RUSSIAN FEDERATION Fiscal Federalism and Regional Fiscal Reform Loan (Loan No RU) Release of the Second Tranche - Full Compliance

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized From: The President June 16,2003 RUSSIAN FEDERATION Fiscal Federalism and Regional Fiscal Reform Loan (Loan No RU) Release of the Second Tranche - Full Compliance 1. The Fiscal Federalism and Regional Fiscal Reform Loan (FF&RFRL) for Russia was approved by the World Bank's Board of Directors on January 29, 2002, in the amount of US$120 million and the first tranche of US$38 million was disbursed in two installments on October 10, 2002 (US$19.4 million) and December 19, 2002 (US$18.6 million); the frontend fee (US$1.2 million) was withdrawn on June 5, The remaining US$80.8 million is to be disbursed in two equal tranches with two installments each: (i) a second tranche expected to be released in the second and fourth quarters of 2003, and (ii) a third tranche expected to be released in the second and fourth quarters of The conditions for the second tranche (US$40 million) - consisting of full compliance with specific tranche conditions, on-track implementation of the reform program, and satisfactory macroeconomic performance - have now been fulfilled. The use of the proceeds of the first tranche was in conformity with the channeling arrangement set out in the note to the Board on "Russia - Controls over Adjustment Loan Disbursements", dated December 9, 1999; it is expected that the same procedures will be applied to the second and the third tranches. Vice President: Country Director: Sector Director: Team Leader: James D. Wolfensohn President by Shengman Zhang Johannes F. Linn Julian F. Schweitzer Cheryl Gray Lawrence Hannah

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3 RUSSIAN FEDERATION Fiscal Federalism and Regional Fiscal Reform Loan (Loan No RU) Release of the Second Tranche - Full Compliance I. Background 3. The Russian Federation has a population of some 143 million people and covers a vast land area of 17,075 thousand square kilometers (almost twice the size of Canada, the next largest country in terms of land mass). There are 89 Subjects of the Russian Federation (oblasts, republics, krays, autonomous okrugs, and one autonomous oblast, as well as the cities of Moscow and St. Petersburg) that form the second tier of government. The third tier is formed by local governments - urban and rural municipalities (very often rural and urban areas are combined in one municipality, also in practice one urban municipality may be a part of another) with some degree of fiscal autonomy, and some small towns, settlements, and villages with no fiscal autonomy at all. There are large differences among the regions in terms of climate, endowments, and economic base that make effective fiscal and economic management at the national level quite complex. Although the system inherited after the disintegration of the USSR is federative according to the Constitution, in practice, formal relations between levels of government have been more like those based on a highly centralized, unitary government. 4. In 1998 the Government adopted the Concept of Reform of Inter-Governmental Fiscal Relations in the Russian Federation for , which was created and has been managed by the Working Group for Improvement of Intergovernmental Fiscal Relations, including representation from the Government, the Duma and the Council of the Federation. The Concept laid out a three-year strategy for the reform of intergovernmental finance. A key feature of this strategy was for the federal government to take an active role in stabilizing and to some extent standardizing the system of intergovernmental relations. Since Mr. Putin was sworn in as President in May 2000 the political situation has solidified. A more cooperative relationship between Duma and the President has developed. To further curtail the powers of the 89 regional governors, Mr. Putin initiated (and managed to pass through both chambers of Parliament) legislative changes which no longer gave governors automatic representation in the upper House of the Federal Parliament (Council of the Federation), and giving him the right to dismiss the governors when they violate federal laws. In August 2001, the Government approved a new program of reforms for the system of fiscal federalism for The objectives of the Government's reform program are stated in the Fiscal Federalism Development Program for (approved by Government Resolution #584 on August 15th, 2001). The Government's commitment to the objectives of improving intergovernmental fiscal relations and reforming sub-national public finance under the loan was confirmed by the First Deputy Finance Minister in a Letter of Development Policy to the

