necessary investments. Indeed, with an integrated approach, tariff reform would bring significant efficiency and growth benefits to the economy. B. Strengthening Payments Discipline 2.8 Along with improvements in cash settlements in the energy sector, various other economy-wide changes have sought to harden budget constraints. Barter and inter-enterprise arrears have largely disappeared and the economy has been re-monetized.22 Various Government initiatives have sought to eliminate the pernicious practice of tax offsets and ensure collections in cash, to require timely payments and minimize the growth of tax arrears, and to eliminate tax exemptions which have favored some enterprises against others. In the past, non-payments have been a major part of the soft budget constraints on enterprises that fueled the non-payments problem and that were the key contributor to the 1998 financial crisis.23 2.9 The strengthening of tax payments has been a key learning experience from the financial crisis. The stock of tax arrears has fallen sharply from over 9 percent of GDP in 1998 to about 5 percent of GDP in 2002 (see Figure 2.2). This improved payment record is partly a result of the greater liquidity in the economy, but strengthened government effoits such as tightened monitoring of large enterprises' tax obligations, the elimination of tax exemptions which were abused, and a pro-active program of tax arrears restructuring have also helped. Restructured tax arrears now comprise almost one-quarter of the total arrears. Further improvements in tax administration (see Chapter 5) are needed to strengthen payments discipline and ensure appropriate incentives for existing enterprises to restructure and improve their financial position. 22 See OECD (2002), Yasin (2002), and IMF (2002). 23 See Pinto et al. (2000). 13 TAh'gu 2.2: Overdune Tsru Psaysbhl if'202 I= OverdueTaxes Payable Restructured 10.0 8.0 6.0 ' 4: 2.0 1998 1999 2000 2001 2002 2.10 Soft budget constraints and tolerance of non-payment of debt continues in agriculture, particularly for large farms. As a result, there is little incentive for restructuring and there is an uneven playing field. Overdue debts of agricultural enterprises grew from 95.5 billion rubles (about US$4.5 billion) at the beginning of 1999 to 177.7 billion rubles at the end of 2001 (about US$5.8 billion), even as agricultural enterprises' average profitability improved considerably.24 A promising new approach has now been developed which is aimed at restructuring all debts of agricultural producers with a view to improving their financial situation before applying the bankruptcy procedures.25 This encourages a radical internal restructuring of farms on the basis of market principles. Its success will depend upon the willingness of enterprises and major private creditors, especially the energy monopolies, to participate and seek a compromise, as well as the capacity of farms to develop restructuring proposals and business plans for submission to the territorial commission. Regional and local level political challenges to farm restructuring also remain huge. Weak political will and close links between farms and local political leaders mean that the enforcement of bankruptcies and foreclosures is weak.26 C. Strengshening CorpDorte Governanee 2.11 Strengthened corporate governance is essential for monitoring and influencing managerial behavior. To that end, several legal initiatives over the past year have strengthened the legal environment for corporate governance. In January 2002, amendments to the Joint Stock Company Law were enacted. These have reduced the risk of shareholder abuse by providing minority shareholders with pre-emptive rights against the dilution of their shareholding and stronger legal protection in the case of company breakups or spin-offs. Later that year, a new code of corporate governance also came into play. Amendments to the criminal code have also tightened regulations with respect to disclosure of information. And finally, a revised bankruptcy law is being processed through the Duma that promises better protection for shareholders and creditors. 24 See Csaki et al. (2001). 25 Law "On Financial Rehabilitation of Agricultural Producers" enacted on July 9, 2002. 26 Most large farms meet the criteria for bankruptcy. According to the Bankruptcy Law (1998), agricultural enterprises with overdue debt lasting more than three months might be declared bankrupt. At the beginning of 2002 the share of such farms was about 80 percent.. 14 2.12 Improvements in corporate governance are more difficult to assess systematically. Moreover, persistent characteristics of the Russian economy continue to pose significant challenges. 27 In particular, the spread and strength of financial industrial groups pose a particular challenge. At the same time, the ambiguities of property ownership and control, the large number of loss-making enterprises, and the inter-relationships between politics and business continue to hamper efforts at improved corporate governance. II. THE INCENTIVES FOR NEW SMALL AND MEDIUM ENTERPRISE GROWTH 2.13 Policies for restructuring the existing enterprises need to be complemented by policies for nurturing the development of small and medium-size enterprises. This requires initiatives that will improve the business environment for small and medium-size enterprises, promote competition through the opening up of markets and the enforcement of competition laws, improve financial intermediation, ensure secure property rights, particularly with respect to access to land, and reform the natural monopolies. A. Improving the Business Enviromnent 2.14 Several enterprise surveys suggest that perceptions of the Figure 2.3: Obstacles to Business in Russia, business climate have improved 1999 and 2002 markedly in Russia. The results from the second round of the Business Environment and Financing Enterprise Performance Survey 4- suggest that the business Russia 199 environment in Russia has Corruption ntructe generally improved over 1999- 2002 (see Figure 2.3).78 2e2 Businesses perceive progress in all dimensions of the business Rule ofLaw Tax environment surveyed-access to financing, quality of infrastructure, taxation, / \ regulations, quality of the judiciary, and problems with Note: 0=no obstacle; 4=major obstacle crime and corruption. Source: EBRD/VVor;d Bank (2002). Discriminatory practices that favored the old enterprises over the small start-ups have begun to diminish. For instance, corruption is now seen to be less of an obstacle to a similar degree by firms of all sizes. The rule of law is perceived to have strengthened. And perceptions of state capture-of parliaments, commercial courts, governments, and political parties-have fallen sharply (by 30-40 percent). 2.15 The Government's de-regulation program-in particular, the reduction of inspections and licensing requirements-has also had a noticeable impact following its enforcement in mid-2002. New survey data, which permit comparison of the situation prior to reform implementation with the situation approximately six months later, shows that inspections have been reduced by 26 27 See EBRD (2002) for more discussion. 28 See EBRD/World Bank (2002), and Fries and Hellman (2002). 15 percent and licensing by 45 percent, though the terms and costs associated with them are still far from the legal benchmarks established in the legislation.29 However, some agencies-such as police and sanitary services-are more likely to impose multiple inspections. The surveys also indicate that competition is growing with firms now viewing competition as a more serious problem than government regulations. In two other areas targeted by the legislation- registrations and certifications-the surveys do not show any change, as laws relating to these areas were implemented only later. 2.16 While the improvements captured by the surveys reflect the ongoing efforts at liberalization, significant policy and administrative barriers to business growth remain. Other administrative barriers that have also been ranked highly by regional businesses are problems with respect to access to construction permits and real estate (including land-use rights and title registrations).30 In particular, a recent in-depth business survey carried out in three regions showed that access to land and construction permits were rated higher than any other administrative barriers to investment.31 Most urban land of interest to investors is still controlled by regional and local governments. Thus most private investors face, in effect, a monopolist real estate market for land, and there are many complaints of non-transparent real estate transactions and discriminatory pricing (both for rental agreements and sales agreements) that appear to benefit well-connected financial industrial groups (FIGs) at the expense of small and medium enterprises in general and potential competitors to the FIGs in particular. Whille the new Urban Land code clearly permits and even encourages privatization of urban land, regional and local governments still lack fiscal or financial incentives strong enough to overcome the benefits they reap as monopolist landlords. Incentives for regional and local govements to privatize land, and to facilitate creation of a competitive secondary market in land is, therefore, a high priority for reform. 2.17 Infrastructure is still a constraint. Days lost due to power outages and water and telephone line disruptions are significant. Access to fimance is difficult, particularly for small firms. Trust in courts is still low, with the share of firms that have voluntarily used courts as plaintiffs to settle disputes only 20 percent (compared with 40 percent in CEE countries). A large number of firms still rely on prepaid sales, which reflects limited security in enforcing legal contracts. This increases transactions costs and the use of more favorable contract arrangements. 2.18 Aggregate level changes also hide various disparities and challenges at the regional level. The progress of de-regulation reforms is not geographically uniform. Better results were seen in localities with better fiscal incentives, less concentrated production structures, and large initial pro-reform small business communities. Policy and institutional barriers at the regional level also continue to inhibit business growth.32 Key problem areas are: increasing concentration which inhibits new fium entry and growth,33 lack of transparency and systematic application of the regulatory regime goveming infrastructure provision, underdevelopment of the commercial banking sector with little intermediation of savings into investments, and problems with the enforcement of legal judgments as well as the capacity of the court systemr 29 The survey was conducted by the World Bank and the Center for Economic and Financial Research (CEFIR) in the spring and fall of 2002. The full results of the survey are available at www.cefir.ru.org. 30 See FIAS (2001). 31 See FIAS (2003). 32 See Broadman (2002). 33 While at the national level, the degree of four-firm concentration ratio (the sum of the market shares of the top four produces) is 60 percent, at the oblast level, it is much higher at 95 percent. 16 B. Reforming Tax Policy 2.19 Notwithstanding significant tax policy reforms undertaken over 2000-02, tax issues are still seen by businesses as a significant obstacle. The reforms undertaken have sought to simplify the structure of taxation, reduce the overall tax burden, and promote new firm growth. Key reforms which have improved the business environment include the following. First, pension, social, and medical fund contributions were unified in 2001 into a unified social tax rate of about 36 percent. The 3 percent unemployment fund contribution was eliminated. Second, the overall corporate income tax rate was reduced in 2002 from 35 percent to 24 percent. In addition, the corporate income tax base was made uniform for all levels of government, greatly simplifying the calculation and reporting of tax incomes. Third, the taxes on the recovery of mineral resources were rationalized and streamlined in 2002. Fourth, the road tax was reduced in 2001'from 2.5 percent to 1 percent of gross sales. These reforms, along with other simplifications of tax policy, have served to clarify the tax regime and, in some instances, reduce the overall costs to businesses. The total fiscal costs of the reforms are estimated at more than 2 percent of GDP which can also be considered a measure of the reduced tax burden on the country.34 2.20 However, a key business climate issue with tax Table 2.2: Payroll Taxes in policy remains the high level of payroll taxes. While the Selected OECD Countries reforms reduced the highest payroll tax rate by 3 % Rate percentage points, payroll taxes in Russia remain high in United States. 14 comparison with many of the advanced OECD countries United Kingdom. 16 (see Table 2.2). High rates may be needed to finance the Sweden 30 social protection and health care system, but they also Germany 34 impose additional business costs, and provide incentives Czech Republic 35 for firms to avoid them by remaining in the informnal Russia 36 sector. In addition, reform of regional/local taxes Poland 39 (including land tax in particular) should be targeted at Note: Rates rounded up to the nearest encouraging land privatization and providing the whole nuorber. appropriate incentives for regional and local governments to improve their investment climate. C. Strengthening the Financial Sector 2.21 The banking sector is far from providing effective intermediation between domestic savings and investments. Monetization and bank lending remain small in relation to GDP when' compared with the more advanced transition or industrial economies (see Table 2.3). The total deposit base (M2) of the country's banking system at end-2001 amounted to no more than 24 percent of GDP, and claims on the private sector amounted to only 17 percent of GDP 'Other indicators of financial market depth such as bonds outstanding and equity market capitalization are also low.35 34 See IMF (2003) for a fuller discussion of tax policy reforms in recent years and their attendant fiscal costs. 35 The relatively higher level of market capitalization reflects the oil and gas companies' privatization in the 1990s. 17 M2 (Mouney me I3anit CRem ai 'taow M0adr E niy sel QunasIMouaey) ]FAveae &ceor OnuasEaI CMjpita&Ma!oM COUNTRY US$ % of US$ % of US$ % of US$ % of billions GDP billions GDP billions GDP billions GDP Russia 74 24 54 17 11 3 78 27 Czech Republic 40 71 25 45 8 15 9 16 Hungary 22 43 18 35 13 26 10 20 Slovak Republic 14 66 5 25 2 13 1 3 Poland 75 43 46 26 35 20 26 15 France 656* 51* 1,232 95 661 51 1,844 142 Germany 1,336 71 2,442 130 1,048 56 1,072 57 Italy 599* 56* 871 80 995 91 672 62 The Netherlands 3260 89* 668 178 321 86 1,844 492 United Kingdom 1,593 113 968 69 607 43 2,150 153 Japan 5,221 123 4,084 96 4,534 107 3,910 92 United States 6,509 64 7,741 76 11,672 115 13,984 137 0 Data is are for 2000. Source: Bernard and Thomsen (2002). 2.22 In comparison with the development of many other aspects of the Russian economy, the growth of the financial sector has lagged seriously. Currently, the Russian economy is characterized by a dual structure. The flow of savings is concentrated in a small number of large, vertically integrated financial-industrial groups to which many banks also belong. These groups rely on raw material production, processing, and exports as their main source of earnings and then use their banks to re-deploy their resources for consumption and investments in their sectors or as an instrument for exporting capital (net private capital outflows). In addition to this problem of interconnected transactions, banks do not support long-term financial transactions and inefficiencies are large. 36 Only a quarter of corporate bank loans are for more than one year and this reflects the banks' inability to attract longer-term liabilities. Borrowing-lending spreads are wide, operating costs in many banks are high in relation to income, bank profitability is low, and there are a large number of small banks which are unable to exploit economies of scale.37 These problems are compounded by the absence of a level playing field between state banks and private banks, and between domestic and foreign banks, and by weaknesses in the financial system's stability because of inadequate supervision and regulation, inefficient risk management, weak internal audit practices, a low level of capitalization, a nontransparent governance structure, and an inadequate use of modem technology. 2.23 To address these problems, the Government has developed a comprehensive program that, if effectively implemented, will establish the Russian financial system on a sound and competitive basis. The program aims to establish a competitive banking system based on international best practices to improve stability and preclude systemic crises, improve the intermediation of savings, strengthen confidence, limit unfair commercial practices, and provide quality services conducive to economic development. Some of the key elements of the program are: (i) promoting competition; (ii) improving intermediation and efficiency; and (iii) strengthening financial system stability. To promote competition, the Government has embarked on a program of: improving bank supervision; enhancing transparency through the adoption of 36 See Bernard and Thomsen (2002) 3 At the end of 2002, Russia had approximately 1,300 banks. 18 international standards of accounting and consolidated reporting requirements; divesting state shares in banks where the state holds less than 25 percent of the shares and gradually increasing the level of required minimum capital (to the EU minimum level of 5 million ECU for all banks by 2007); and strengthening investor rights. To improve intermediation and efficiency, the following measures are being pursued: introducing deposit insurance, fostering greater transparency regarding the financial condition and ownership of banks, and providing institutional arrangements to reduce credit and liquidity risk. To strengthen financial system stability, the Government program emphasizes stronger regulation and liquidation procedures, improvements in the payment system, and stronger corporate management. 2.24 Along with these measures to build essential trust, the sequencing of some of these reforms is also important.38 In particular, it is crucial that the strengthening of the banking system takes place either prior to, or in conjunction with, the introduction of the deposit insurance system. In terms of the latter, the design and enforcement of the criteria for those banks gaining access to the deposit insurance system, as well as for those banks that would be required to exit the system, would be critical for its successful implementation. Corrective actions need to be developed and implemented for banks that are not immediately eligible for participation. Moreover, along with these measures to develop client trust in the banks, complementary reforms in the enterprise sector are needed to strengthen the banks' trust in borrowers. These complementary reforms would include strengthening corporate governance in enterprises, ensuring the enforcement of contracts, and promoting income growth and profitability. These inter-related reforms will require sustained effort and government commitment over several years to show results. D. Reforming the Infrastructure Monopolies 2.25 Given the size of the sector, structural reforms here are central to promoting private investment in Russia. While the transition in Russia has seen some private sector involvement" the maintenance of infrastructure monopolies and uneconomic pricing (discussed earlier) continues to provide a significant constraint to investment in the sector. As a result, investment has fallen far short of the levels needed to maintain and sustain the various networks. The consequence has led to a deterioration in the existing networks accompanied by the increasing risk of a serious decline in the quality of service provision. The need for significant levels of investment is now recognized. Tariff increases are essential and have been discussed earlier. But so are reforms to promote competition and improve governance in the sector. 2.26 The energy sector still lags behind in investment relative to its needs even as the stresses on the sector's generation and distribution capacities have begun to show. RAO-UES has estimated that investments totaling US$50 billion will be needed over the next ten years to rehabilitate and upgrade the network in order to maintain current service levels, whereas current investments are reportedly only a small fraction of that. Similarly, it is estimated that Gazprom will require total investments of about US$80-100 billion during the same period merely to keep its production at current levels (of 530 BCM/year) compared with investments of US$2.6 billion in 2001 and an estimated US$3.3 billion in 2002.39 Pipeline projects and equipment upgrading demand substantial additional capital inflows. If Russia is to stay committed to expanding its gas exports and improving its competitive potential, large investment flows (including external investments) are needed. 