RUSSIAN ECONOMIC REPORT #17 Limiting the impact of the crisis, deepening structural reforms

1. RUSSIAN ECONOMIC REPORT #17Limiting the impact of the crisis, deepening structural reforms Zeljko Bogetic Lead Economist for Russia December 19, 2008 AmCham, Mariott Aurora Moscow

2. From global to Russian crisis • Anatomy of the Russian crisis • Policy response • Social Impact • Outlook

3. A perfect storm––the US subprime mortgage and financial crises • Housing market bubble in the US (2007) • Sub-prime mortgages/derivative bubble • Russia was initially immune • By mid-2008, the global financial crisis began to reach Russia on the back of a weakening and highly oil-dependent economy.

4. I. From Global to Russian Crisis—Some preliminary messages • Dramatically changed international environment 2. Financial crisis: new, complex challenges for policy 3. But structural weaknesses and oil dependence in Russia worsened the impact 4. Yet, crisis presents opportunity to address longer term challenges of competitiveness, diversification, and financial sector modernization.

5. Before the crisis: Russia overheating until mid-2008

6. Main messages of World Bank’s Global Economic Prospects (December 2008) • Developing countries, long resilient, have been hard hit by the global financial crisis since mid-September 2008. • Recession in high-income countries and a sharp slowdown in developing countries seems inevitable; world trade is likely to contract, and capital flows to fall by 50% in 2009. • Strong underlying growth potential in developing countries is expected to support a rebound by 2010. • The immediate threat to recovery is further failures of major financial institutions; but there remain many risks for a more prolonged slowdown . Source: Global Economic Prospects World Bank. December 9, 2008

7. Worsening international environment

8. Sharp decline in GDP growth expected in 2009 with rebound in 2010 Growth of real GDP, percent Developing High-income Source: World Bank.

9. The great depression was a different order of magnitude US GDP, annual growth GDP Price Deflator GDP Volume Source: U.S. Department of Commerce.

10. II. Anatomy of the Russian Crisis:Russia was hit by a simultaneous, triple whammy • Oil price shock: USD144/b (July) – USD45/b (Dec) • +/-USD1 oil price on avg = +/-USD1.6 billion/year in export revenue (or USD4.3 million/day) • +/- USD1 oil price on avg = +/-USD1.1 billion/year in fiscal revenue (or USD3.0 million/day) • “Sudden stop” in capital flows: USD81.2 billion (07) to USD -88 billion (11 months 08) • Sharply tightening external borrowing conditions by domestic banks and corporations • Russian corporate bond spreads widened, reaching 940 bp on October 6 (up 629 bp from end-2007), compared to a 381 bp increase in corporate emerging market bond index to 676 bp; now down to 750 but still high

11. Since July, near perfect correlation of the RTS index with the price of oil

12. Across-the-board, general slowdown, accelerating in Q4 • Both tradeable and non-tradeable sectors began significant slowdown in Q3, but this accelerated in Q4 with industry and manufacturing registering sharp decline in November 2008. • Industrial growth in November 08 (year-on year) -8.7% • Manufacturing—the engine of Russia’s industrial growth—registered -10.3%. • Construction sector and services, similarly, registering significant slowdown from very high growth rates just a few months ago.

13. Three Phases of the Crisis: (1) Orderly decline; (2) liquidity crisis; and (3) swift policy response • First phase (May 19-Sep 12): gradual decline in the RTS index (-46.1%), largely driven by oil price decline and worsening international crisis. No major policy response. • Second phase (Sep 15-18): confidence crisis generated a liquidity freeze leading to a sharp increase in selloffs; massive margin calls as investors cashed in their rapidly declining equity positions (RTS down -21.1%). • Third phase (Sep 19-Nov 14): market initially bounced back, recovering losses from the second phase, but the subsequent impact of the set of policy measures on equity markets was limited. Oil prices kept falling and a panic in world markets ensued (RTS down -48.1%).