4 -3- Bank On the Main Areas of the Regional Fiscal Reform Process in the Russian Federation for the Period up to 2005, dated November 28, The overall reform program is clearly on track: previously unfunded federal mandates have been phased out, a more advanced equalization formula has been adopted, 100 percent of the personal income tax was assigned to the regions, regions were provided with the sales tax for which they could set a tax rate and with the share of profit tax where they can vary the tax rate within the boundaries, tax and expenditure assignments became more transparent and amendments to existing legislation on clear division of responsibilities between different levels of government (which in general are in line with international practice) were drafted by the Presidential Administration and are currently under consideration in the Duma. In general, the federal government has chosen a road of a more centralized control over subnational budgets with less discretion of subnational authorities over their expenditures. Thus, in addition to the equalization fund, several new targeted transfer windows have been created within the federal budget. The most important are: Compensation Fund to fund law on disabled and child allowances, Social Co-financing Fund to finance part of housing subsidies. As a result, equalization transfers in the 2002 federal budget are almost equal to non-equalizing transfers. 7. Consistent with the objectives contained in the Government s program, the FF&RFRL seeks to strengthen the system of fiscal federalism and to support the regions of the Russian Federation in the development and implementation of fiscal reform programs that will promote financial transparency, budgetary accountability, and strengthened fiscal management policies and practices at the regional level. The FF&RFRL is designed to deepen reforms in the following areas: (i) budget process; (ii) tax policy; (iii) expenditure management; (iv) the intergovernmental system within region; (v) debt management; and (vi) information and audit. 8. The mechanism agreed with the borrower to promote reform at the regional level is the Regional Fiscal Reform Fund (RFRF) - a transfer window within the federal budget that provides transfers to regions who present competitive reform programs and implement them. 9. The companion technical assistance project - Regional Fiscal Technical Assistance Project (RFTAP, Loan No RU) - continues to be available to assist the Government and participating regions in implementing their reform programs. This project is being implemented satisfactorily. 10. The U.K. Department for International Development (DflD) responded to a request from the Government to support their fiscal federalism reform program by funding a E5 million technical assistance facility in April 2002, which assists in the implementation of the FF&RFRL. This facility comprises a resource center to assist regions to compete for resources from the RFRF, support for additional analytical work on fiscal federalism and an advisor on regional finance issues to the Ministry of Finance (MoF).

5 Recent Economic Developments 11. The main economic indicators continued to exhibit favorable albeit slowing trends in Real GDP has grown by 4.3 percent, bringing the cumulative post-crisis growth over to more than 25 percent; the overall budget surplus amounted to 1.4 percent of GDP on a cash basis; and the trade surplus for the year was equal to US$45.4 billion, pushing up the Central Bank s reserves to US$48 billion. In 2002 Russia s stock and bond markets were, for the second consecutive year, among the best performing in the world. Russia s external debt trades at yields that are lower than those of other countries with similar credit ratings, although rating agencies made a series of upgrades in 2002 (see paragraph 20 below). 12. An analysis of different scenarios for oil price developments suggests that Russia s fiscal and Balance of Payment (BOP) positions are likely to remain sustainable even if oil prices fall substantially below present levels. Russia could ensure a primary budget surplus without incurring overall budget deficit even if the price for Urals crude falls to US$18.5/bbl in Indeed, energy prices would have to fall and remain at US$12/bbl for Urals for the next two years (without a change in net capital outflows) to create fiscal and BOP gaps. Only a sustained and deep drop in energy prices would likely result in significant financing needs. 13. However, the medium and long-term prospects for sustaining today s growth rates still remain overly dependent on volatile natural resource prices, as productivity growth lags behind real exchange rate appreciation and real wage increase, capital outflows remain high (although decreasing), and the growth rates of investment have slowed significantly. Overall, the economy s assets remain concentrated in the extractive industries, with exports almost entirely dependent on natural resources. Despite the increase in overall medium and longterm lending to the private sector, domestic bank credit still plays an insignificant role in financing capital formation by Russian enterprises and investment remains dominated by the natural resource and the budgetary sectors. To overcome all these impediments to sustainable growth, the Governmeht embarked on a comprehensive structural reform program: restructuring natural monopolies, housing and community services reform, pension reform, public administration and civil service reform. The Government has maintained a good record in designing and pushing reform enabling legislation through the Duma in This momentum is likely to be maintained and reinforced in 2003 as the Government currently discusses approval of a Medium Term Program with special emphasis on diversification of the economy. 14. Industrial Growth: Supported by domestic demand, with consumption becoming increasingly important, output continued to grow in Growth in industrial output amounted to 3.7 percent for In 2002 growth accelerated in export oriented industries (ferrous and non-ferrous metals, fuel and energy, wood and processing)- to 5.5 percent (weighted average) from 4.2 percent in 2001, while growth in industries that primarily produce for the domestic market (electricity, chemical, machine building, construction materials, light and food industry) decelerated to 2.5 percent, down from 6.3 percent the previous year. Negative rates of growth were registered in electricity (-0.7 percent) and light industry (-3.4 percent).