38 See World Bank (2002c) for a detailed assessment of the "problem of trust," recommendations, and sequencing of reforms. 39 World Bank staff estimates. 19 2.27 IPoweir $ector Reforinma The GGovernment has initiated a reform of the electricity sector, which envisages unbundling the sector-and RAO-UES-into generation, transmission, system operation, and distribution and supply segments. The generation segment will be further unbundled into a number of independent generation companies, while transmission network and the system control will be incorporated as separate entities. Distribution networks will be separated from the "lenergos" (regional electricity companies) and then aggregated into a number of regional distribution ("wire") companies. The reform plan envisages the creation of a competitive wholesale electricity market, as well as the eventual Hberalization of the retail market, which would allow competing suppliers and the rights of consumers to choose supplies. It is expected that private participation will increase in generation, trading, and supply, while the level of state ownership may increase in transnission and system operation. Nuclear power plants will continue to be 103 percent state owned. The min elements of the reform plan are encoded in the Federal Electricity Law (PEL) that passed its second reading in the Duma on February 14, 2033. 2.28 The main facets of the refomn - restructuring, demonopolization, and increased liberalization of the sector - are supportive of the . 201 e Cay lnea en IPM'DWer 03&t0r RIeaIr in IRtnadn objectives of increasing Key Issues in power sector reforms are: efficiency and attracting o Social: how to manage the social impact of sector reforms in a manner private investment. They which is fiscally affordable, sustainable, and better targeted toward the are also consistent with the neediest. general approach for o Regulatory: how to transit from tie currently fully regulated sector with reforming the electricity major pricing distortions in the form of cross-subsidies embedded in the industry that has e e present tariff structure, to a more liberalized electricity market with competitive and thus more cost-reflective pricing and a de-politicized adopted during the last regulatory institutional setup (not only in electricity but in other closely couple of decades by an related areas such as naural gas), which would facilitate increasing number of demonopolization and private investment. countries across the o Market structmre and trading arrangements: how to design, sequence, development spectrum. pace, and implement market structure and trading arrangements to The FEL and the associated enable open access to transmission and distribution networks, facilitate regulation,however, leave wholesale and retail competition, and enhance investnent and operating regulations, hoee,lae efficiencies, in a power system which spans the vast geographic significant room to the territory; has a number of electrically isolated or semi-isolated systems; Government as to how to runs a wide range of power plants in terms of their efficiency, implement the reform-in technology, and vintage; is attive to capture by vested interests; and terms of its design, has numerous transmission constraints, relatively short experience in sequence, pace and commercial operation, and likely sub-optimal metering and system sequence, pace and control infrastructure. coordination of its various elements-and how to ° Ownership and corporate governance: how to involve and take into account the interests of minority shareholders in RAO-UES and consult and involve vanous reconcile them with some of the objectives of sector restructuring, such stakeholders in the proess as minimizing or eliminating cross-ownership between monopolistic (see Box 2.1). Given the (transmission network) and competitive elements of the system technical complexities of (generation, trading, supply). the reform, its significant O Privatization: how to attrat private investment in the sector while economic impact, and the promoting and ensuring sustainable comlpetition in investment and major political sensitivities, operation. its implementation is likely to take several years. 20 2.29 The adoption of the FEL is a significant milestone. However, the reform process could easily become derailed and reversed if improperly managed and implemented in all its details. The implementation design for various elements of the reform has been advancing, but there are still significant disagreements within the country. It appears, however, that all stakeholders share the need to proceed with caution and some gradualism, to allow for learning and corrective actions as needed.40 2.30 Gas Sector Reforms. The gas sector remains dominated by Gazprom, which owns about 70 percent of the gas reserves, produces about 95 percent of Russia's gas, owns the transmission network, and controls (via its subsidiary Mezregiongaz) all exports outside the CIS. Under- investment in the gas sector has started to show in Gazprom production declines of 7-8 percent per year. 2.31 The Government has a stated commitment to reform the sector and institute significant corporate changes in Gazprom. While higher investments will require a significant increase in tariffs (discussed earlier), greater competition is also needed in the sector. In this context, Gazprom has shown signs of becoming more accommodating of other gas producers' needs for access to its transmission system and hence to markets. But additional measures are required, including repeal of the Gas Supply Law, so as to provide clear and certain revised conditions under which gas producers can gain access to Gazprom's gas transmission line. Efforts to unbundle gas services have also not made much progress. In addition, efforts to create greater transparency and improved corporate governance are required. 2.32 A major challenge to the Government in reforming the gas sector is to balance the stated view that Gazprom is a "powerful lever of.political and economic influence over the rest of the world" and the "foundation of the Russian economy" with the need to introduce more competition into the sector. In addressing this challenge the Government has recognized the need for greater transparency. An option that has received past consideration is to transfer the storage and transmission systems to a wholly owned subsidiary operating at arm's length. This proposal recognizes the importance of providing non-discriminatory access to the transmission system and, hence, to markets if new investment is to be attracted to the sector. While a transparent separation of activities under the Gazprom umbrella will not provide the competitive stimulus that a complete unbundling would provide, it does have the potential to attract new players and thereby promote more competition within the sector. 2.33 Measures are also required to address envirorimental issues in the energy sector. Gas flaring remains a major environmental concern. In addition, there is a significant legacy of environmental mitigation requirements related to oil and coal that need resolution. The. Government should therefore develop a medium term program to deal with the myriad environmental issues in the energy sector. 2.34 Railways Reforms. Russia is the most highly rail-dependent country in the world. More than 85 percent of domestic, surface ton-km (pipelines excluded) travels by rail in Russia in comparison with about 47 percent in China and 50 to 60 percent in the United States and Canada. Rail dependence is even higher in the Asian part of Russia due to the almost total lack of highway transport in Siberia. Russia also has a high market share of rail in long distance passenger transport and, in Moscow and St Petersburg, in suburban passenger transport. The future growth 40 One such idea is the introduction of a limited competitive wholesale market in parallel with the regulated one as a transitional arrangement. 21 of the Russian economy, especially in the Asian part, where significant poverty exists, will be directly linked to the effectiveness with which the rail sector performs. 2.35 The sector is characterized by a monopoly provider, an emphasis on physical inputs and outputs, and little focus on service to particular marlkets. There are significant cross subsidies from the profitable freight sector to the unprofitable passenger sector. In 2002, the losses within the passenger sector (long haul passenger services as well as suburban passenger services) were estimated at US$1.7 billion (55 billion rubles), which effectively imposed a 15 percent surcharge on freight tariffs - a heavy drag on an economy that is so rail freight dependent. Within the freight sector there are also damaging, but unquantified, cross-subsidies from mnufactured goods to basic cargoes. 2.36 A new reform program for railway BI51 2.2: Re$nuliCys Fr n restructuring was enshrined in law in January 2003. The Phase 1: The railways will be split between the Government function program lays out a phased (MPS will continue as a regulator and policy maker) and a rail restructuring of the sector enterprise which will initially hold all of the infrastructure and operating (see Box 2.2). But there are companies. three main regulatory Phase II: The rail enterprise will become an entity owning and operating challenges to railway the infrastructure, part of the freight wagon fleet and some of the restructuring in Russia. locomotives, and there will be a series of Joint Stock Company (JSC) First, the setting of subsidiaries operating freight, intercity passenger, suburban passenger, infrastructure access inter-modal, refrigerated services, and other services. Commuter and charges will be complex intercity passengers will be subsidized by direct payments from because full cost recovery govermnent(s). The total cost of infrastructure will be paid through will require allocation of access charges (now in development). fixed costs to users Phase III: Some of the subsidiaries will face the possibility of witheeach fothr.capac Su privatization, and in both the second and third phases, private with each other. Such competitors will be allowed on the infrastructure paying access charges charges will require that are non-discriminatory economic discrimination, a challenge that has not yet been successfully met elsewhere. Second, freight tariffs will need to be regulated because the rail sector is certain to retain monopoly power, though this could, in principle, be reduced by making access for com,peting freight carriers easy and cheap (by allocating fixed costs to the state freight operator). Third, the system is to be "open" access, which implies that all entrants will be allowed to run trains. In practice, this will not be possible because of capacity and scheduling constraints. The regulator will be required to develop the conditions under which entry will be permitted and encouraged. 2.37 The reform program is the beginning of a long process of change. No other country has faced the challenge of simultaneous regulation of access charges and operating (freight and passenger) tariffs, and there are no clear answers to the issues involved. Handling these tasks will require a greatly strengthened regulatory policy development and implementation capability. 41 The existing freight tariff structure is relatively flat, with little demand-based pricing: in fact, the reliance on the manufactured goods category for most of the profits probably violates demand-sensitive pricing since certain bulk commnodities, especially coal, might be able to cany higher tariffs (and the Energy Ministry mnight have a conflict of interest in regulating rail tariffs on coal). 22 E. Promoting Competition through Global Integration 2.38 Global integration is essential to strengthen the domestic competitive environment, attract new foreign investment, and provide new export markets. By some measures, Russia is already well integrated with the global economy. The trade to GDP ratio in 2002 was 56 percent. But by many other indicators, global integration remains a challenge. Energy products comprise more than half of total exports. Foreign direct investment flows (FDI) remain low notwithstanding the general global slowdown in recent years. And finally, Russia still needs to accede to the WTO. 2.39 WTO accession must be a central pillar of Russia's strategy for strengthening the competitive environment and promoting global integration. To that end, Russia needs to: (i) reduce tariff peaks for certain products and move towards tariff uniformity; (ii) continue the recent initiatives to improve the climate for investment; (iii) improve the services offer to the WTO to encourage FDI by foreign service providers; and (iv) make further progress in the areas of customs reform, trade facilitation, and standards.42 2.40 Tariff Level and Uniformity. Russia's average import tariff rate- 1I percent for MFN-is lower than the average tariff in most developing countries. Moreover, there is a low variance in the Russian tariff structure, at least among the ad valorem tariff rates. However, there are some significant products for which tariffs are quite high. While the maximum ad valorem tariff is 25 percent, for'many tariff lines Russia employs a combined system, in which the tariff that applies is the maximum of the ad valorem tariff rate or the specific tariff. This results in applied tariffs above 25 percent in some cases. The most notable products in Russia with tariff peaks are automobiles (35 percent), certain automobile parts such as tires (50 percent), beer (83 percent), and certain high alcohol products (52 percent). These tariff peaks distort the tariff system; their reduction and movement toward uniformity would improve efficiency, reduce incentives to lobby for protection with an attendant reduction in corruption, improve customs administration (as the incentives to misclassify goods are reduced), and reduce the incentives to smuggle since it is the products with tariff peaks that mostly attract smugglers. 2.41 Foreign Direct Investment. FDI inflows to Russia have typically been between 0.8 and 1.7 percent of GDP between 1997 and 2000 (less in earlier years), and have halved since the optimism of the mid-1990s.43 This compares unfavorably with flows to other comparator countries (see Table 2.4). FDI inflows pale in comparison with the large net outflows of private. capital-estimated at almost US$20 billion in 2001-which deprive the economy of much needed scarce domestic investible resources." Attracting more FDI is important for Russia to enable it to fill the investment gap, promote growth, boost competitiveness through technology transfer and management expertise, and diversify the economy. This requires an environment in which multinationals view Russia as a country where investment can result in a global competitive 42 Trade facilitation refers to procedures that allow goods to enter and exit the country without undue delays and with transparent non-discriminatory rules. Progress in standards means reducing technical barriers to trade, and sanitary and phytosanitary barriers that are discriminatory or that limit the flow of goods. This would include, in the case of Russia, greater reliance on intemational certification agencies for the certification of safety, as well as the effort to move away from mandatory certification of non-safety requirements. 43 FDI flows are much lower than for other countries in the region when they are also adjusted for population size and other measures. See Broadman and Recanatini (2001). 44 While these capital flows may be helping in the short run to mitigate the pressures for real appreciation of the exchange rate engendered by the large inflows of export receipts, and are in some measure a rational and predictable response to large current account surpluses, they reflect fundamental distortions in the economy and a general lack of confidence in obtaining positive and attractive risk-adjusted retums to domestic investments. 23 advantage for the multinational.45 While an open trade regime is a prerequisite, so are low policy and administrative barriers to investment (as discussed above) and trade facilitation. 2.42 FDI flows also have a strong regional bias. Four western regions account for close to 60 percent of the FDI.46 The uneven distribution of the benefits of FIDI may well contribute to an unequal regional pattem of investment, industrial development, and poverty. Transportation and telecommunications costs are especially important for remote regions, and the elimination of barriers to FDI in these service sectors may be especially important for regional growth and poverty reduction. 2.43 LUberlzmioim of fe Sen-vce Sectors. Relative to Russia's tariff barriers on goods, the barriers to FDI by multinational companies in areas such as banking, insurance, securities, accounting, telecommunications, maritime transportation, and aviation appear to be quite high. This difference is reflected in the progress that is being made in the accession discussions at the WTO. While Russia is making good progress in negotiating its market access offer on goods, the Working Party on Russian Accession is quite concerned about lack of progress in the services offer.47 Table 2Z4: Net IForegm IMirect llmvesumneist lNllows -Tiw=1:j iani Ot1er lected COrnties, Net FDI nflow ($ billion) Net FDI as % of GDP Country 1995 1996 1997 1998 1999 200 2001 1995 1996 1997 1998 199920002001 Russian Federation 2.0 2.5 6.6 2.8 3.3 2.7 2.5 0.6 0.6 1.5 1.0 1.7 1.1 0.8 Czech Republic 2.6 1.4 1.3 3.7 6.3 4.6 4.9 4.9 2.5 2.4 6.5 11.6 9.0 8.7 Hungary 4.5 2.3 2.2 2.0 2.0 1.7 2.4 10.1 5.0 4.7 4.3 4.1 3.7 4.6 Poland 3.7 4.5 4.9 6.4 7.3 9.3 8.8 2.9 3.1 3.4 4.0 4.7 5.9 5.1 Argentina 5.6 6.9 9.2 7.3 24.0 11.7 3.2 2.2 2.6 3.1 2.4 8.5 4.1 1.2 Brazil 4.9 11.2 19.7 3.2 28.6 32.8 22.5 0.7 1.4 2.4 4.1 5.4 5.5 4.5 China 35.9 40.2 44.2 4.4 38.8 38.4 46.8 5.1 4.9 4.9 4.6 3.9 3.6 4.0 Mexico 9.5 9.2 12,8 11.3 11.9 13.3 24.7 3.3 2.8 3.2 2.7 2.5 2.3 4.0 Sources: World Bank (2002e) and UNCTAD (2001). 2.44 The liberalization of producer services is important, and a growing body of evidence and economic theory suggests that producer services are an important source of agglomeration externalities for growth and regional development. To date, the wider benefits to the economy and the gains to labor interests in the service sectors that will benefit from FDI have not been sufficiently well articulated to overcome the concerns of the incumbent service sector businesses and of the line ministries that resist reform. New studies of the benefits of the reform of these sectors in Russia are becoming available, and should allow a clearer articulation of these benefits and encourage commitments to reform in the services sectors."' 45 See Bergsman, Broadman and Drebentsov (1999). 46 These regions are Moscow, Moscow Oblast, St. Petersburg, and Leningrad Oblast. For details, see Broadman and Recanatini. (2002). 47 See World Trade Online: U.S., EU Criticize Russia for Lack of Answers in WTO Accession Talks, June 21, 2002. 48 See Jensen, Rutherford, and Tarr (2002); National Investment Council of Russia (2002). 24 2.45 Customs Reform, Trade Facilitation, and Standards. It is important to develop customs procedures and regulations on standards that will facilitate the flow of goods and will not impose undue burdens on exporters and importers. Among the principal areas of reform in this area are: legislation, customs clearance and control, and corruption. As regards legislation, the new customs code before the Duma is a significant improvement relative to the existing legislation. For customs clearance and control, in the absence of a computerized risk management system, current cargo inspections involve physical checks, of all trucks and transportation units and excessive documentation leading to considerable delays in the release of goods from customs. Regarding corruption, there is a need to develop and implement a comprehensive integrity enhancement strategy that will reduce the perception in the trade community of excessive discretion and non-transparency in customs operations. Concerning standards, quality based standards are too often "government mandatory" rather than conforming to international best practices. Similarly, a mandatory pre-market certification applies to an unjustifiably long list of goods. F. Improving Labor Market Flexibility 2.46 If resources are to move across sectors to provide diversified growth, labor flexibility is essential. Russia has made some progress in moving to a market-based allocation of labor. The determination of wages also has started to reflect market forces. The returns to education have markedly increased (although returns to vocational education have fluctuated over time), and the returns to work experience have declined. With recent growth, real wages, employment, and labor productivity have increased, with an average annual rate of growth similar to that realized by Central and Eastern Europe. The unemployment rate has declined sharply - more so than in Central and Eastern European countries during a similar growth period. Wage arrears and inappropriate fringe benefits (housing, kindergartens, etc.) also have sharply declined, although they have not completely disappeared. 