Russia: Reform After the Great Recession

Russia has weathered the global crisis better than initially feared, in part due to its large stimulus package, and is now likely to witness a robust but relatively jobless recovery. But the crisis has emphasized the country’s long-standing needs to modernize its public sector, strengthen its financial sector, improve its investment climate, and advance diversification.

The Great Recession and the Government’s Response

A triple shock––to oil prices, capital flows, and external financing––led Russia’s real GDP to fall 7.9 percent in 2009, driven by the drop in domestic liquidity and collapses in industrial production (IP) and aggregate demand. Unemployment and poverty rose, and the ruble fell. The fiscal surplus turned to deficit for the first time in a decade. The banking sector, which had relied heavily on non-deposit financing, faced severe liquidity constraints. A deposit run at the end of 2008 exacerbated the liquidity crunch, and threatened financial stability.

In response, the government enacted a large stimulus package equivalent to almost 7 percent of GDP—a broadly adequate size, given the force of the demand collapse and the country’s relatively weak automatic stabilizers. The policy response was especially effective in stabilizing the financial sector, and also helped contain unemployment and poverty. The Great Recession did not lead to a currency crash, major bank failures, or large-scale corporate defaults in Russia. The reflow of deposits as early as February 2009 shows that confidence in the banking system has been restored.

Unemployment rose less than expected––from full employment before the crisis to 8.2 percent at end-2009—in part due to the large anti-crisis response, but also reflecting labor hoarding, part time employment, and involuntary vacations. Poverty also increased less than expected, reaching 14 percent at end-2009, compared to the 17 percent anticipated without the government’s interventions, which included sizeable increases in minimum and public wages, pensions (which had been announced before the crisis, but the timing of which helped cushion the social impact), and less significant increases in unemployment benefits.

However, the structure and implementation of the policy response could have been more effective. First, the package’s tax cuts and the breadth of its measures, including broad pension and wage increases, made it more expensive than it otherwise would have been. In addition, its relative lack of focus on infrastructure and targeted social assistance kept the overall output multipliers low. And the slower implementation of the fiscal stimulus measures that focused on the non-financial sector—which appear to have been implemented in the second half of 2009—kept them from mitigating the deepest growth contraction, which occurred in the first half of 2009.

Robust But Jobless Recovery

With global demand, oil prices, capital flows, and domestic demand recovering, Russia’s real GDP is expected to grow 5 to 5.5 percent in 2010, mainly reflecting the low base effect but also the gradual spread of recovery.

Outlook for Russia

Consumption, particularly household consumption, will drive growth in 2010, especially towards year-end, aided by inventory restocking in the first two quarters of 2010. Higher oil prices will increase Russia’s fiscal revenues and, along with the withdrawal of some stimulus expenditures, will likely lower the fiscal deficit. Rising oil prices and the return of capital inflows, which began in the last quarter of 2009, should improve the current and capital accounts. Credit risks and the banking system’s remaining portfolio problems will keep credit constrained, however, while inflation will continue on its mildly downward trend. The pace of economic growth will moderate in 2011 and will depend on the banking sector’s ability to provide long-term credit to facilitate growth in fixed investment.



However, the recovery in Russia—and many other countries in the region—will likely remain jobless. A number of factors, including the relatively weak growth expected (compared to the pre-crisis boom), the skills mismatch—reflected in the rising share of the long-term unemployed—and the financing constraints on small and medium size businesses, which suffered disproportionately during the crisis, will keep unemployment high.

Large Structural Agenda Remains

If it is to achieve its goal of catching up to Western Europe in productivity and income, Russia must enact daunting structural reforms. Difficult as they are, public sector reforms—including modernization and improved efficiency of expenditures—offer the most promise in the short- to medium-term. Financial sector and investment climate reform is also essential, as is closing large infrastructure gaps.

Public Sector

Since the 1998 crisis, which highlighted the importance of sound public finances, the government has maintained strong fiscal management, gradually improving its budget formulation and execution using best practices from other OECD and oil-rich countries. The budget is now consistently based on conservative assumptions about the prices of Russia’s key exports, oil and gas. The Ministry of Finance has introduced a three-year budget and is preparing to implement performance budgeting and long-term fiscal planning. Russia now has a modern tax system, with value added tax (VAT) as its key instrument, a relatively low tax burden, a very simple income tax, and low trade taxes. It has also maintained fairly open trading and capital account regimes.

But, based on Russia’s poor performance on international governance and transparency indicators, much more needs to be done to reduce corruption, increase transparency, improve the efficiency of public expenditures and large state corporations, and reduce arbitrariness in regulatory interventions. Russia must also dramatically reduce barriers to small and medium size enterprise growth, without which its long quest for diversification will remain fruitless. Better targeting of social assistance programs and pension, health, and education system reforms are also needed to restructure Russia’s public expenditures and improve its social and health outcomes.

Financial Sector

Russia must also increase the capacity of its financial sector and ensure the long-term soundness of its financial markets. With the crisis abating and the financial sector stabilized, now is the time to reemphasize the remaining financial reform agenda. Recently increased capital levels will likely foster banking sector consolidation, but a new framework is needed for orderly reorganization of deposit-taking institutions in the case of bankruptcy. An improved corporate insolvency system would provide effective mechanisms for corporate rehabilitation. Prudent bank regulation and supervision, as well as operational risk management and other forms of corporate governance of banks, should be brought up to international standards and must include consolidated supervision of large financial groups. Improved disclosure of financial product information to retail customers is also recommended, as are easy-to-use redress mechanisms and other forms of consumer protection. Further reforms of the credit information systems, as well as collateral laws and registers—particularly for movable collateral (such as company inventories and receivables)—would also help banks increase credit to businesses and households.

Investment Climate

In addition, the investment climate must be improved significantly. Newly released results of the European Bank for Reconstruction and Development (EBRD)-World Bank Business Environment and Enterprise Survey (BEEPS), which looks at the business environment in Central and Eastern European and CIS countries, show that Russian firms saw some improvements in tax administration and corruption, evidenced by the lower incidence of bribes. This may reflect the government’s recent efforts to raise transparency (e.g., e-government) and to improve regulatory effectiveness through impact assessments. But the size of the bribe tax and bribes to secure government contracts have increased.

Some old problems, such as the frequency of tax inspections, remain high on the list of private sector complaints. But the surveyed firms now cite the lack of adequate skills among workers and weak transport, electricity, and telecommunications infrastructure as significant concerns as well. 

EBRD-World Bank Business Environment and Enterprise Survey

The Great Recession and the more constrained post-crisis environment, including moderate oil prices, have given Russia the opportunity to rethink and accelerate public and financial sector reforms, as well as promote diversification. Most of these challenges will require strong and substantial reform measures, not just money, and the lessons—and the large, long-term agenda—must not be lost in a return to business-as-usual after the crisis.

Zeljko Bogetic, Lead Economist and Country Sector Coordinator for Economic Policy at the World Bank, is the main author of the World Bank’s periodic Russian Economic Reports on which this note is based.