6 Inflation and Money: Inflation remained at moderate levels, with a year on year CPI increase for the year 2002 of 15.1 percent. The Central Bank (CBR) has been continuing its rapid accumulation of reserves in 2002, with reserves increasing from US$36 billion at the end of 2001 to US$48 billion at the end of 2002, while preventing nominal appreciation at the same time. By end April 2003 CBR increased reserves to US$60 billion, while the ruble has appreciated in nominal terms against the dollar by about 4 percent in the first four months of Exchange Rate and Terms of Trade: The sharp appreciation of the Euro against the dollar in the second half of 2002 caused Russia s real effective exchange rate (REER) of the ruble to depreciate by 0.7 percent, the first real depreciation since Cumulative appreciation of the REER exceeded 46 percent since end 1998 (to approximately 20 percent below pre-98 level). At the same time, the average monthly trade surplus fell from US$5.1 billion in 2000 to US$4.2 billion in 2001, and to US$3.8 billion in While the large trade surplus has facilitated CBR s reserve build up and the servicing of foreign debt, net capital outflows have continued to be high, although decreased in 2002 to estimated US$11 billion (down from US$16 billion in 2001, and US$22 billion in 2000). Russia s foreign investment position remained negative in 2002, with total investment to Russia increasing by 38.7 percent to US$19.8 billion, while Russian companies invested US$19.9 billion abroad. FDI, however, grew by only 0.6 percent, while other investments (portfolio investment and trade credits) grew by 56 percent, up to US$15.3 billion- the strongest indicator of an increased willingness to finance business in Russia despite continuing problems with corporate governance and the business environment. 17. Budget: According to the Ministry of Finance data, the Federal budget reported revenues of 17.1 percent of GDP in The primary surplus (IMF definition) amounted to 3.8 percent, and the overall surplus to 1.4 percent of GDP on a cash basis. On December 29, the Budget Law for 2003 was signed by the President, after approvals by the Duma (the lower chamber of the Parliament) and by the Federation Council (the upper chamber of the Parliament). The Federal budget 2003 envisages continuation of the sound macroeconomic policy of generating budget surpluses in Income, Poverty and Labor Market Indicators: Russia s recent economic performance has had a beneficial impact on wage incomes and social transfers. According to preliminary estimates, real disposable income grew by 8.8 percent in 2002, slightly faster than in For the third year in a row, real income grew faster than the economy, a reflection of the favorable balance of trade and continued shift from profit to wage incomes. Real wages grew by 16.6 percent, after 19.9 percent increase in 2001, indicating that wage growth outpaces other components of real disposable income. In the wake of the substantial real appreciation of the ruble in , the average monthly dollar wage increased by 27 percent in 2002 to almost US$141. In December of 2002, the average monthly dollar wage was US$185, approaching the record level of US$205 recorded in December The share of the population with incomes below the subsistence level (R1800, or about US$57, per month for 2002) fell from 27.3 percent in 2001 to 25 percent in The unemployment rate, reported by Goskomstat (ILO definition) declined steadily from 10.4 percent at the end-2000 to 8.7 percent at the end-2001, and 7.1 percent at the end-2002.