2.47 Despite these gains, key constraints still confront the Government, employers, unions, and workers. Years of slow restructuring, limited economic reforms, and lack of job opportunities have led to a decline in formal labor-market activity and a shift toward subsistence self-employment, primarily in agriculture. Despite recent declines, the level and duration of unemployment are not low by OECD standards, and the recent slowdown in economic activity has started to gradually reverse unemployment trends. Most unemployed are older and less skilled workers. These workers have difficulty in finding jobs despite the resumption of economic growth. The employment share of the private sector remains small, genuine entrepreneurship is limited and job creation rates remain low. However, self-employment in the agriculture sector is significant and has been increasing. Wage inequality, already high by regional standards, has increased since 1998. 2.48 Labor market regulatory institutions have not evolved significantly since the socialist era and the safety net is not very effective (see Chapter 4 for more details on the latter). Despite recent changes, the new labor code is still quite restrictive relative to OECD standards and is not enforced properly. Other labor market institutions are also weak. Employers are limited in their ability to adjust their workforce in response to economic and technological change; workers and employers do not have adequate opportunity to voice their concerns; contract enforcement is weak; and mechanisms for resolving workplace disputes and addressing health and safety concerns are limited. Even though the Government created a modern safety net in the early 1990s, limited financing of this program has made the system largely ineffective, contributing to high rates of poverty among the unemployed (relative to national levels). Moreover, as the Government progresses with further economic restructuring (for instance, of railways, 25 metallurgy, one-company towns) the subsequent labor downsizing will require addressing its social consequences through severance, back wage payments, and programs to help laid off workers get back into the labor force. The recent slowdown in growth makes the remaining agenda difficult to achieve. 2.49 The Government recognizes the importance of a labor market policy that promotes efficiency but protects the basic rights of workers. It has made this strategy an important component of its economic reform program. This strategy has four key elements: (i) to ensure growth in jobs through sound macroeconomic policies; (ii) to provide a flexible framework for labor markets, especially through legislation ffiat facilitates the hiring and firing of workers; (iii) to provide better worker/employer representation in unions to ensure fair resolution of disputes, reduce contract violations, and ensure basic safety and health conditions in firms; and (iv) to provide social protection through a strong and reliable safety net (including unemployment benefits, an Active Labor Market Program [ALP], severance payments), shifting protection away from firms and reducing regional inequity in benefit provision. G. lPirorodnotg Rul r almvestamemns 2.50 Given its tremendous potential, agriculture could be a solid foundation for attracting new investment and growth in the rural areas, and for providing higher incomes for a significant part of the Russian population. After the decline of the early transition years, the agriculture sector has been showing some economic growth since 1999, growing by an average rate of about 5.5 percent per year over the past four years. But such growth is not yet sustainable, and with the real appreciation of the ruble, it is becoming clear that production is relatively uncompetitive by international standards and pressure is growing for higher protection from imports.49 Radical improvements in the overall efficiency of the sector are needed and this cannot be achieved without deeper structural reforms and investments in rural infrastructure. 2.51 Land lPglhts. Agricultural investments are hampered by limited private ownership, the absence of a unified cadastre, and the question of the certainty of the property rights to agricultural land. The Table 2.5: ReFvate ˘DwOermbp fm AgiAnftmirmR Laui1, base of private land (as of J -oL :i,n:' 1, X32) ownership is very Of which narrow (see Table . Used for Ofnwhic The Share of 2.5). The share of Categories of Land Agricultural Lands i Privately Owned privately owned Users and Owners Producfion, mln. ha Ownership Agricultural agricultural land in mln. ha Land, % the total land area is Household Plots and about 20 percent. Other Individual Land 26.5 5.4 20.3 Holdings 2.52 Land reforms Private (Peasant) 16.9 6.4 37.8 have received a boost Farmers from the new Land Agricultural 560.7" 3.4 0.6 Code (November Enterprises Co01)ande (November o Total Land 632.82' 129.0 20.4 2001) and the Law on " Includes 112.9 mln. ha of land shares. Agricultural Land 2/ Includes 26.7 mln. ha for populaton involved in North deer breeding. Tumover (July 2002). Source: World Bank estimates. The latter legislation 49 In 2001 food imports grew by 19 percent, while the supply of some items of domestically produced food exceeded the demand. 26 provides clear, concrete rules regulating transactions in agricultural land, and is a major step forward for the private ownership of agricultural land and the development of the land market. The Law strikes a good balance between the rights and responsibilities of the Federal Government and those of regional governments. Most important here are the rights reserved to the Federal Government concerning limitations on land transactions and the issue of foreign ownership of land. The sale of farmland to foreigners is prohibited. Foreigners can hold agricultural land plots on a leased basis only. The term of the lease may not exceed 49 years. The role of regional authorities in regulating relations associated with possession, use, and disposal of land plots is considerable. 2.53 However, there remain deficiencies in the current legislation. First, local administrations have preferential rights to purchase land and the right to start privatization of agricultural land in the region. It is not clear how this will achieve its objective of preventing "bad" sales, while it is clear that it will hinder the operation of markets and could lead to excessive concentration of land ownership by the Government. Second, the Law could have been improved by further limiting and clarifying the circumstances under which land may be forcibly taken by the state. Third, agricultural land parcels, including those on a shareholding basis, may be leased out if they have been inventoried for the state cadastre purposes. This requirement may turn out to be a costly burden for millions of rural people who cannot afford to pay for these services to private and state land surveyors. And, finally, there is still no efficient mechanism to identify the true market price of agricultural land, and the cadastre value in most cases is conditional. This requires the creation of a unified state land cadastre system. 2.54 Rural Infrastructure and Finance. Russia currently lacks an overall rural development policy. As a result of decreasing financing from the traditional sources, the state of rural physical and social infrastructure continues to deteriorate. Except for the expansion of natural gas networks, investments in infrastructure have declined dramatically during the last decade. Moreover, the infrastructure service gap between rural and urban areas is large. For instance, in 2001, only 40 percent of rural dwellings had running water as against 87 percent in cities, 31 percent had a sewer system as against 85 percent in cities, and 19 percent had hot water supply as against 77 percent in cities. 2.55 As the transition has progressed and rural social problems have emerged, there has been some progress in separating issues related to social services from those specific to agriculture. But there is still a need to recognize more fully that social problems should be addressed using policies different from agricultural policies, which will require, inter alia, the devolution of responsibility for rural infrastructure from the enterprises to the municipalities, along with some means of funding it. In December 2002, the Government approved the Federal Targeted Program "Social Development of Rural Areas until 2010.",5° This program covers a broad set of areas including house-building, general education, primary medical and social services, reconstruction of electric grids, supply of gas and water, telecommunications networks, and improvement of roads. The program is primarily focused on the social and physical infrastructure in rural areas. Effective implementation of this law is likely to address some of the key rural infrastructure issues. However, work also needs. to be done on a strategy for devolving responsibility for social assets from the farm enterprises to the local governments. so The financing of this program is expected to be provided from: the 2003 Federal Budget (18.5 billion rubles out of the total 167.8 billion rubles); regional and municipal budgets (76 billion rubles); and out-of-budget sources (e.g.; state and private enterprises and organizations, agro-holdings, individuals with their personal savings). 27 2.56 The inadequacy of rural finance reflects the general under-development of the financial sector and the low level of financial intermediation. As a result, policymakers have focused mainly on increasing and making more efficient use of Government funds, rather than on creating incentives to link farmers to the commercial credit system. Institutions that play an important role in rural credit in other countries -- credit cooperatives, warehouse receipts, commercial credits provided by banks and others -- have had a marginal role. Not surprisingly, there has been a rapid growth of state-owned credit institutions - a state-owned agicultural bank, a state-owned leasing company, and state-owned food corporations in the center and the regions. There is a serious danger that these institutions will become a powerful force lobbying for their own perpetuation and expansion of funding from the Government budget, will pose potential contingent liabilities for the state budget, and will crowd out the development of private finance. 2.57 Price [lmne1rvezntis in Agriculure. The Government has T1ablDe 2IS: Esmu3 e? AgacuRtnnre $upDpr, had only relatively moderate NW__=_ agricultural interventions in trade and 24$N pricing at the federal level. Grain Russa 14 2 3 interventions introduced in 2001-02 TSE 1.5 0.4 0.5 were not massive but are guided by EU the objective of boosting domestic PSE 36 29 34 grain prices by 15 percent. Since OECD 1.6 1.6 1.4 1998, there have been relatively small PSE 33 35 32 policy-related distortions of input and TSE 1.5 1.4 1.3 output prices, far lower than the EU EU Accession and OECD averages, as well as the PSE 21.7 18.7 16.5 averages for the EU Accession TSE29 .17 Note: PSE is Producer Support Estimate as a percentage of total countries (see Table 2.6). However, production values. TSE is Total Support Estimate as a percentage of as the real exchange rate has recently GDP and includes all transfers to producers and general non-product- appreciated, pressures are increasing specific budgetary support to agriculture. for a return to greater protectionism, Source: Melyukhina (202). including additional tariffs and imnport quotas on livestock products.51 2.58 At the regional level, however, explicit price and trade policy distorions are significantly worse. Product and regiornal disparities in input subsidies, support policies and trade barriers, and effective protection rates vary substantially across products and regions. This also has the effect of fragmenting the national market. Moreover, in the absence of reliable market infornation on prices and exchange quotations, officially established prourement prices may create distorted signals for producers. Though public procurement has fallen sharply from the dominant share of the early 1990s, it is still significant, especially at the regional levels. There are also some signs that public procurement may be increasing. In addition, there is a danger that the revitalization of the reference price system at the federal level will also revive the system of commodity credits at the regional level, which was carried out on a considerably reduced scale last year.52 2.59 Public procurement at the federal and regional levels at guaranteed (or other "regulated") procurement prices should be halted. Use of these prices contradicts the intention to use competitive procurement procedures. Any public procurement should be minimal-only to supply public sector needs (hospitals, prisons, etc.) - and should be carried out through a system 51 Starting April 1, 2003, import quotas were introduced for poultry, meat, beef, and pork and tariffs increased. 52 The federal reference prices are being recommended as a reference point to set advance payments to agricultural producers by procurement agents under "commodity credits." 28 of public tenders and bids. With respect to other input or credit subsidies, if they continue, they should be administered through private channels on a competitive basis (e.g., interest rate subsidies through a qualified private credit institution, or input vouchers to be spent by the farmer at his/her choice of supplier), not through state-owned or monopoly suppliers. All remaining subsidies to producers should be administered by some incentive-neutral mechanism (e.g., payment per hectare), and should not be dependent on input usage or output. This would greatly facilitate Russia's entry into the WTO, while sending credible signals about future plans would remove uncertainty and allow the private sector to better plan investments in the rural financial sector. Russia should use the WTO Accession process to make a binding public commitment to its agriculture reforms. Greater control needs to be exercised over regional policy, including developing means of enforcing the prohibition on inter-regional trade barriers, and developing means to ensure that regional policies do not interfere with international economic policy objectives. WTO Accession will also provide Russia with stronger protection against arbitrary actions by its trading partners against its exports. III. CONCLUSIONS 2.60 The investment climate in Russia, though improving, remains seriously constrained. Prospects for new investments and economic diversification will remain limited unless significant bottlenecks are overcome. While various reforms have been initiated to enforce financial discipline on existing enterprises and to encourage the growth of new firns, the remaining agenda remains large. This needs to be addressed if Russia is to accelerate and sustain broad-based growth. This will also require a strategy for addressing the political economy challenges of reform implementation, particularly at the regional and local levels. 29 3. MANAGING MACROECONOMIC RISKS 3.1 As Russia enters its second decade of transition, managing macroeconomic risks and volatility is essential to developing a stable investment environment, achieving high growth, and alleviating poverty. While macroeconomic policies have generally been conducted prudently and financial discipline in the economy has strengthened significantly since the 1998 financial crisis, the rapid recovery and financial stabilization has been aided by high global oil prices since 1999. The recent slowdown in growth, weakening of the fiscal position, and slower than envisaged reduction in inflation highlight the critical role of renewed vigilance in the conduct of macroeconomic policies and reform implementation. A. Key Macroeconomic Challenges and Risks 3.2 Russia faces a number of critical, inter-related challenges and risks over the coming years in preserving macroeconomic stability. Achieving high sustainable growth rates is essential both to raising living standards and to securing fiscal and external sustainability over the medium- to long-term. s has been discussed earlier, improving the investment climate is critical to strengthening growth prospects. At the same time,, a further gradual reduction in inflation to single digits is desirable to contain upward pressures 'on the real exchange rate and improve investment conditions. Concurrently, of course, it is important to support growth by maintaining a competitive real exchange rate, which is essential to encourage economic diversification and address the structural imbalances in the economy. 3.3 But there are two key macroeconomic risks which need to be managed as a complement to policy and institutional reforms addressed at the investment climate. These are: (a) Securing fiscal and external sustainabiity. This entails ensuring the longer-term solvency of both the Government and the country vis-a-vis the rest of the world, and ensuring that fiscal and external operations remain c6nsistent with the available market-based financing without the need for renewed exceptional financing over the medium term. Achieving these objectives requires a further reduction in the external and public sector debt burden through pursuing a strong fiscal position and appropriate monetary and exchange rate policies, restoring access to international capital markets, attracting FDI, maintaining adequate reserves, developing the domestic capital market, managing inter-governmental fiscal relations, and making room in the budget for potentially significant reform costs. (b) Managing macroeconomic volatility and avoiding Dutch Disease. Managing macroeconomic volatility and avoiding Dutch Disease are essential if Russia is to preserve its newly found macroeconomic stability, enhance economic diversification, and target higher rates of growth. While volatility and Dutch Disease risks arise from the large swings in global energy prices, this has been accentuated by the large swings in private capital flows as evidenced in 1997-98. Dutch Disease is inherently difficult to diagnose, but there is some evidence that the high oil prices prevailing for most of the period from 1999 to the present have been associated with a concentration of resources in the energy sector, with real appreciation outpacing productivity improvements, and with the relatively poor performance of non-energy exports in international markets.53 5 Soos et al. (2002) note the loss of market shares in Europe of Russia's manufacturing exports in the 1990s and also note that this trend has not yet been reversed owing to limited investments in this sector. On the 30 3.4 The conduct of macroeconomic policies plays a key role in addressing these challenges and risks. Fiscal policy is clearly an essential element in securing fiscal and extemal sustainability, but it also has important bearings on inflation-in part owing to the limited development of domestic financial markets-as the tansition history has shown. In a similar vein, it influences the real exchange rate and can help address macroeconomic volatility and Dutch Disease. Also, fiscal policy plays a key role in supporing reforms and diversification more broadly through changes in the size and structure of public fnances, both between the different levels of govermment and in the composition of revenues and expenditures. 3.5 Monetary and exchange rate policy is no less important. Generally, Russia appears best served by its current managed float, given its size, exposure to external shocks, moderate inflation rate, and the likely changes in the real equilibrium exchange rate associated with the transition process. The now comfortable level of intemational reserves gives the CBR considerable discretion in managing the exchange rate within this framework. Monetary policy should be geared to ensuring a further reduction in inflation. While it may be premature to shift to formal inflation targeting in view of the need to further develop monetary instruments, strengthen the financial sector, and improve the understanding of the transmnission mechanism, the CBR should pursue a more ambitious disinflation process. 