14. Transmission of the crisis • Phase I • Stock market (July-November 2008) • Banking sector (September - ) • Phase II • Real economy (October - ) • Phase III • Regional economies (October - ) • Employment and incomes (November - ) • Poverty (November - )

15. Further erosion of competitiveness: Real wage growth continue to outpace productivity gains, but growth in real wages is slowing

16. External current and capital account surpluses--declining • Non-oil external current account deficit continues to deteriorate very fast in 2008 as import volumes grow faster than non-oil exports. • Net capital account, fell from USD84.3 billion in 2007 to USD0.5 billion in 9 months of 2008, then to -88 billionin 11 months of 2008. • FDI—non-debt creating flows—declined, worsening the composition of capital flows towards borrowing

17. Capital flows became more volatile in 2008, and the banking sector experienced a sharp reversal of capital inflows

18. While public external debt remains moderate, private (corporate and bank) debt grew rapidly

19. Many Russian banks were relying excessively on non-traditional (borrowing) sources of funding

20. Banking––rollover risk sharply rising and consolidation starting • Short-term external debt remains low (20% of total external debt) ––but in private financial institutions (small and medium-sized banks) this share is significantly higher (40%), and thus more vulnerable to rollover risk. • With hefty repayment obligations at a time of tighter global credit, the rollover risk has risen, but the systemic risk is limited. • A number of banks were taken over or withdrawn licenses—consolidation started Source: CBR

21. III. POLICY RESPONSE Timely, massive, and broadly appropriate, loosening monetary stance and providing fiscal support to ease liquidity crisis; exchange rate continued to be managed with progressive widening of the bi-currency corridor Aggregate fiscal, quasi-fiscal and monetary cost and sources of financing of anti-crisis policy measures Source: World Bank staff estimates.

22. POLICY RESPONSE:Against these developments, monetary and fiscal policy proactively responded to contain the impact of the crisisMonetary-exchange policy and inflation––risk shifting from inflation towards liquidity and CBR loosening the monetary stance • Earlier monetary tightening was not enough to reduce inflation • Inflation pressures have eased • In September, CBR moved dropped interest rates and raised reserve requirements) • Greater flexibility of the exchange rate, since mid-November f

23. Fiscal policy––aiming to limit the impact of the crisis • Russia’s consolidated (general) budget was executed with the strong surplus of 11.1% of GDP in the first nine months of 2008, compared with 9.4% for the same period in 2007. • The government is aiming to provide fiscal/quasi-fiscal support to banks and enterprises facing liquidity and external repayment difficulties. • However, the latest fiscal data from October-November indicate large revenue losses from major taxes (profits tax, VAT) reflecting sharp decline in economic growth and the credit crunch. • MinFin now revising the budget using conservative oil price assumptions for 2009-11.

24. IV. Social impactLimited so far, but bound to deepen with rise in unemployment • Social impact so far limited because: • Less than 1% households own stock and stock ownership highly skewed towards wealthy individuals • Two thirds of households have no significant term deposits in the banking system • Main source of income is employment, which was not affected significantly so far BUT: Social impact will deepen because: • Unemployment rising, especially in labor intensive industries (construction, retail, services, banking) • Disruptption and delay of large infrastructure projects • Lower growth in real wages, possible wage arrears due to weakening payments discipline • Imported goods more expensive due to weaker ruble • Regional and municipal governments exp. Cuts • Estimated 1.3 million people in 08-9 NOT moving out of poverty, others becoming more vulnerable