7 Creditworthiness: Russia s positive macroeconomic performance resulted in several upgrades by rating agencies. In a series of upgrades Moody s raised Russia s sovereign risk from B2 to BA2 (with stable outlook), and Standard and Poor s- from B to BB (with stable outlook). Aside from good fiscal performance and large trade surpluses, rating agencies emphasized political stability, progress in macroeconomic management, the implementation of tax reform and the level of foreign reserves which should enhance Russia s debt service capability. However, Russia s ratings remain below the investment grade and consequently will not lead to major portfolio adjustments among investors abroad. 20. In sum, the present macroeconomic framework is satisfactory for disbursement from the FF&RFR loan at this time. The IMF concurs with this assessment Progress Against Tranche Release Criteria 21. The release of the second tranche is contingent, pursuant to section 2.02 (d) of the Loan Agreement, upon progress satisfactory to Bank with respect to: (i) implementation of the reform program as set forth in the Letter of Development Policy dated November 28, 2001; (ii) maintaining a macroeconomic policy framework that is consistent with the objectives of the program; and (iii) the specific conditions described in Schedule 3 and Annex to Schedule 3 of the Loan Agreement. Progress in terms of the macroeconomic framework is described in paras above. 22. Progress in carrying out the program continues to be satisfactory, and there has been no reversal of the actions taken in compliance with the first tranche of this Loan. In addition to meeting the specific tranche conditions, described below, the participating regions demonstrated substantial progress in reforming all core areas as outlined in the Letter of Development Policy, including extension of coverage of the budget and improvement of the clarity and methods of budget process; systematization of tax policy in regions so that it is discourages arrears; improvement of overall use, allocation and mechanics of budget expenditure; improvement in clarity and predictability of resource flows between regions and local governments; improvement of the information base and management of debt; adoption of adequate auditing of the use of public resources. The highlights of recent reform progress in the regions are described in the core conditions 4 and In general, the FF&RFR design has proven to provide sufficient incentives for regions to prepare and implement high quality reform programs. At this stage, a total of 24 regions have presented applications and reform programs to the RFRF under the FF&RFR. There are six specific conditions for the second tranche, as specified in the Schedule 3 of the Loan Agreement. All six conditions have been met, as described below: 24. Condition Nd. The RFRF is continuing to operate in accordance with procedures agreed between the Borrower and the Bank as provided for under the Annex to this Schedule. Satisfactory operational principles were agreed and attached as an Annex to Schedule 3 in the Loan Agreement. The Methodology for Selection and Evaluation of Cohorts

8 -7- was reviewed by the Bank and found satisfactory. Amendments to the selection methodology for the third cohort competition were cleared by the Bank in July Each region is expected to receive two transfers from the RFRF in different years (in order to give it adequate time to implement reforms). RFRF continues to be a transfer window in the federal budget, transfers are allocated to the winning regions of different cohorts on a grant basis as a reward for successful implementation of their respective Regional Reform Programs. 0 The RFRF has, therefore, been created, in full compliance with the Loan Agreement, as an expenditure line item in the Federal Budget in 2002 and 2003 with annual amount of US$40 million in ruble equivalent each year. RFRF is operating according to the agreed procedures. Calculation of the total pool of potential resources for each cohort is the local currency equivalent of an average of US$8 million per selected region. RFRF resources for each cohort are allocated to selected regions on the basis of 30 percent of the pool divided equally, 30 percent proportional to regional population and 40 percent according to assessment of individual Regional Reform Programs. 0 Regional governments applied in three cohorts, seven oblasts or krays or republics in the first cohort, seven in the second cohort, and thirteen in the third cohort. Five regions of the first cohort and five regions of the second cohort were selected on a competitive basis and in compliance with agreed transparent procedures upon successful implementation of phase one of their respective regional fiscal reform programs (both phases were successfully implemented in the five regions of the first cohort). The selection of the five regions, the winners of grants in each cohort, occurred in November 2001 and October These programs were developed within a standard framework for all the regions. However, emphasis differed across regions, given the variations in the initial conditions among regions as determined by the diagnostic work. The Ministry of Finance (MoF) evaluated the conformity of the regional fiscal reform programs from first two cohorts to the announced criteria, success in their implementation and compliance with required minimum standards (agreed with the Bank). Selection of five regions, the winners of grants in each cohort, occurred in November 2001 and October 2002 and was cleared by the Bank. Grants from RFRF were provided to five regions of the first cohort (Samarskaya oblast, St Petersburg City, Vologodskaya oblast, Chelyabinskaya oblast, Republic of Chuvashia) in October 2002 and to five regions of the second cohort (Republic of Karelia, Khabarovskiy kray, Krasnodarsluy kray, Astrakhanskaya oblast, Saratovskaya oblast) in December Condition N2. The Law on the Federal Budget for the year 2003, as adopted by the Borrower, contains a line item for the funding of the RFRF in the amount of US$40.0 million equivalent or a lesser amount as determined by criteria established for the Program and as agreed between the Borrower and the Bank.