3.6 In general, there is a need to improve the coordination of financial policies in the short term with a view to deciding on the best policy mix. This process has been derailed in the past by arguments over who should bear the cost of sterilization. While the latter should be the responsibility of the CBR, the bank has been mainly passive, referring to the lack of adequate instruments and concerns about its income position. Recent initiatives to nomalize relations between the Government and the CBR are welcome, but these efforts need to be pursued further and supplemented with more substantive discussions on economic prospects and the appropriate policy mix. In this context, it is important to bear in mind that monetary policy is unlikely to be effective in managing the real exchange rate beyond the short term where real factors, notably productivity developments, are the key determinants and fiscal policy is a more useful instrument. Furthermore, policies should be set in a comprehensive medium-term macroeconomic and fiscal framework to ensure consistency and sustainability, and progress on this front in the context of the 2003 budget is an important step in this direction. lBo §ecuring Fisc aind ExtemS s §lnnilm ay 3.7 Securing fiscal and external sustainability has both a medium- to long-term and a short- to medium-term perspective. The former entails stabilizing the fiscal and external debt and debt service ratios at prudent levels and avoiding excessive current account deficits. Also, fiscal policy should take account of contingent liabilities, potential reform costs, and the need to avoid unsustainable expenditure compressions or reoccurrence of arrears. It is also necessary to address intergovermmental fiscal relations with a view to ensuring that policies are sustainable at all levels of government (see Chapter 5). In the short to medium term, Russia should strive to avoid renewed recourse to exceptional financing, and external and fiscal balances will be constrained by limited external financing and a still underdeveloped domestic financial system. other hand, de Broeck and Sloek (2001), comparing productivity and real exchange rate movements in transition countries, note that it is too early to assess Dutch Disease versus Belassa-Samuelson effects in Russia owing to the still short period of output and productivity growth. UBS (2002) estimates that the real exchange rate is still some 40 percent undervalued. 31 3.8 Russia has made considerable progress in securing fiscal and external sustainability since the 1998 crisis. The large fiscal surpluses, helped by high global energy prices, and the strong recovery in output from 1999, combined with debt reduction from commercial (and bilateral official) creditors, led to a reduction in the Federal Government external debt ratio from 90 percent of GDP at end-1999 to about 45 percent of GDP at end-2002.54 3.9 Looking ahead, the evolution of fiscal or external debt ratios depends on the initial level and composition of debt, the primary fiscal balance (or non-interest current account balance), the real interest rate, and the real GDP growth rate (see Box 3.1). The assessment of fiscal (debt) sustainability is thus sensitive to the specific assumptions regarding these key variables. In general, the higher the real interest rate, or the lower the real growth rate, the higher a primary fiscal balance will be required to stabilize or reduce the debt ratio. 3.10 In the discussion on medium-term prospects (see Chapter 1), real GDP is projected to grow at 4 percent per annum. While real interest rates are currently relatively low reflecting the easy monetary conditions and risk-free interest rate on rescheduled debts to official and commercial creditors, this will change gradually as new financing is accessed. Rates are assumed to stabilize around 6 percent in line with typical levels in non-crisis emerging markets and consistent with current secondary market spreads and spreads on new private issues. Further, given external risks, Russia should aim to reduce its external and fiscal debt ratios to below 30 percent of GDP over the medium term.55 Under these circumstances, Russia should be targeting primary fiscal surpluses of about 2-3 percent of GDP per year in the coming years. The fiscal position can be eased once Russia achieves its growth potential and the debt burden (and real interest rates) have been reduced to a lower level. Given the volatility of global oil prices, it would be prudent to base such a fiscal stance on some long-term average oil price. 3.11 The proposed fiscal stance is also consistent with Russia's medium-term financing constraints. Although the accumulated fiscal (financial) reserve and the comfortable level of international reserves will help manage the large debt service payments falling due in 2003-04, the as yet untested re-accession of international capital markets (which could be jeopardized by a large decline in oil prices) and underdeveloped domestic financial markets limit available non- inflationary financing. 5 This also reflected the reversal of the exchange rate overshooting associated with the 1998 crisis. 55 While this is considerably less than the ratio of 60 percent of GDP required of members of the European Monetary Union, it is warranted by Russia's vulnerability to global commodity price swings and the experience of some crisis countries that have had considerably lower debt levels. It is also consistent with current or targeted debt levels in advanced transition economies. 32 Debt dynamics are determined by the initial level of debt, the primary fiscal balance, the real (exchange rate adjusted) interest rate, and the real GDP growth rate. The primary fiscal balance required to stabilize the debt ratio is given by: PB = D*(R-G)I(I+G); where PB and D are the ratios of the primary balance and debt to GDP, respectively, R is the real interest rate, and G is the real GDP growth rate. The table below simulates the debt ratio for various assumptions regarding the key maco-variables, given Russia's initial (end-2001) debt ratio of 49 percent of GDP. The real interest rate is assumed to be 6 percent for each of the three cases below, with three different growth scenarios. Each of the scenarios shows the evolution of public debt for the next 10 years under three altemative assumptions about the Government's primary fiscal balance. Growth = 2 percent Growth = 4 percent Growth = 6 percent Lowz C:e Scenario SlOZ C:aCD ESnotcrlo 4t :0 . ait,Dw 2 3 2 0 4 4 0 0 o0 00 2 2 4 0 0 o so 0 O W2 2* * O Z 0 a4 TOOt5Og2 a M4 o O 03 5s - - - PWODP;OO- - PM'QDP.=O3| e . . . ..MOPD PBMJODPO.01 p_ Go10=.oI 3.12 At the same time, the budget is likely to remain under pressure from significant costs related to the implementation of the structural reform program. Tax reforms in 2001-02 have already cost more than 2 percent of GDP, and planned reforms in 2C03-04 may impose additional costs on the budget despite offsetting increases in excise taxes.S5 At the same time, pressures are mounting on the expenditure side, especially in the social sphere but potentially also from the banking and enterprise sectors. There is undoubtedly significant scope for rationalizing expenditures in several areas, including through better targeting of social expenditures. While a further lowering of the overall tax burden is probably desirable, the potential fixed costs of structural reforms suggest that great caution should be exercised in accepting a further decline in revenues. Estimating the fiscal costs of structural reforms is difficult, given that many reforms have not been fully articulated. Even where the reforms are clear, they are affected by reforms in other parts of the economy and it is difficult to estimate the net effects. 3.13 The Government's medium-term fiscal strategy is to maintain overall budget surpluses while reducing non-interest expenditures from around 13 percent of GDP in 2002-03 to less than 12 percent of GDP in 2004-05. Further expenditure cuts, in the order of 2 percent of GDP, are expected at the subnational government level in order to reduce total non-interest spending by about 3 percent of GDP from its current level by 2005. This would preserve a primary fiscal balance of 2-3 percent of GDP. It is clear that this will be a major challenge. Furthermore, given 56 See UIF (2002). 33 the CBR' s limited sterilization capacity, it is conceivable that an even tighter fiscal stance will be required in order to secure a continued reduction in inflation if the balance of payments strengthens further (see also the discussion below). C. Managing Macroeconomic Volatility and Avoiding Dutch Disease 3.14 Both external and domestic factors contribute to macroeconomic volatility in Russia. As discussed in Chapter 1, inadequate structural reforms, lack of financial discipline in the economy, an unsustainable fiscal policy, and the policy of holding on to a fixed exchange rate for too long combined to produce the severe financial crisis in 1998. While domestic policies are an important determinant of private capital flows, these flows also respond to sudden changes in investor confidence and are also influenced by conditions in international financial markets. Sudden and large swings in private capital flows, whether in one direction or the other, pose significant challenges for policymakers. The same is true for large swings in global energy prices. A collapse of oil prices undermines the budget and may lead to renewed balance of payments problems, including through its negative impact on profits, investment, and exports in the energy sector, while a prolonged period of very high prices puts upward pressure on the real exchange rate and undermines the profitability of the non-energy sector (Dutch Disease). In Russia's case, there also tends to be a link between the two, with part of the export windfall from high oil prices being kept abroad. In the following sections, the continued challenge of managing volatile energy prices, and a potential rapid reversal of private capital outflows are addressed. 3.15 Managing volatile energy prices. Global oil prices are subject to large swings and tend to follow a random walk with any mean reversion being very slow, although in the long run prices tend to revert to a range of around $18-20 per barrel (see Figure 3.1). International gas prices tend to follow oil prices with a lag of about six months. Figure 3.1: Crude Oil Prices in 1999 Dollars 100 00 80 00 70.00 -60.00 X 50.00 - -- - - - - 40.00 30.00 20.00 10.00, 3.16 Changes in the price of oil directly affect the balance of payments, the fiscal accounts, and national output. A one dollar change in oil prices is estimated to raise exports by about US$2 billion, but allowing for some adjustment of imports and some real exchange rate effect the impact would be around US$1.5 billion. The overall balance of payments effect would tend to be smaller as part of the change in export revenues in the past has been offset by changes in net private capital outflows. The impact on the fiscal accounts has changed significantly in recent 34 years reflecting mainly changes in the tax syStem.57 These changes have made the budget more sensitive to changes in oil prices, but the elasticity should also become more stable. In 2002, each dollar per barrel brings about US$1 billion (0.3 percent of GD?) for the Federal Government and around 0.5 percent of GDP for the consolidated budget (including indirect effects through the real exchange rate and output). The impact on output is the most difficult to assess, notably because of the uncertainty regarding the real exchange rate impact aEd its effect on trade as well as the uncertain relationship of investment to profits.58 Generally, there appears to be significant non- linearity in the relations between oil prices and key macro-variables.5 3.17 Fiscal policy can and should play a key role in managing volatile energy prices. The key considerations in this regard are the need to ensure a stable expenditure path, the need for fiscal policy to be counter-cyclical, and the need to help sterilize the balance of payments surplus and address upward pressures on the real exchange rate arising from a prolonged period of high prices. While the conduct of fiscal policy in recent years has been instrumental in managing the impact of the high oil prices prevailing since 1999, the dmatic improvement in the fiscal balance since the crisis has been more the result of the need to adjust to the sharp decline in available financing and, more recently, the desire to accumulate a financial reserve to help cushion the large debt service payments falling due in 2003 (and the following years). In this sense it is somewhat misleading to say that fiscal policy has operated as an informnal stabilization fund. This is also confirmed by the weakening of the fiscal position since 2001 despite continued high oil prices. 3.18 Fiscal policy should be based on a constant oil price in line with the long-run average range, or alternatively some measurement of the non-oil balance, with the level of the balance determined by medium-term sustainability considerations as discussed above. Ideally, this would be done in the context of a fiscal rule. Should prices turn out to be higher, the excess revenue should be saved or used to pay off debt, and vice versa. The key consideration in this regard is to ensure an efficient management of assets and liabilities. A formal stabilization fund, as the Russia authorities plan to establish from 204, may be a useful vehicle for this purpose, although clearly neither a necessary nor sufficient condition for effective management of fiscal policy in the context of volatile oil prices (it would only constrain fiscal policy to the extent that financing constraints are binding). Experience from other countries that have established natural resource funds has demonstrated that transparency and good governance are critical conditions for success. This includes the establishment of the fund by law rather than decree, the integration of the fund into the budgetary process with no independent expenditure authority exercised by the fund, and with coordinated asset and debt management. 3.19 Managing DaVG?c capal' flows. Many emerging markets and advanced transition economies have been subject to periods of large, speculative private capital inflows taking advantage of relatively high domestic interest rates and exchange rate stability. While such inflows have been important to finance current account and fiscal deficits, they have also led to a number of problems. In particular, they have often been associated with excessive appreciation of the real exchange rate and increased vulnerability of the corporate and financial sector owing to inefficient intermediation and weak corporate governance practices. Shap reversals of these 57 These tax changes include: changes in the schedule of export tariffs, the introduction of a mineral extraction tax to replace a number of other energy taxes, and changes in the profit tax regime. 58 See IMF (2002). 59 Govemment revenues become less sensitive as export tariffs are zero at prices below US$15 per barrel. A collapse of oil prices could render higher cost producers unprofitable and could have a large impact on output. The same follows from the fact that a substantial part of windfall gains has been saved (rather than being used to boost demand). 35 inflows in response to deteriorating growth prospects and financial imbalances have in turn led to macroeconomic instability and in some cases to outright financial crises. This was the situation in Russia in 1997-98. Following a period of large private capital outflows in 1998-2001, these flows strengthened significantly in 2002 although in net terms they remained negative. Nevertheless, in conjunction with the large current account surplus, in part reflecting high oil prices, the overall balance of payments recorded very large surpluses. 3.20 The appropriate policy response to a surge in private capital inflows depends on the nature of these flows. To the extent that they represent foreign direct investment this is generally welcome, as they should be associated with higher investment and productivity growth. Also, imports would be likely to grow more strongly than exports in the early phase of an increase in FDI, offsetting some of the upward pressure on the real exchange rate. Sirmilarly, private flows could help finance much needed infrastructure investments, whether by the private or the public sector, which would raise the productive capacity of the economy. However, to the extent that private capital is used to finance the budget, it is critical that such financing is sufficiently long term. This has generally proved difficult to achieve. Most private portfolio flows are of a short- term nature and are subject to rapid reversals, potentially causing critical roll-over problems. Reliance on such flows, whether to the public or the private sector, should generally be resisted. A prudent fiscal policy that relies mainly on long-term financing is key to ensuring stable budget financing, and efforts to develop domestic capital markets and extend maturities are needed. At the same time, policies aimed at strengthening the financial sector, including through improved' regulation and supervision, and at improving corporate governance practices are essential. Restrictions on capital inflows (and outflows) tend to be ineffective, although liberalization of the capital account should proceed cautiously. 3.21 Although the precise nature of the recent strengthening of private capital inflows in Russia is uncertain, it appears that these inflows reflect mainly a surge in extemal corporate borrowing, in particular from the energy sector, rather than an increase in FDI (the government bond market remains closed to outside investors). While companies seem to have been successful in extending maturities to the 5-10 year range, there is valid concem about what these resources are being used for. There is some evidence that they have been used to acquire other companies in an effort to enhance market control rather than possibly more productive investments. Under these circumstances, the Government needs to monitor these flows carefully, without appearing as a guarantor for their repayment. It may also be advisable to continue some degree of sterilized intervention to further strengthen reserves and reduce upward pressures on the real exchange rate. D. Conclusions 3.22 Russia's prudent conduct of macroeconomic policies in recent years, the continued strong balance of payments, the significant decline in public and external debt, and the comfortable reserve position have placed it well in terms of preserving macroeconomic stability in the coming years. Russia should be able to manage both the hump in debt service payments in 2003-05 and a significant decline in oil prices from their current level without needing again to access exceptional financing. 3.23 Nevertheless, important challenges remain. In particular, a continuation of very high global oil prices combined with a further, sharp strengthening of private capital inflows could lead to excessive upward pressures on the real exchange rate, thus undermining already fragile growth prospects. At the same time, fiscal expenditure pressures may increase further as a result of both the upcoming elections in 2003-04 and the costs related to the implementation of the 36 reform program. Under these conditions, it is critical to maintain a firm underlying fiscal stance with a primary balance of 2-3 percent of GDP over the medium term, including through ensuring that additional tax reforms do not result in a further significant decline in revenues and rationalizing expenditures. Also, monetary policy should be geared to ensuring a more ambitious reduction in core inflation in the context of a less managed floating exchange rate regime. 