25. Impact on Russia’s poor troubling, vulnerability to rise, some regions to experience sharp increase in unemployment

26. V. Baseline Outlook for Russia: 2008 and 2009 • World output growth: expected to be low in 2008 (2.5%) and 2009 (0.93%) • High-income: growth of 1.35% in 2008, and -0.15% in 2009 • Developing: growth of 6.3% in 2008, and 4.45% in 2009 Oil prices: USD101.5/barrel in 2008; USD74.5/barrel in 2009. High uncertainty in world economic outlook. • Russia’s outlook: deteriorating but with recovery towards end-2009 • Growth: 6% real GDP growth for 2008 (compared to 6.8% estimated before the crisis), and 3% in 2009 (6.5% before the crisis). [revised: 2-3%] • Unemployment: moderate rise to 5.9% by end 2008 (up from 5.3%), then further to 6.6% in 2009. • Inflation broadly unchanged: 13.5% by end 2008. Will be difficult to reduce inflation below 12% in 2009. [revised: 11-12] • Decline in twin surpluses (federal fiscal and external current account), and widening capital account deficit. • Current account surplus around USD100 billion in 2008 and about USD40 billion in 2009. • Capital account would deteriorate in 2008 to a deficit of about USD50 billion and to deficit of USD100 billion in 2009 [revised 2008: -$100-120 billion] • Impact on CBR reserves should be limited to a possible loss of no more than additional USD100 billion in 2009, still leaving a relative reserve cushion.

27. Downside risks remain—some unpleasant scenarios (yet to be fully developed) • Preliminary indications are that: • If oil prices in 2009 average $50/barril • Twin surpluses would turn into twin deficits • Federal fiscal surplus could turn into a deficit of over 4% of GDP • Reserve fund would be used to finance the deficit and no recourse to international sovereign finance is envisaged • If oil prices in 2009 and 2010 average $30/barril and global crisis continues to worsen • Pressures on CAB and public finances would rise significantly with further adverse impact on growth.

28. Areas where future policy response could be improved going forward • Concern about some protectionist measures that may not yield desirable results (such as introducing new trade barriers to protect domestic auto producers and poultry). • Implementation of policy measures must be as transparent as possible in order to avoid perceptions of favoritism. • Small and medium size enterprises will also need access to finance if Russia is to begin diversifying its narrow industrial structure. • Most critical infrastructure bottlenecks should be addressed even under current conditions as they could undermine long term growth. • Social assistance to cushion the impact on the poor must be improved by urgent assistance and better targeting the benefits to the truly poor. There may be a case for well designed public works and training programs as part of the a possible, additional fiscal stimulus package in 2009.

29. Remaining policy challenges • Limiting the impact of the crisis on liquidity and the real economy while safeguarding macro stability. 2. Intensifying structural reforms (bank consolidation, reducing red tape and constraints to SMEs) to diversify the economy, strengthen institutions and financial sector for sustained, long-term growth. • Continuing integration into the global economy, including the acceleration of accession to the WTO. • Limiting the impact of the crisis at the regional level and of non-payment problems. 5. In 2009, deeper recession might require an introduction of a fiscal stimulus package, including strengthening of the unemployment, training and social assistance and possibly well designed public works.

30. Real GDP Growth: Fall in consumption and investments between Q4 2008 and Q2 2009, followed by a slow recovery in Q3-Q4 2009

31. Middle income countries–perceived vulnerability index

32. VI. Enhancing competitiveness: improving energy efficiency in Russia • Outlook • Challenges • Policy recommendations

33. Low energy efficiency affects Russia’s economy and requires government intervention • Russia’s energy efficiency (EE) potential is huge – some 300 mtoe/year, equivalent to 2% of all energy produced in the world in 2005. • Comprehensive policy is required to tap into energy efficiency potential • Energy waste mainly occurs on the demand side • Russia can reduce energy consumption by 45%

34. Risks and policy challenges Risks • Limited administrative resource and funding allocated to EE • Poor coordination among ministries • Underdeveloped mechanisms of implementation and monitoring Policy challenges • Raising awareness • Removing barriers • Creating targeted incentives • Developing financing instruments • Monitoring • Creating a strong federal EE agency and leave and expand regional and local mandates in the area of EE

35. Thank you!