9 -8- RFRF is a line item in the Federal Budget 2003 with RUB million or US$40 million equivalent budgeted for this year. Law on Federal Budget for 2003 has been approved by both chambers of parliament and signed by the President at the end of December Condition Ng3. Regions for second and third cohorts have presented applications and reform programs to the MOF for evaluation. Applications and reform programs have been submitted to the MoF by the second cohort of seven regions (Republic of Karelia, Khabarovski y kray, Krasnodarskiy kray, Astrakhanskaya oblast, Saratovskaya oblast, Krasnoyarskiy kray, Kaluzhskaya oblast) in November 2001, and by the third cohort of 13 regions (Republic of Bashkortostan, Republic of Buryiatia, Republic of Mariy-El, Republic of Sakha (Yakutiya), Krasnoyarskiy kray, Stavropolskiy kray, Kaluzhskaya oblast, Leningradskaya oblast, Nizhegorodskaya oblast, Permskaya oblast, Rostovskaya oblast, Tverskaya oblast, Taymirskiy Aoutonomous Okrug) in January Applications and reform programs have been communicated to the Bank in hard copy and/or electronic form in March 2002 and in February 2003 and were found by the Bank eligible for participation in the subsequent stages of the competition. 27. Condition N24. Satisfactory progress in implementation of the second stage of fiscal reform programs in at least one region belonging to the first cohort based on minimum standards satisfactory to the Bank and consistent with procedures of the RFRF approved under the Program. Results of implementation of second phase of first cohort were submitted to MoF, who reported to the Bank that five out of the seven regions have accomplished their second phase programs. The Bank has reviewed these results and found that the second phase of the reform program, based on minimum standards, satisfactory to the Bank (and reflected in the agreed Minutes of Negotations) and consistent with procedures of the RFRF were successfully implemented in Samarskaya oblast, St Petersburg City, Vologodskaya oblast, Chelyabinskaya oblast, Republic of Chuvashia. The regions achieved significant progress in the following areas: St Petersburg- monitoring and execution of off-budget accounts by the city treasury; adoption of the advanced equalization transfers and tax sharing arrangements methodology; work on prevention of new overdue accounts payable by budgetary organizations to natural monopolies; advanced debt management which allows the city to comply fully with its debt liabilities; improved internal audit of the use of budget funds; the use of targeted welfare benefits (allowances). Samarskaya oblast- gradual transformation towards treasury principles of budget execution; improved equalization transfers methodology; monitoring of the consolidated debt of the public sector; monitoring and capping tax exemptions; overdue accounts payable of the regional Administration and of budgetary