37 4. ENHANCING HUMAN CAPABILITIES AND PROTECTING THE VULNERABLE 4.1 The ultimate challenge for Russia is to improve the living standards for all its people. A key aspect of this effort is to build on the strengths of the Russian economy in terms of its human capital base, notwithstanding the adverse trends during the early transition period. Strengthening human capabilities is essential to ensuring that current and future generations can exploit the growing opportunities in the economy and improve their living standards. This needs to be complemented by moves towards a fiscally affordable social safety net system that provides adequate benefits to those most in need. This is particularly important to cushion the adverse social impact of economic restructuring. The role of public expenditures is particularly important in providing old age security as well as social transfers to the most vulnerable groups. A. Enhancing Educational Outcomes Figure 4.1: Educational Outcomes for Selected 4.2 Evidence from international surveys Countries, 1999 suggests that Russia's academic standards in two areas of traditional strength - mathematics and science - are being maintained. For example, 90 72 per cent of its eighth grade students tested by 70 the Third International Mathematics and Science so " Study (TIMSS) in 1999 reached the median i;1i9 international benchmark score in mathematics 40 ||191 (Figure 4.1), about the same proportion as four X 30 years earlier. In both level and trend, Russia 1. matched the average achievements of other L countries in the sample classified by UNDP as s I "high human development" for both years and i s did considerably better than, for example, the 5 United States and Italy. In science its TIMSS results showed a similar picture. 4.3 However, in the OECD Program for Ji International Student Assessment (PISA), 4 L Russia is a little behind the high human 0 development countries in reading literacy, I mathematical literacy, and scientific literacy. 40 While the demands of a market economy may s require greater stress on the latter, the gap is not c Hungw Pohnd Pbnn LaNh Hgh MD large and can be addressed through a more flexible approach to learning, which would not P s~~~~~~~~~~~~~~ P*oio teo t w P#of rd cy tsoWo k jeopardize traditional strengths. However, Pdonna t on( kodnehmtbal RcMs=W other gaps are emerging which raise questions Sources: UNICEF (2002) Mullis et al. (2000), OECD about future prospects for the accumulation of (2001). human capital and for national competitiveness. 4.4 Declining Enrollment Rates in Below-Secondary Education. The first decade of transition has seen drops in enrollment rates at most levels of education. At the pre-primary level, in common with the rest of the Europe and Central Asia region, enrollment rates fell sharply in the early 1990s, but they have risen slightly again since 1994 to around 65 percent of the age 38 group: such schools had a custodial as well as a developmental role and their decline is mainly reflected in the falls in female labor force participation. Basic education enrollment rates also slipped in the early years of transition but have revived since 1993. Nevertheless, dropout in the lower secondary phase of basic education is worrying and is reflected in poor graduation rates and growth in the number of 15-18 year olds who ame neither in school nor in the labor force. Enrollment rates in both types of secondary vocational/technical schools have fallen in Russia as in other parts of the region, but have stabilized at just over 40 percent since 1994. The fall reflects the closure of some vocational schools, especially those directly linked with non-viable enterprises outside of urban centers. 6 4.5 lReeonad llnequ<y. There is a growing and persistent regional inequality, reflected in differences in educational expenditures and progress in educational reform, with many of the poorest regions struggling to maintain the basic mquirements for high learing achievement in schools.6' Regions with declining school-age populations have not tended to close schools proportionately, and so their average enrollments and student-teacher ratios have fallen and unit costs have risen. There is evidence of enormous variation between regions in their ability to construct new schools and to make repairs and improvements to existing ones.62 4.6 Income Jleqhtiec. Earlier data from 1996 had indicated that enrollment rates were lower for children from poorer families. More recent data are not available to indicate whether these have persisted or not. However, the importance of family income and parental education in determnining enrollment and attendance rose during the 1990s. This in turn implies the increasing burden of schooling costs and may make it difficult for children from poorer families to stay in the school system. At the same time, there is evidence that access to education and the quality of schooling are notably worse in rural than in urban areas. Rural schools cannot afford proper maintenance, sanitation is inadequate, school materials and textbooks are lacling, and fimancial support is less than that for city schools. These trends, which tend to widen the gap between the rich and the poor, are being aggravated by the emergence of an elitist ethic in educational circles, with increasing emphasis on selective secondary schooling in gymnasia and lycea, and exclusive school-university agreements. The growth of private options is important and is inevitable as the market responds to the changing demand for superior quality education and provides greater choice. But these private options also widen the opportunity gap between the rich and the poor, making it more difficult for the poor to take advantage of, and contribute to, economic growth. 4.7 Weak Financial lEncendives for Boetfter Benonmmnmee. Even as the obligations for educational spending have largely devolved to local levels, the limited revenue autonomy and revenue base imply that most regions still rely on federal transfers through a non-transparent and inflexible budget process which undermines incentives for efficient use of funds. There is little incentive for schools to economize on particular areas of spending, since the school is unlikely to benefit from the savings. Indeed, there is an incentive for schools to inflate their "needs," for example, by hiring and retaining as many teachers as possible. 60 In upper secondary general schools, in contrast, enrollment rates have risen significantly, particularly since 1994, to around 29 percent. This has not been sufficient, however, to prevent a fall in the total upper secondary enrollment rate (vocational/technical + general) from 78 percent in 1989 to 70 percent in 2030. Tertiary education-has boomed in Russia as elsewhere in the region, with enrollment rates rising from less than 25 percent in 1989 to over 36 percent in 2030. The proportion of women in higher education, always high in Russia, has increased slightly to 56 percent. 61 See Canning et al.(1999):20, for a more detailed discussion, albeit on 1999 data. 62 To some extent lower educational expenditures per child may be masked by measures of educational expenditures per head of the population because of regional differences in dependency ratios and other special characteristics of regions. 39 4.8 Teachers' Incentives. Perhaps the greatest single problem facing schools in Russia is the collapse in the purchasing power of teachers' salaries. Real salaries in education fell by between 50 and 80 percent between 1989 and 2000 (see Figure4.2: TrendsinTeachers'Salaries,1989-2000 Figure 4.2), with adverse consequences for teachers' standards of living. This has led 120 to low morale, and lower intake 100 v Azertbaan of younger teachers in 8 -9- Armenia comparison with advanced " 80 --* Na countries. Delays in the 60Ussia payment of inadequate salaries 40 \ Uzbek-t- have also been common in the -- 1-\ UkrWSne past. Teachers' salaries currently 20 range from Rb450 to Rb2,025 o- _ _ , _ per month, and the average 8 ': g g a a wage in education in 2001 was Rbl,8 15, only 55 percent of the nil,85ol averag wge.rcento Source: CIS Stat and TransMONEE database. national average wage. Recent Government initiatives have sought to redress this imbalance through real increases in public sector wages and reductions in wage arrears. But a program to provide incentive wages to teachers will have to rely on sectoral budgetary savings to- finance such incentives. These savings could come from projected demographic changes which suggest a reduction in the future school cohorts.63 This would suggest some scope for school consolidation and a reduction in the number of teachers. 4.9 Public Expenditures on School Maintenance and Supplies. Of the total state expenditures on education in 2001 (of Rb221,727 million), 46 percent was spent on salaries, meals, and medical expenses; and only 3 percent was spent on construction and 2 percent on equipment. Over 37 percent of compulsory schools are judged to be in need of major repairs and over 5 percent are condemned. Shortages of teaching materials and equipment are affecting the quality of education."( 4.10 The Government Program. To address the above issues, the Government's reform program stresses three objectives: accessibility, quality, and merit.65 In general education, reforms are being planned around a shift to the modernization of education content and the rationalization ("optimization") of school networks to respond to a shrinking population. Plans for the latter include a proposed shift to a formula-funding mechanism that will distribute funding through capitation grants - the principle of "money follows the student"; it is hoped that this will begin to counter the underfunding that, since 1992, has contributed to the deterioration of the education system and to the unfair distribution of its availability to different sections of the population. 4.11 The amount of money allocated to a school will be based on the number of its pupils, adjusted only for location (urban/rural), school size, type of education, education for children with exceptional academic abilities, special needs or health problems, enhanced education in 63 Between 2000 and 2005, the number of children in the 3-17 age group is expected to fall by 20 percent, with even larger falls in the cases of primary and lower secondary school-age children. 64 See TIMSS (2000). 65 The State Council of the Russian Federation Project: Educational Policy of Russia at the Current Stage: July 2001. 40 specific subjects, and "family education." Each school will have its own bank account, and the school director (accountable to the municipality and to parents) will be responsible for budget management and will be permitted to transfer savings made under one budget heading to another. This reform is expected to encourage rationalization of the schools network (since schools with very few pupils will become non-viable) and optimization of the use of resources within schools. However, it will need to be reinforced by the provision of reliable and affordable transport to school for rural pupils, and to be accompanied by measures to prevent the benefits of rationalization from accruing disproportionately to the more informed educated/middle classes and to protect the interests of children in schools destined for closure. 4.12 There has also been progress in reconsidering the chaotic and unpredictable arrangements for measuring student progress and the certification of standards achieved. These activities have also contributed to inequitable access to different levels of education as they became fragmented and distorted with the decentralization of the education system. The development of open certification standards through the introduction of a single state examination for entry to the tertiary level of education is now being piloted on a regional basis. Preliminary results from this program in 2001 are encouraging in that some of the underlying problems of the system are becoming more apparent to policymakers. 4.13 The E-Russia and E-Education programs are two of several major policy initiatives related to ICT that have been launched by a Government motivated by President Putin's declared vision of a modemized Russia. These Federal Government programs are complemented by several large-scale private sector programs that are still being workled out; but these are aimed at teacher training, Internet portal development for education, and satellite educational television. However, there is a lack of a strategic planning framework and of coordination for these programs, stemming from the involvement of multiple players (including several federal ministries) with often overlapping responsibilities. 4.14 Additional fiscal resources are also being redirected to the education sector. Most of these measures are for teachers' salaries which, for the most part, are now paid on time. But increases in investments are also being made to modernize school facilities through the installation of computers within the Eramework of the E-EdMcation program. In a number of regions, additional expenditures are also being undertaken to finance the provision of school buses, and a broader program of rural school restructuring is under way. B. limproving IHIenltJ (Dutcommes 4.15 The threat to economic growth and productivity stemmuing from illnesses and premature deaths is a serious problem in Russia. Death rates from chronic non-communicable diseases remain high and death rates are projected to grow because of infectious diseases-in particular, the dual epidemics of tuberculosis (TB) and HIV/AlDS. The standardized death rate (SDR) from cardiovascular diseases (for ages 0-64, per 100,000 population) is 211 compared with the EU average of 53. As result of the resurgence of tuberculosis, and of AIDS and other sexually transmitted infections, the SDR from infectious diseases is significantly higher-19.7 in Russia compared to 6.3 in the EU. As discussed in Chapter 1, adult mortality has risen sharply during transition. Increased mortality rates for adults, primarily males, are driven by increased rates of cardiovascular diseases, circulatory problems, alcohol-related causes, and violence. As a result, male life expectancy is only 59 years compared with 68 years in Poland and 75 years in the United Kingdom. The probability of males dying between ages 15 and 59 is 35 percent compared with 11 percent in the United Kingdom. 41 4.16 The Growing Threat of AIDS. According to the Russian Federal AIDS Center, Russia has around I million H[V positive individuals, and, together with Ukraine, has the highest growth rate of registered infections worldwide. The number of registered cases has doubled every 12 months and by May 1, 2001, had reached 193,400 persons.66. Until now, HIV has been predominantly transmitted among intravenous drug users who share needles (the high-risk core transmnitters), but the disease is spreading rapidly to the general population through sexual contacts, blood transfusions and, especially, prostitution (the bridge population). The younger generation is disproportionately affected, with about 60 percent of the HuV-infected individuals being between 20 and 30 years of age 4.17 This trend is a serious threat to the long-term growth and welfare prospects of the country.67 If no policy changes are made, estimates suggest that, by 2010, the number of deaths due to HIV/AI)S may be very large, and the cumulative number of HIV-infected individuals may rise to at least 2.3 million. Under conservative assumptions, this could lead to a decline in GDP of 10 percent by 2020 relative to a scenario without the spread of HIV. This is likely to be accompanied by even larger declines in investment and labor supply. As time goes by, these costs will accumulate more rapidly. Most important, if HIV continues unabated, it will undercut Russia's long-term economic growth rate more severely. By 2020, growth is then estimated to be lower by a full percentage point. 4.18 The costs of the spread of HIV arise from different sources. First, the treatment cost for preventing the onset of AIDS in those who are HIV positive is very expensive. Antiretroviral treatment comes to about US$9,000 per patient per year. Recently, several countries managed to negotiate down these costs, but even a resultant cost of US$3,000 per patient per year would break the health budget in a country such as Russia, where annual GDP per capita is a little above US$2,000. Second, the spread of the disease will lead to a reduction in the supply of labor as people die; labor productivity will also suffer as soon as HIV is detected. Third, savings and investment will be affected by the diversion of resources necessary to fight the problem. Finally, the disproportionate numbers of the young affected by the virus will worsen the demographic changes in society and increase the burden on the working population. 4.19 Russia's response to the HIV/AIDS epidemic has been weak and patchy to date, with little emphasis on prevention among the most vulnerable groups. In 1995, the Russian Government adopted the Federal Law on the Prevention of the Spread of Disease caused by HIV. The law has been implemented through the Federal Anti-FHV/AIDS.Program, which ran from 1996 to 2001. The current Federal Anti-HIV/AIDS Program will last from 2002 to 2007. There are signs of increasing political commitment to start addressing these issues as evidenced in part by progress in scaling up HIV/AHDS and tuberculosis control. 4.20 Inefficiencies and Inequities in Health Spending. Real public sector health care expenditures have declined by one-third in the past decade. Despite falling trends in public expenditures, inefficiencies remain. While there have been modest declines in the number of beds and staff per 1,000 population, the figure remains significantly higher than that in much wealthier countries. There are also issues related to the types and distribution of personnel. There are excessive numbers of personnel that are too specialized and too hospital-based, while the more cost-effective primary and emergency care systems remain underdeveloped. Despite this 66 However, relatively few people in Russia have taken an AIDS test and therefore estimates of the total number of infected individuals depend on the "multiplier" used to translate registered into actual cases. These estimates vary from 800,000 to more than 1 million. 67 See World Bank, 2002f. It provides a simulation model, designed to calculate the economic costs of HIV. The full report is available at: www.worldbank.org.ru. 42 discrepancy between the low level of resources and the excessive hospital infrastructure, the norms and standards for clinical practice and for the organization of health care have not been adjusted to modernize the health care delivery system. Protocols of care are sometimes decades behind comparable standards in EU countries. The current system of financing lacks appropriate incentives to providers to improve efficiency or quality. Regional inequities are growing. Per capita public spending variations are now estimated to be tenfold to fifteen fold across the 89 regions, with rural-urban disparities within regions and a burgeoning underclass in Russia. The private sector is largely unregulated, but out-of-pocket expenditres are estimated to be about 54 percent of all spending for 2001. This suggests significant risks of impoverishment of access to "f health care services and drugs, especially for the poor who can hardly afford these informal payments. Efforts to improve health status, services, and finance should focus on improving health outcomes and developing both the instruments and the institutional capacity for a more efficient and equitable health systemL 4.21 ?aor Qualty of lHeealth erviceas Shifting from specialized inpatient care to outpatient services has been the main strategic focus of restructuring in the past decade, particularly at the level of primary care. However, despite the introduction of the State Family Medicine Program in 1992 and the General Practice (family medicine) Program in 1999, efforts to improve the primary medical care system have progressed slowly, largely because of weak interaction with the rest of the health care systenL In addition, the training and accreditation of family doctors have not been standardized in line with global best practices. Experience to date shows that the expansion of primary medical care is not possible without the withdrawal of resources required for the improvement of primary care from other parts of the health care system. This would require significant restructuring of secondary care, which at the moment absorbs a disproportionately high share of resources. Since the late 1980s, pilot projects have been implemented in Russia to introduce new provider payment systems, which could create financial incentives to improve service outcomes. While some pilots had rather impressive outcomes, it is clear that changes in the fundamentally provider payment system alone cannot reform the entire health care system. This is especially true if facility sizes are to be reduced and if facilities are merged or closed. The introduction of a proper scheme of financial incentives is a must but it is not the only prerequisite for rationalization. 4.22 Frugnnentiomn oi HleeR Sectoir Gove mm Wei Pae,ge t. lHealth system reforms in Russia have suffered from the inconsistencies and contradictions in the operating legislative and legal basis. This legislation developed during the 1990s to define the obligations and responsibilities of the various stakeholders at different Government levels, but the legislation was not always in compliance with the basic federal laws,68 and did not clarify the authority necessary for effective operations between the health administration and the health insurance system. While Russia has developed a decentralized health care system in which financing comes from payroll contributions in the regions complemented by allocations from regional budgets for the non-working population, the role of the federal level remains unclear. 4.23 At the federal level, the capacity to carry out the regulatory policymaking guidelines and economic and financial analyses is limited. Since decentralization, the Ministry of Health (MOH) has occasionally made some attempts to take the lead in health care reform, but it lacks the resources to develop the technical and regulatory basis for consistent reform country-wide and its financial leverage to influence the regions is limited. Some regions still expect guidance from the federal level, but many have assumed significant autonomy. About 10-15 regions have 68 The basic laws were: "Fundamentals of Legislation in Public Health Care in the Russian Federation"; and the Russian Federation Law "On Public Medical Insurance in the Russian Federation." 43 introduced various degrees of innovations experimenting with new methods of organizing health care and paying providers, often in contradiction to outdated federal norms. As a result, there is little consistency in the quality and scope of state-sponsored care across regions. The majority of regions lack the capacity to correctly manage health resources or develop appropriate reform strategies. At the facility level, managers are mostly physicians without management training, and are not appropriately trained to plan and manage physical, human, and financial resources. 4.24 Fragmentation of Health Insurance. In 1991 and 1993, Russia adopted a series of laws introducing payroll-tax financed mandatory health insurance (MM) to supplement public budgets for health. This involved the establishment of a Federal Health Insurance Fund (FBIF) to oversee the system country-wide, Territorial Health Insurance Funds (TH1F) to implement the system at the regional level, and health insurance intermediary organizations (public and private) to receive capitation payments from the THIF on behalf of consumers and in turn to purchase services from providers on their behalf. 4.25 The implementation of MHI has not generated the expected favorable results. Rather than increasing resources for health as intended, the introduction of MI has actually led to the erosion of budgetary allocations for health as increases in payroll funding have been offset by cuts in budgetary expenditures. The regions have also been unwilling to pool funds under the regional health insurance funds as called for in the legislation. This has effectively created two parallel health care delivery structures with cost shifting by providers. The allocation formula across regions and within regions for budgets (to be distinguished from payroll-based funds) tends to be the same as in Soviet times - input-based, such as number of beds or staff-and does not provide the necessary incentives for improvemeDts in service delivery. The money reaches facilities on a line-item budget basis which fails to allow for the use of funds across lines or across budget years. The establishment of separate sources of funding which are not pooled but allocated separately and under different rules has led to the fragmentation of health expenditures, and has made it more difficult to adopt consistent reforms at the regional level. 4.26 The Government's Reform Program. The Govermnent's strategy in the health sector was originally documented in the "Concept for Development of Health Care and Medical Science in the Russian Federation," adopted in November 1997. The MOH is designated to lead the Government's effort under this program. The central theme of the document is the urgent need to improve the efficiency of health care services by the following means: (a) Rationalizing the structure of health services at all levels with an increased role for preventive measures and primary care services and more efficient use of diagnostic and hospital resources and improving the interface among all levels and types of care. (b) Improving financial and resource management and introducing appropriate incentives for providers. (c) Improving sector-wide governance and clarifying governance relationships between different levels of government - federal, regional, municipal, and district. (d) Establishing a unified medical-social insurance system (MSI) so as to avoid the problems caused by the present fragmentation. 44 4.27 Since the Russian Federation began to reform its health system a decade ago, real progress has been limited in the areas of institutional development and modemization of the approaches to surveillance, health promotion, and disease control. Areas for additional action include: (i) a large-scale program of disease control and health promotion which would include the control of TB and HIVIAIDS, tobacco control, the promotion of healthy diets and exercise, and moderation in alcohol consumption; (ii) the development of an epidemiologic2l surveillance system; and (iii) capacity building for professionals and institutions, including improved access to and utilization of global knowledge. Without rapid and effective government interventions, the burden of communicable and non- comnmunicable diseases risks IFaguire 63: ' le Tha :.U ni O & S o L I 1 -,]i Rn pushing Russia's health system tfe ĥrOul Z i' 3 la eItlLil2() onto a high-cost trajectory. C. Emsunring 01d Age Security 69 4.28 The pension system in / / Russia is the largest component of / i - the social benefits system, ! contributing to almost two-thirds \ \ *.- of the benefits received by the population (see Figure 4.3). The recent introduction of a multi- - . pillar pension reform program V signals a major shift in pension provision in Russia. Specifically, the reform embodies significant Source World Bank, 2002. changes in the pay-as-you-go (PAYG) systen, or the first pillar, shifting from a defined benefit (DB) system to a notional defined contribution (NDC) system, supplemented by a basic benefit, and introducing a mandatory privately managed second pillar. The funded part of the ]Russian pension scheme will have the structure of a provident fund with extemal asset managers (i.e., workers will not have a choice of managers), and will be operated by the Russian Pension Fund. 4.29 The reform addresses several problems embodied in the old pension system. The old system featured very complex and overlapping benefit fonmulas, and extensive eligibility conditions, including early retirement for many occupations. The benefit formula also mixed distribution and savings/insurance objectives. Combined with the high tax rate, these over- lapping objectives reduced the incentives to contribute to the system distorted labor markets, and introduced perverse incentives to retire early. The declining contributor to pensioner ratio increased the financial costs of the scheme. Moreover, the aging of the population further accentuated problems with respect to the fiscal solvency of the pension system. 4.30 The new pension system seeks to improve transparency and reduce the complexity of the pension system by creating a simple benefit formula and simple eligibility conditions. By separating efficiency and re-distributive goals in the benefit formula, the reform seeks to increase individual incentives to contribute and to work longer, and to reduce labor markcet distortions. Linking benefits more tightly to contributions also has the objective of increasing the financial solvency of the pension system. The savings/insurance objectives of the scheme will now be met 69 This section derives from Rashid et al. (2002). 45 by the NDC system which links benefits explicitly to contributions; and by the funded privately managed scheme (second pillar). The re-distributive elements will be embodied in the flat benefit provided to all eligible workers by the basic pension scheme. The occupational pensions will be replaced by an employer-based funded scheme and early retirees will receive a commensurately lower pension. Shifting some contributions to a funded and privately managed system should help deepen capital markets and promote economic growth. 4.31 The main question regarding the ongoing reforms is whether these ambitious goals will be realized. Will the reform provide adequate returns on the savings of individuals, while achieving financial solvency? Is the administrative capacity of the Russian Pension Fund and the tax authorities adequate to store more individual information, manage individual accounts, and allow the exchange of money and information required in the new pension system? Are financial markets ready to handle the flow of funds from public pension savings? Is the regulatory and supervisory structure adequate to prevent any governance and corruption issues that may arise from private and public management of pension funds? 4.32 The reformers are well aware of the challenges they face and the work that will be required to implement pension reform, but they are optimistic that these goals are well within their reach. The passage of the necessary legislation for reforms was critical to initiating the reform process. Now, the passage of the remaining legislation (e.g., the investment law and occupational pensions laws) and reform implementation will be the main focus of their efforts. The reformers also stress that the initial infrastructure to support the reform-namely, an individual accounting system which covers all current workers (more than 65 million people)-- has already been introduced and should help in the implementation of the reforms. However, there are four key issues that will need to be addressed to ensure that the pension reform is successfully implemented in Russia. 4.33 Pension Reform Design. The design of the first pillar poses significant challenges to achieving the reform objectives. Specifically, the NDC system proposed for Russia is different from that practiced in other countries: retirement ages are not increased (despite limited differences in life expectancy at retirement between Russia and other transition and OECD countries where the retirement age is much higher) and the benefit payout period is not linked explicitly to life expectancy at retirement. The tight link between contributions and benefits found in the standard NDC system is compromised by a very heavy tax on worker contributions imposed by the restrictive valorization of individual accounts. These design features of the new pension system will reduce the incentives to work longer, as well as dampening incentives to contribute to the pension system. They will also reduce the potential gains in the direction of fiscal solvency. Further, international evidence indicates that the second pillar design chosen by Russia-a provident fund-requires the Pension Fund of Russia, the key implementation agency of the reform, to improve its transparency and its accountability to the public. 4.34 Fiscal Sustainability. The pension reform program is fiscally sustainable (and even realizes some surpluses) under base case economic assumptions, but with two caveats. First, while there is a surplus in the basic benefit program, the notional defined contribution program remains in continuous deficit. Thus, fiscal solvency assumes that surpluses from the basic benefit program will in fact be used to cover the deficits of the NDC system. Second, given unchanged retirement ages, fiscal solvency can only be achieved at very low and falling replacement rates. Under base case assumptions, replacement rates declined from 36 percent to 24 percent in 2012, and further to 19 percent at the end of the projection period. The reform is therefore not likely to be politically sustainable. Demand from pensioners to increase pensions is likely to lead to ad hoc Government interventions to increase the generosity of pensions that might ultimately 46 undermine its fiscal sustainability. Fiscal sustainability and higher replacement rates (and therefore political sustainability) can only be achieved by raising the retirement ages of the pensioners and linking the pension payout period to life expectancy at retirement. These measures will also improve incentives to work and contribute to the pension system. 4.35 ComRemnenitiry Finamic Mairket ?ReTonms. Russia currently lacks many of the main financial market requirements for successful pension reform. While some degree of macro- stability has been achieved, less progress has been made towards developing the following: a core set of solvent banks and licensed custodians; strict regulations that allow entry of only high quality asset managers (through international bidding) to manage pension funds; a government debt management strategy (because initially most managers will be heavily invested in bonds); and some basic elements of financial infrastructure and corporate governance (correct valuation of assets; reliable information about participating institutions; and protection of minority stakeholders). However, the slow pace of pension reforms, the proposed limits on private sector participation, and a passive investment strategy (assuming proper valuation of assets and the construction of an index by an independent agency) mean that the absorptive capacity of financial markets is not an immediate issue. However, in the long run, capital market development in Russia will have to go hand in hand with pension reform. While some of the capital market constraints can be overcome through the investment of pension funds abroad, this is unlikely to be politically feasible. 4.36 Asldmfnistve Cap&acty. The new pension system imposes considerable administrative challenges for the Government. The main administrative issues that should be addressed for the successful implementation of pension reform are: (i) creating an accurate, integrated, national database for tracing pension credits and accounts of individual workers; (ii) developing a modern financial mnanagement system to track the movement of funds through the pension and tax systems and generate reports of the fimancial condition of the pension system (through private sector audits of key institutions based on international accounting practices); (iii) instituting the regular issuance to each individual worker of an annual statement showing pension contributions credited to the worker in that year and the current balance in the worker's funded account; (iv) upgrading staff skills/capacity, and concluding regional agreements to implement PFR's new payment function role; (v) ensuring the coordination of functions between the Treasury, the Tax Authority and the Pension Fund on the collection of data and funds and instituting procedures for tax reconciliation of differences; and (vi) last but not least, developing an implementation plan. The successful implementation of a reform as complex as the Russian reform requires good planning, effective coordination, and realistic implementation timeframes. Intemational evidence from Sweden and Poland shows that, for successful implementation, these issues should ideally be resolved prior to the implementation of the reform. ID. Targedng the Safety Net Systemn70 4.37 Notwithstanding its many problems, the safety net system in Russia is generally credited with having softened the social impact of the economic crises.71 The public social assistance program comprises a range of cash benefits (such as child allowances and social assistance) as well as subsidies and privileges (such as housing allowances, transportation subsidies, subsidized 70 This section derives from Rashid and Posarac (2002). 71 Lokshin and Ravallion (2000) found that during the 1998 crisis the incidence of poverty was reduced relative to that which would have occurred if such public programs had not existed. Richter (2000) also found that keeping transfers at the 1994 levels would have reduced poverty by 10 percent in 1998. 47 utilities, special benefits to particular groups) and social care services for vulnerable individuals, including long-term institutional care. 4.38 Social Privileges and Subsidies. The coverage, level of benefit, and targeting (marginally) improved between 1998 and 2000 (according to Goskomstat data and the RLMS) because of improvements in economic conditions over the two-year period. However, these programs are not well targeted to the poor. The actual coverage of subsidies and privileges is lower than formal entitlements. In 1999, according to particular assumptions based on household budget survey data, there were about 32.8 million recipients of privileges and subsidies. Transportation and housing subsidies were the most prevalent among the population-received by about 20 percent of the households respectively in both years, while the number of recipients of food subsidies was very low-only 4-5 percent of all households in 1999-2000. The main recipients of subsidies-in terms of incidence-were concentrated in urban areas, even though rural areas have a higher incidence of poverty. Only food subsidies had a higher incidence in rural areas. The Government's economic reform program proposes to phase out most of the privileges and subsidies and convert others into cash benefits or wage supplements. However, the proposed phasing out of benefits is facing strong political resistance and therefore has yet to be realized. 4.39 The privilege/subsidy system faces three main issues: (i) by law, the eligibility covers over 70 percent of the population; (ii) the Government does not, indeed cannot, financially honor all its obligations under this mandate; and (iii) the privilege/subsidy system promotes inequitable use of scarce resources, as it does not explicitly benefit the neediest, that is, families with low income and at high risk of poverty. 4.40 Cash Benefits System. The cash benefits program includes child allowances, social assistance payments, maternity benefits, birth grants, and benefits to mothers with children under 3 years of age. Only child allowances and social assistance are specifically targeted to the poor. The Government introduced means testing of child allowances in the early 1990s and also introduced a federally mandated regionally financed targeted social assistance program. The most recent reform program strengthened the Government's resolve to improve the targeting of cash benefits. The de-linking from 2000 of these benefits from the minimum wage (which had been substantially eroded in real terms in the 1990s) is an important step in the decompression of cash benefits. 4.41 Recent economic growth and fiscal surpluses improved the coverage of child allowances between 1998 and 2000 as arrears declined, but targeting remains a problem. Evidence from the RLMS surveys shows that the targeted cash benefits program (social assistance/child allowances) in 2001 still covered disproportionately few poor and provided low benefits. While the targeting of child benefits improved in 2001 (relative to 1998), the targeting efficiency of the program could still be improved substantially. Since mid-2000, child allowances and, more recently, unemployment benefits, are financed by federal general revenues, but are implemented at the regional level. The reason for the consolidation of financing/benefits payments at the federal rather than the regional level was to eliminate arrears and disparities in financing across regions, which resulted from the decentralized provision of benefits. It is not clear whether this consolidation will be sufficient to achieve these objectives. The experience with child allowances suggests that arrears and regional inequities can persist even after the benefit is paid from general revenues. 4.42 The efforts to consolidate benefits at the federal level have not affected social assistance. The benefit is mandated by the Federal Law, but the responsibility for its funding is devolved to 48 the regions.72 The only federal mechanism for providing social assistance is the regional equalization fund. However, as noted above, this fund does not specifically earmark transfers for social assistance. Specifically, regional budgets (41 percent), local budgets (32 percent), the federal budget (6 percent), and other sources such as donations (21 percent) are used to finance social assistance programs targeted to the poor. The information on expenditures on social assistance at the regional level is difficult to obtain, as the benefit is paid at the municipal level and is often paid in kind. It is therefore very difficult for the central or regional governments to monitor the effectiveness of this program 4.43 Seia Caire SeiRvlce. Over the last 10 years the number of children deprived of birth parental care in Russia has increased by 40.3 percent, reaching 663,080, or almost 2 percent of the child population in 2000. The number of neglected and homeless children has also increased, though their composition and number remain controversial. This increase in the number of vulnerable children has occurred at the same time that falling birth rates have reduced the total population of children in the country. Ensuring that these vulnerable children develop into socially well adjusted and economically productive individuals is therefore of critical importance to Russia. 