10 -9- organizations were completely eliminated; a new asset management strategy was developed. Chelyabinskaya oblast- contract registration system adopted and implementation started; a system for checking compliance of contracts with different limits was implemented; more advanced equalization transfers methodology approved and implemented; a cap on tax benefits was put in the law on the annual budget; overdue arrears of the oblast budget and budgetary organizations to natural monopolies were completely phased out; a debt ledger created and consolidated public sector debt liabilities are monitored; steps towards building more advanced treasury system made; asset management strategy and privatization program started to be implemented; real estate registration improved. Vologodskaya oblast- gradual minimization of amendments to the annual budget law; consolidation of off-budget funds; gradual introduction of the treasury system; improved contract registration system; the decision to allocate 10% of net profit of unitary enterprises to the regional budget made; methodology on assessment of tax exemptions adopted; utility tariffs audits conducted in seven municipalities; monitoring of consolidated public sector debt liabilities performed; formal methodology on assessment of expenditure efficiency adopted. Republic of Chuvashia- eighty percent reduction in tax arrears due to the regional budget in the first nine months of 2002; liquidation of cross-subsidization with respect to utility tariffs; adjustment in utility tariffs was accompanied by targeted assistance to the poor and energy savings measures; gradual transformation towards treasury system made; consolidation of off-budget revenue and spending by treasury; a modern tax sharinglequalization transfers system established; legal base for the modern budget cycle created and necessary budget procedures implemented. 28. Condition N25. Satisfactory progress in implementation of the first stage of fiscal reform programs in at least one region belonging to the second cohort based on minimum standards satisfactory to the Bank and consistent with procedures of the RFRF approved under the Program. Results of implementation of the first phase of second cohort were submitted to MoF, who reported to the Bank that five out of the seven regions have accomplished their first phase programs. The Bank reviewed and cleared these results in December The first phase of fiscal reform programs was successfully implemented based on minimum standards satisfactory to the Bank and consistent with procedures of the RFRF in Republic of Karelia, Khabarovskiy hay, Krasnodarskiy kray, Astrakhanskaya oblast, Saratovskaya oblast. The regions achieved significant progress in the following areas: Astrakhanskaya oblast - extrabudgetary funds consolidated into the oblast budget; more advanced equalization methodology applied; inventory and

11 -10- monitoring of federal mandates performed; monitoring of unitary enterprises and enterprises with the oblast stake started; and asset management techniques improved. Republic of Karelia- treasury principles of budget execution implemented, including single account principle; information on accounts payable and receivable is available to the public; control over targeted use of funds tightened; debt ledger was created and debt management system improved; relatively stable and formalized system of tax sharing and equalization transfers adopted; progress in centralized registration of real estate transactions achieved. Krasnodarskiy kray- capital budget started to be developed; elements of treasury budget execution implemented; internal audit procedures improved; improved open tender- budget procurement practices introduced. Saratovskaya oblast- regional treasury is phased in; inventory of debt liabilities and unified system of debt liabilities monitoring created; better procedures for debt registration of regional and municipal unitary enterprises adopted; real estate registration system installed. Khabarovskiy kray- progress in treasury budget execution made; budget forecasting and financial planning improved; hay extrabudgetary funds consolidated into the budget; assessment of regional health ministry expenditures by means of special methodology made; stable equalization transfers formula introduced; monitoring and audit of unitary enterprises and enterprises with the region s stake(50%) performed. Even region which did not get a grants made some visible improvements- Kaluzhskaya oblast made significant efforts in implementation of the treasury principles of the budget execution; equalization transfer formula was introduced; several legislative acts passed and a database was created in order to facilitate better budget procurement practices. 29. Condition N26.Disbursements to regions from RFRF have been made according to agreed procedures and timetable as provided for under the Annex to this Schedule. RFRF grants were scheduled to be made twice yearly, not later than June 30 and December 31 of each year. However, the first installment was transferred in October due to delays in establishing the accounting arrangements on the part of the Government. The second installment was disbursed on time in December Grants were awarded to those regions that have successfully implemented their Regional Reform Programs and have met the minimum standards. The Bank received notification letters (on receipt of federal grants) from all regions receiving transfers. Such notification letters were typically sent to the Bank within 3 business days and five business days at a maximum. Use of the RFRF grant resources in a region is determined by the regional government concerned in compliance with the Russian

12 -11- Federation legislation and in conformity with the provisions of the respective Regional Reform Program. IV. Conclusion 30. In view of the overall macroeconomic framework, good progress with the implementation of the program supported by the Loan, and in full compliance with the specific conditions of release as described in paragraph 2.02 (d), Schedule 3 and Annex to Schedule 3 of the Loan Agreement (Basic Principles of the Regional Fiscal Reform Fund Operations) the Bank has informed the Borrower of the availability of the second tranche of US$40 million. Washington, D.C. June 16,2003