4.44 Most of the children deprived of birth parental care have been placed in a family environment-adopted, placed with relatives (under a guardianship or trusteeship), or cared for by foster families. However, some 27 percent are institutionalized. In 208, approximately 400,000 Russian children were placed in residential institutions because of deprivation of birth parental care, disabilities (particularly mental disabilities), or poverty. Most disturbing over the past decade is the fact that the share of residential care in the annual placement of children deprived of birth parental care has been steadily growing. In 200, some 29 percent of new placements were in residential institutions (versus 22.5 percent in 1990). In addition, another 8.6 percent were in temporary shelters waiting to be placed (in 1990 there were no new entrants waiting to be placed in care). 4.45 The institutionalization of children contributes to a major loss of human and social capital in Russia and has been emnpirically found to be detrimental to a child's mental and social development, impairing his/her ability to successfully integrate into mainstream society. Institutionalized children tend to incur higher rates of crime and abuse than children who live in a family enviromnent. Institutionalized care is also a very expensive care option. For these reasons, most Western countries have sharply reduced or even eliminated institutionalized care. Countries such as Latvia, Romania, and Bulgaria have also started the de-institutionalization process. Like Western countries, these countries have initiated the development of alternative forms of care for children deprived of parental rights. 4.46 The alternatives to de-institutionalization include preventive care services and family based options for care. Preventive, or social welfare services, provide families at risk with counseling and/or other services (alcohol/abuse prevention) that help vulnerable/at risk families solve their problems and stay together. These services effectively reduce the flow of children deprived of birth parental care. For those children who are not able to stay with their own parents, despite assistance from social welfare services, alternative family based care options include adoption services, foster care, and guardianship. Family based options allow children to receive care in a nurturing family environment-the best option for children without birth parental care. 72 In compliance with Presidential Decree #405 "On Immediate Measures to Stabilize Living Standards of the Population of the RF in 1993" dated 3/27/93, subjects of the Russian Federation were made responsible for the provision of social assistance to the poor. 49 4.47 At the same time as these services are being developed, it is important to address the problems associated with the de-institutionalization process. This involves finding alternate family care for children currently in institutions; re-deploying staff through training (for transforming them into care givers); and rationalizing facilities currently in use at institutions. 4.48 Government Strategy and Issues in Implementation. The goals of the Government's strategy for social safety nets are: (i) developing a social assistance program that is adequately financed and well targeted to the poor, and that minimizes work disincentives; (ii) phasing out privileges and subsidies; (iii) shifting care for vulnerable children from institutionalized care to preventive services and family based care; and (iv) instituting the monitoring of programs to ensure that they achieve their objectives of targeting the most vulnerable groups. The main challenges facing the Government in this strategy are the following: (a) Reducing the mismatch between resources and obligations. A necessary condition for ameliorating regional inequities and providing greater certainty of benefits (no arrears) is to ensure that adequate financing for program obligations is budgeted and that these financial resources are available for execution throughout the year. (b) Improving targeting and program adequacy. While the recent payback in arrears has improved the targeting of both cash transfers and privileges/subsidies (at least of fuel and rent subsidies) towards the poor, these programs still continue to leak towards non-poor households. Improvements in targeting will allow an increase in the level of social assistance and child allowances, making them more adequate benefits than is currently the case. To improve the targeting of the safety net, the following should be considered: (i) The phasing out of privileges should be expedited, as many of these privileges appear not to be targeted to the poor. Moreover, privileges tend to provide extra retirement income to supplement pensions. This suggests that if entitlements were frozen (and grandfathered), most privileges would be phased out in a relatively short time. Privileges for the small proportion of individuals (5.1 percent) who receive them as part of their job should be transformed into "employee benefits" and paid as cash transfers rather than being paid in-kind, if they are deemed appropriate additions to compensation. The phasing out should be followed by the provision of an effective social assistance (or poverty) benefit at the regional level. (ii) What type of targeting works best? The innovative practices in targeting the poor through the child allowances, social assistance, and housing allowances should be evaluated so that best practice techniques can be identified. It would also be important to assess whether, as in other transition countries, informal income makes targeting of child allowances/and housing allowances on the basis of income and/or assets difficult, and whether some other characteristics for targeting should be introduced to further screen recipients for poverty. For example, to reduce exclusion errors, the program might be targeted to single parent families with many children, which are among the poorest households in Russia. (iii) The targeting practices of the regional equalization fund should be evaluated to ensure that it targets the most needy regions and reduces regional disparities in social assistance. 50 (c) vie g eke suabsies e ngwSi&Nan. The use of a poverty line (such as the subsistence nimum) to target benefits to the poor is consistent with international best practices. As in the case of many countries, Russia targets on the basis of a share of the poverty line where resources are scarce. However, where resources are not scarce, the level of the minimum subsistence should be evaluated to ensure that it is not set too high relative to the wages prevailing in a paticular region. Full targeting at the full subsistence minimurm might have adverse fiscal implications if the subsistence minimum is too high relative to the income per capita of the regional population. Another reason for not targeting at the full subsistence minimum when this is a very high proportion of average wage or minimum income is that it may create work disincentives. This is not an issue now in Russia, given that benefit levels remain low, but it could be a problem in the future if benefit levels increase relative to the subsistence minimum but with no reference to the average regional wage. Therefore, even where resources are not scarce, the ratio of the benefit should be set relative to the average wage (and as some share of the subsistence minimum) in order to avoid work disincentive effects. Finaly, the use of an exogenously determined subsistence minimum might be contrasted with one that might be developed endogenously based on household consumption of food and non-food goods, using the household budget survey. This would allow a more rigorous estimation of the subsistence level of families (for both essential foods and non-food goods) and would potentially avoid political pressu3res from the regions to raise the level in order to garner federal resources. (d) lIDeveloHin modemr soc welIm swvRcns. The changes that have taken place over the last ten years have laid a good foundation for the development of a rights- based, child and family centered, efficient and effective family and child welfare system. Completing the transition from institutionalized care to social care will require a comprehensive child welfare reform strategy, changes in financial allocations, and improved functional coherence of care across diverse administrative bodies in delivering care. It will also require an expansion of preventive family and community based programs. In the case of vulnerable children such programs include family based substitute care arrangements (adoption, placement with relatives, non- kinship foster care), community based group homes, and programs for the inclusion and integration of the disabled into the community. Public information in the form of messages that highlight the changing shift in care and its concrete applications, and the dissemination of best practices, would also be important for garnering support for this critical shift in care for vulnerable groups. (e) fNproyiug oarnibniog and evainndpa. Improving the monitoring and evaluation of safety net programs is essential to help policymakers fne tune or redesign policies to reach children and other poor recipients. This means (i) improving regional financial systems so that information on regional soial protection expenditures is transparent and readily available; (ii) upgrading the administrative data on beneficiaries and improving the sharing of the data between regions and with the federal level; and (iii) using nationally and regionally representative household budget surveys and appropriate welfare measures to assess risk, vulnerability, or poverty, and to evaluate whether social protection programs are indeed reaching the vulnerable groups. Key monitoring indicators which can be used to measure the success of Government programs are: improvements in the coverage, adequacy, and targeting efficiency of cash schemes; the phasing out of privileges/subsidies; and a reduction in the number 51 of children in need of care and/or in institutions and an increase in the number of vulnerable children in family based care. E. Conclusions 4.49 The health and human capital stock of Russia is a source of strength that can enable the country to take advantage of new opportunities. But there are emerging risks, particularly from the growing inequalities across regions and income levels, and from the expansion of communicable and non-communicable diseases that, unless addressed aggressively, threaten to undermine Russia's potential growth. At the same time, the pension and social safety net systems are under financial stress. In particular, the targeting efficiency of the latter has to improve so that the vulnerable can be adequately protected in a fiscally affordable manner even as the challenge of economic restructuring remains large. 52 5.1 While policy and institutional improvements in the economic environment, and better management of macroeconomic risks, will undoubtedly strengthen the investment climate and encourage new private sector activity, the Government also needs to strengthen its effectiveness in providing the essential public goods and services needed to stimulate private sector growth. This requires reforms of the state. A comprehensive approach was developed by the authorities in early 200. Some improvement is already evident in several areas. In pareicular, prudent fiscal management, which emerged as a key learning experience from the 1998 crisis, is at least partly responsible for improvements in public finance and for the development of initiatives to strengthen public administration. Key public sector institutional arrangements that influence the provision of public goods include: intergovernmental fiscal arrangements, public financial management, tax and customs administration, the civil service, and the justice system. This chapter addresses each of these areas in tum. A0 nteirgovnmnenfmt isca Reatflons 5.2 A key aspect of ensuring the effective delivery of public services, as well as supporting overall fiscal sustainability, is maintaining proper incentives at the regional and local levels. While Russia has decentralized budget resources, its fiscal powers remain extremely centralized. The reforms of 2000-01 have increased the relative size of the federal budget, sharply reduced money surrogates in tax collection, increased the size and effectiveness of federal transfers, launched a process of linking expenditure mandates with financial responsibility, and strengthened control of subnational budgets through the federal Treasury. However, they have failed to increase genuine subnational budgetary autonomy. Inter-budgetary relations continue to suffer from an excessive degree of central control over explicit subnational budgets. The limited fiscal powers allow subnational governments to shift the political and financial responsibility for balancing subnational budgets and maintaining social services to the federal budget, accentuating budgetary and macroeconomic pressures. 5.3 Recognition of the importance of strengthening intergovemmental fiscal relations led to the adoption of a Fiscal Federalism Development Program for 2@02-05.73 The implementation of this program has proceeded along several key fronts. First, some clarity has been provided to the delineation of spending powers among the various levels of govemment and to the reduction and elimination of various "unfunded mandates." Second, greater ,redictability has been provided to tax assignments, with the centralization of some receipts.7 The concomitant reduction in unfunded mandates and the greater stability in tax arrangements have been beneficial. Third, the system of intergovernmental transfers has been extended futher. in addition to the system of equalization and the Compensation Fund (for allocating resources to fund mandates such as child allowances), an incentive-based system has been introduced to promote fiscal reform at the regional level. This takes place through a federal fund which rewards, on a competitive basis, regions that have successfully completed a program of fiscal reforms. While this currently covers only a small percentage of total transfers to the regions, the mechanism offers an alternative incentive-based system for fiscal transfers that helps to promote economic reforms. The Government is currently considering expanding such an approach to other types of reform. 73 See Govemment Resolution No. 584, dated August 15, 2001. 74 Revenues of subnational governments have declined by 6 percentage points of GDP in the period 1998-2002 (from 44 percent to 32 percent of consolidated govemment revenues). 53 5.4 The elusive challenge for policymakers has been to provide the subnational spending authorities with real expenditure powers balanced with the available financial resources. Notwithstanding some improvements in the legal framework, the reduction of unfunded mandates, and the elaboration of rules-based transfers and revenue sharing, problems remain. Most recently, the federally mandated wage increase has increased budgetary pressures on subnational governments even as reductions in the profit tax rate and the centralization of tax revenues have reduced subnational revenues. While some expenditure savings or revenues can be generated at the subnational levels through efficiency gains in expenditures, higher cost recovery in housing and communal services, and the privatization of commercial assets, the challenge for subnational governments is to achieve these gains without incurring fiscal arrears or compromising service provision. 5.5 At the same time, the centralization of revenues at the federal level, and permanent changes in the rules of the game regarding tax-sharing and inter-budgetary transfer mechanisms imply that regional and especially local governments lack long-term incentives to build their tax base and to bring all of their earnings on-budget. These incentive problems need to be addressed over the medium to long term through: extending the taxation powers of regional and local governments (while preventing unfair inter-regional tax competition); assigning major revenue sources to respective budgets on a long-term basis; reducing the scale of revenue-sharing between levels of budget systems; replacing the remaining non-transparent transfer windows with transparent formula-based windows; and reducing the number of transfer windows in line with the limited number of clearly defined transfer priorities. The strategy should aim at formally recognizing at least part of the existing fiscal autonomy at the lower levels of govemment, within clearly defined bounds, together with enforcing genuine subnational budgetary responsibility. Regional and local governments should be able to adjust explicit tax and expenditure policies at the margin to effectively manage their fiscal resources and respond to changing incentives from the center. B. Public Financial Management 5.6 Improved public financial management in Russia since the 1998 crisis has contributed to better fiscal outcomes at both the federal and the regional levels. These improvements include systemic changes in tax collections, the tightening of budget discipline with restraints on aggregate public expenditures (which have been reduced as a share of GDP), the extension of budget coverage, dramatic reductions in payment arrears, and a sizable reduction in the stock of public debt. Some examples of new institutional arrangements are: the adoption of the Budget Code in 1998 (further amended in 2000); the consolidation of most extrabudgetary and earmarked funds in the budget; the progressive expansion of the federal Treasury (the remaining parts of the defense establishment were incorporated in 2002); and the suspension of most unfunded federal mandates. While a public procurement law has still not been passed, more than 50 percent of public procurement is being channeled through competitive methods. With respect to sovereign and subnational external borrowing, the Government has established an agency to monitor and manage public debt. In 2002, Russia was also taken off the U.S. Treasury's Financial Action Task Force (FATF) list of nations with inadequate safeguards. 5.7 At present, with the emergent federal budgetary surpluses and the growing imperative of sustaining growth, the Government has given greater importance to financial management and accountability reforms in achieving its development goals. To that end, the Government has developed and launched a wide-ranging reform program intended to improve budget preparation and implementation, Treasury operations, government accounting, and public sector auditing. Central to these reforms is the development of a federal Treasury system which now accounts for 54 all federal expenditures (48 percent of total expenditures in 2002) as well as for expenditures by 32 regions for which it acts as an agent. The challenge for the Government is to sustain the implementation through fostering buy-ins by the line ministries and other levels of goverment, and through extending implementation to the regions and lcal govements which account for most of the spending on key social sectors and where public services are delivered. 5.8 However, other pressing challenges remain as the Goverment seeks to strengthen its financial management systems. Several issues are involved here. First, emphasis needs to be placed on budget preparation reforms.75 While in the earlier macroeconomic crisis environment there was a dominant need for budgetary control which led to an exclusive focus on expenditure retrenchment and the reduction of fiscal imbalances, the current more stable environment calls for a consolidated effort to strengthen budget preparation. This would require, at a minimum, developing the policy basis for budget formulation, moving towards a program-based classification, developing a uniform and mutually consistent budget and accounts classification, and costing out the recurrent cost implications of current policies and programs. It would also require establishing uniform budget and accounting standards at the regional and local government levels. 5.9 Second, the transparency and competitiveness of public procurement practices need to be strengthened. This is a more important issue at the regional level where the bulk of public procurement takes place. This action would require eliminating the limitations on participation by outsiders (from outside the purchaser's region, including foreigners), strengthening the legislation and its enforcement (particularly through the development of detailed sub-legislative texts), developing procurement capacity in the line ministries, and publishing the results of public tenders. 5.10 Third, systems for financial accountability need to be strengthened in terms of both internal and external audits. A Government-wide system of internal audit needs to be instituted. Such a system should aim at detecting systematic weaknesses and assessing the adequacy of the control framework of ministries and other budget agencies, and should provide information and advice to managers on the deficiencies in the current system and on measures to address them. Progress on this front needs to follow the development of better budgetary classification and data. Further capacity building is also needed for the Accounts Chamber to enable it to effectively perform its statutory role. 5.11 And finally, fiscal transparency needs to be further strengthened through preparing public draft documents on annual budgets and budget execution reports in line with approved budgets as well as through reporting on contingent liabilities, tax expenditures, and quasi-fiscal activities to keep the public informed of the "true" fiscal liabilities of the public sector. C0 Tam aind Customs Administradom 5.12 With the recent slowdown in growth, tax and customs administration reforms have come into prominence, given their potential contribution to improving the investment environment. Reforms in tax and customs administration in Russia, as in most other transition countries, have generally lagged behind reforms in tax and customs policy.76 However, the improvements in tax collection in recent years have been driven not only by higher revenues associated with the oil 75 This was a key conclusion of a series of sectoral analyses of federal expenditures over 2O0-01. These covered various sectors including public investment, transport, health, education, housing, utilities, science, extrabudgetary funds, and public administration. 76 See, for instance, Mitra and Stem (2002). 55 and gas sectors and the tax buoyancy from a rebound in growth, but also by various systemic changes. On the policy side, the reduction in personal incomne and corporate tax rates may have contributed to a widening of the tax base. At the same time, institutional changes such as the integration of social taxes, the establishment of large taxpayer units, the wide adoption of functional structures, and the consolidation of registration activities are also likely to have contributed to strengthened tax collections. 5.13 The Govermuent recognizes that current tax and customs administration organization, management, and operations do not facilitate an efficient and fair collection of tax revenues. This may have led to widespread evasion and frustration in the business community, which is typically at the receiving end of harassment by tax and customs officials, and is reflected in surveys of business perceptions. The Government has developed a strategic plan to strengthen tax administration, and has used this plan to develop a federal earmarked program for tax administration reform. Changes have already been enacted to Part I of the Tax Code to remove a number of obstacles to efficient tax administration. 5.14 Tax administration reforms being pursued by the Government include the following: (a) Organizational reformns. These reforms include the country-wide transformation of local and regional tax inspectorates and departments into functionally organized structures; the streamlining of the network and staffing in accordance with the amount and complexity of the workload; the improvement in cooperation and information exchange with other Government agencies (such as the Customs and the Treasury); and the creation of modern data processing centers capable of storing and processing large information flows. (b) Business process reforms. These reforms should correspond to the new functional principles and newly defined job descriptions and should include the development of standardized workflows to be followed by all tax inspectorates and the establishment of an adequate legal, regulatory, and appeals framework; the development of a unified state register of taxpayers; the development of electronic filing and tax payment accounting systems; and the strengthening of the audit, investigation, and taxpayer services functions. (c) Improved efficiency of resources and training. Both the physical infrastructure and the human resources need to be upgraded to meet the new organizational structure and professional tasks. This would require the development of an IT infrastructure as well as policies for staff career development, adequate remuneration, training and.re-training, and the management of professional.ethics - and staff integrity. 5.15 .Until recently,- reforms have been slower to take off in customs. However, with the imperative of harmonizing customs administration with WTO standards, the. Government. has named improvements in customs administration a priority in its Medium-Term Program of Social and Economic Development of the Russian Federation in 2002-2004. Following up on this, the Government is developing a new Customs Code in cooperation with the trade community, and customs has been implementing an earmarked modernization program to make Russia's customs 77 Ministry of Taxation (2001), "Strategy for the Development of Tax Authorities for the Period 2002-06,"- mimeo. 56 compliant with the revised Kyoto Convention of the World Customs Organization (WCO) and with a long-term vision of customs as a service-providing public agency. 5.16 In order to promote internationally acceptable practices for the processing of international trade flows by customs, and to increase the compliance of foreign trade participants with the customs legislation, the customs administration in Russia will have to be changed to meet the criteria for: (i) expeditious customs clearance; (ii) the transparency and predictability of custorns actions for participants in foreign economic activity; and (iii) a partnership attitude between customs and the participants in foreign economic activity. Specifically, the key reforms include the following: (a) Cluseors ovpieovos refo7ms. These reforms include introducing a risk-based customs clearance system while at the same time strengthening customs control, especially post-release control and control over transit operations; streamlining and making transparent and uniform the legal and regulatory requirements for customs clearance; and introducing electronic declaration and web-based services for the trade community. (b) Managemen and infrnsgrMcgore Fromeferr. These refonns will require introducing a performance-oriented operational management in the customs service; strengthening financial management through improving budget formulation and evaluation and implementing a Financial Management System; building institutional capacity for efficient human resource management by applying modern HR management techniques, including the development and implementation of a Human Resource Management Information System; improving integrity in customs administration through control over and prevention of corruption and through the development of a Code of Ethics; investing in informatics infrastructure for speedier and more efficient customs operations. (c) Organizazldonag re.foFms. The current organizational structure needs to be modified to remove existing inefficiencies, to make it correspond to upgraded customs operational practices, and to prepare it for the effective implementation of modern management systems. 5.17 These reforms are subject to serious implementation risks and challenges. The major risk for both reforms is seen in their comprehensiveness, which will require strong coordination among reform measures in different areas, as well as preparation for the dramatic changes in the professional activities, practices, and mentality of tax and customs officers, who will be affected by the reforms at the local, regional, and national levels. Indeed, implementing the proposed changes will be an arduous process, which may take over five years to show measurable results. This would require sustained Government efforts and commitment to these reforms. D. PubHec Administratao mamd he Civl $errvhce 5.18 Implementing the Govermment's reform agenda depends crucially on the quality of Russia's public service, especially at the regional level. Business surveys repeatedly suggest that the lack of a service culture and meritocracy, as well as corruption, plague the public administration. International evidence suggests that the costs of corruption in public service typically fall disproportionately on the poor, who are the most dependent on the state's provision of social services and who lack the means to pay these extra costs. The Government has 57 recognized that an efficient public service is essential if Russia is to provide effective public services to its citizens and also attract domestic and foreign investments. 5.19 Two sets of key problems plague the current system. First, the national Government comprises a number of competing and overlapping structures with unclear accountability. These structures cover the Government (ministries and line agencies), the Apparatus of the Government, and the Administration of the President. These parallel structures weaken the policymaking role of the line ministries and fragment decision-making. Lack of functional clarity and weak accountability arrangements complicate internal coordination and hinder effective decision- making. In turn, this leads to the wide use of inter-ministerial commnissions to resolve complex inter-agency issues, which increases transactions costs and undermines the transparency of decision-making. 5.20 Second, the capacity of the public administration and the civil service remains low. The low civil service salaries are not competitive with salaries in the private sector, which leads to significant difficulties in recruitment and retention, and which encourages low level bureaucratic corruption. Performance orientation is lacking. Internal and external accountability mechanisms are weak, public participation is limited, and the complex legal and regulatory environment provides excessive scope for the use of discretionary powers, especially at the local levels. However, the size of the public service does not appear to be a problem despite an 80 percent growth in numbers over 1992-2002. The aggregate numbers compare favorably with advanced OECD countries. At the beginning of 2002, the total number of public servants stood at just over 1 million, of which 32 percent belonged to federal bodies. Overall numbers may have begun to decline in recent years, especially in the federal bodies, but there is continued growth at the regional levels. 5.21 In order to address these problems, Government efforts have begun to target public reforms of the state. Three sets of complementary and inter-linked reforms are being developed and implemented. The first concerns civil service reform. A Presidential decree was issued to guide the implementation of civil service reforms over 2003-05.78 Significant pay reform is foreseen to address recruitment and retention issues and to help rebuild the incentive structure for civil servants. At the same time, a Code of Conduct for civil servants was approved in 2002. The reform program also seeks to achieve a major shift towards full transparency in the decision- making and operations of the civil service. A new draft State Service System Law has been developed, together with a new draft Civil Service Law designed to give better effect to the application of the-merit principle. Administrative and decision-making processes are intended to be computerized to increase efficiency and strengthen effective inter-*ministerial working as well as to limit the opportunities for corruption. A further-challenge is seeking approaches to persuading each of the subjects of the Federation to develop and pursue parallel reforms for the subject's own-civil service. 5.22 The second set of reforms concerns adrninistrative reform. Proposals in this area are still under development but are expected to include decisions on how many different types of government bodies there should be (ministries, agencies, services), what the respective role of each different type of body should be, what the accountability arrangements between different types of bodies should be, and what the precise functions of each body of the federal government should be (to be determined under a program of functional reviews). The third set of reforms concerns local government reform and the'optimization of the allocation of functions across the three levels of government. 78 Presidential Decree No. 1336 dated November 19, 2002. 58 5.23 The priority measures for strengthening the public administration are as follows: (a) )p?inize Govamreng sirt˘ie mgnrJ Pri: Prorities in this area include launching the review of overall govenment structure, then launching the detailed ministry/agency-level program of "functional reviews" to align Government functions more closely with the key priorities of the reform program and to eliminate, commercialize, or spin off non-priority functions and all commercial services currently being undertaken within Goverment structures. (b) Begin implemeia&n of civfl service renfaDa: Priorities here are to put in place an appropriate legislative base for the modem, merit-based civil service envisaged in the program approved by the President; to introduce the measures designed to promote the transparency and accountability of the civil service; and to continue pay reform through strengthening the link between pay and performance and through redressing pay imbalances with the private sector in areas of particular recruitment and retention difficulty (focusing on remuneration for senior management and professional skills areas where recruitment and retention problems are at their most acute). (c) IZmpr'ove sevice adfvery 9hrough s$ye eegtaitea: This requires initiatives along various dimensions, including moving towards output-based norms for fiscal transfers and extending greater revenue-generating powers to local governments (see discussion in Section A, above). This measure (and indeed measure (b) above) also requires promoting civil society involvement in monitoring and evaluation, which could strengthen traditional accountability mechanisms. IE. llTe busalkhe $ystamn 5.24 The Government recognizes that Russia needs to develop a credible and efficient justice system in order to give the individuals and companies an opportunity to fully benefit from the legal environment. Several important developments have taken place over the past two years in three key areas. (a) The ,Ydic& Syseem. Reforms have proceeded in several directions. (i) In 2001, a package of four laws was adopted.79 The legislative changes seek to: strengthen the independence and accountability of judges and attomeys through, among other things, reforming the Qualification Commissions in a manner that reduces the tireat of judicial corporatism; set time limts for holding the Court Chair's position; introduce mechanisms for the execution of the Constitutional Court's decisions; and set unified standards for attomey's qualifications and ethics. (ii) The Government has also launched a Federal Targeted Prog, Development of the Russian Judicial Syseem in 2002-2006, which seeks to increase judges' salaries (four-fold by 2006) and strengthen the court infrastructure. 79 The package included amendments to the laws "On the Status of Judges", "On the Judicial System", "On the Constitutional Court of the Russian Federation" and a new law "On the Bar and the Lawyer's Activities." 59 (iii) Steps have been taken to professionalize the administrative and logistical functions in the courts and to help the judges to concentrate on these tasks. The positions of court administrators and judges' assistants' were recently introduced though the scope of the court administrators' authority is very limited and needs to be better defined. (iv) A new Criminal Procedures Code came into force in July 2002. Among other features, this Code has transferred the authority for arrest from the investigative bodies to the courts, provided opportunities for the court appeal of decisions taken by the investigating bodies, introduced plea bargain for crimes punishable by up to five years of imprisonment and drastically reduced the scope for the courts' returning the case to investigating bodies for additional investigation. (v) Trials by jury are being introduced nationwide. This will raise the quality of trial preparation and will likely have positive spill-over effects on non-jury trials. (vi) The Federal Law "On Arbitration Panels in the RF' (adopted in the summer of 2002), obliges courts to consider alternative dispute resolution mechanisms. In the long run, this measure should alleviate the pressure of case loads and accelerate settlement of disputes. (b) Modernizing Legislative and Regulatory Drafting Mechanisms. The State Duma has reactivated its work on draft laws concerned with legislative development mechanisms.80 This would redress the lack of legal regulation and make the procedures for development of laws and implementing regulations of the Executive more transparent and enforceable.8' Civil society participation in regulatory impact assessment is growing with many NGOs providing analytical support to policy development and legislative drafting. (c) Legal Awareness, Education, and Access. Legal education programs in Russian secondary schools is being expanded. A guild of court reporters has been created. Public information offices have been opened. Access to legal services is expanding through the growth of legal clinics, promotion of alternative dispute resolution mechanisms and training, and the creation of a national union of attorneys. However, the issues related to funding mandatory representation remain unresolved. 5.25 However, tremendous challenges remain. The - legislative and regulatory drafting mechanisms should be strengthened by developing a system for regulatory impact assessment. Both branches of the court system need to improve case and court management based on a redefinition of roles and use of modern methods. The successful models of strengthening legal awareness and education developed under pilot schemes need to be replicated. Improving access to legal services requires the development of a legal welfare policy and allocation of adequate funding for legal protection of disadvantaged groups. The implementation of reform also needs to be supported by mechanisms for impact monitoring. 8 There are two laws: "On the Procedure of Enactment and Coming into Force of Federal and Federal Constitutional Laws" and "On Normative Legal Acts". 81 Currently the legislative development mechanisms are subject only to the internal regulations of the State Duma 60 F. C˘mmeausons 5.26 A key challenge for Russia is to strengthen public sector effectiveness and service delivery. hnprovements in the efficiency, economy, and effectiveness of public services are essential if the state is to fulfill its due role in supporting the development of the private sector. Public sector management reforms have lagged behind policy reforms, though more progress has been made in some areas (such as public financial management and intergovernmental fiscal relations) than in others (such as the civil service, tax and customs adrministration, and the judicial system). Reforms in these areas are the next generation of reforms for Russia, particularly because the effective implementation of policy reforms is dependent on an efficient public sector. By their nature, these reforms are also more arduous and take time to show results, and thus will be successful only with sustained Government effort and commitment. 61 STATISTICAL ANNEX 62 kli'-lrL1fH Animex 1I bllie X:o Gros loID $9,206 c/ Data for 1999 d/ Data for 2001 el Data for 2000 f/ Data for Sep. 01 g/ Data for Dec. 01 73 Statistical Annex Table 12: Vulnerability Indicators 1999 2000 2001 2002 (est.) A. Market Indicators Annual percent change in average exchange rate 153.7 14.3 3.7 1.1 Annual change in stock market index (%) 346.6 -2.85 53.6 65.4 B. Risk Ratings ICRG composite (1-100, bad to good) 49.8 66.3 69.5 70.0 Euromoney (1-100, bad to good) 20.9 30.0 37.6 45.3 Institutional Investor (1-100, bad to good) 19.3 26.7 26.8 39.0 C. Banking Sector Indicators Foreign currency to total deposits (%) 37.0 36.0 36.0 Non-perf. loans of commercial banks (% of total) 6 3 3 2.7 D. 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