RUSSIAN ECONOMIC REPORT

Transcription

1 RUSSIAN ECONOMIC REPORT October 2002 The World Bank, Russia Office 4

2 RUSSIAN ECONOMIC REPORT OCTOBER 2002 Introduction On an aggregate level, Russia s economy continues to perform well, and has been growing steadily in an international environment where growth threatens to become the exception. Oil prices are up. Business and consumer confidence levels are at post-crisis record highs. True islands of competence have emerged, in particular in the corporate sector (in the main in the service and consumption goods industries), where new and improved ways of doing business have created demonstration effects, spreading good practices across industries and improving demand for domestically produced intermediary goods. Optimists argue that the networks established between these islands are becoming strong enough to lift the entire economy onto a sustainable growth path, by generating a diversified industrial base which serves strong domestic markets. On the other hand, there is a familiar litany of structural imbalances. The public sector remains inefficient, public resource management inadequate and public service provision often dismal. And the economy remains highly concentrated in at least three dimensions. Ownership in the private sector is concentrated in a few conglomerates. New firms and start-ups, the drivers of growth in other transition economies, have been slow to develop, with the enterprise structure inherited from the socialist period still dominating much of the economy. Above all, Russia s economic performance remains crucially dependent on natural resource exports, and in particular on oil. This period may well turn out to be decisive in determining the path of economic development in Russia. In a period of high oil prices and political stability, reforms have been carried out at unprecedented depth and speed. But these favorable external conditions are unlikely to last forever. Only then will it be clear whether the economy has changed enough to adapt to adverse circumstances. This report looks at structural change from several angles. In the general review of recent economic developments (part I), we use sectoral disaggregation to determine whether Russia s positive growth performance has led to greater diversification of the economy. Oil extraction and the public sector not only continue to attract the largest share of domestic investment, but these are also the two sectors where wage increases have by far outperformed the rest of the economy. Not surprisingly, labor and capital both go where the money is. However, the outcome of this re-allocation is that Russia s economy is even more dependent on natural resources. Part II of the report contains a brief overview of the increasing per capita income differentials across regions, which are driven mainly by domestic fixed capital investment. The published data suggest strongly that these flows are again primarily attracted by the availability of natural resources. Finally, Section III introduces the first of a series of bi-annual surveys designed to capture the effects of the Government s recently introduced deregulation laws to encourage small firm growth. I. Recent Economic Developments Russia s macroeconomic performance has improved over the course of 2002, but growth rates have stabilized at a lower level than the previous year. The balance of payments shows a sharp decrease in capital outflows. Business surveys indicate growing confidence in some regions and sectors, and Russia s enterprises find it easier to finance their activities, domestically or abroad, than in previous years. Yet, despite three years of high growth, high oil prices and 2

3 political stability, and with much of the economy now operating at full capacity utilization, the growth rate of fixed capital investment has slowed, and GDP growth with it. It will be lower this year than at any time during the period, raising the question as to why the favorable environment has not translated into investment rates which could accommodate Russia s needs for finance and technological renewal. In part this is because real incomes have continued to rise and real wages, together with other cost factors, have started to exercise pressure on enterprise costs. Overall profitability fell and in some sectors, payment discipline started to erode. Consumption continued to outpace investment, while rising real incomes allowed customers to substitute imports for domestic products, despite slower appreciation of the real exchange rate. In addition, growth remains highly dependent on the prices of oil and gas. Just as moderate oil prices had an adverse impact on the rate of growth earlier this year, growth started to pick up after oil prices rose. If the growth rate of industrial production is disaggregated, it becomes clear that growth accelerated in the natural resource sectors and decelerated in domestic manufacturing. Moreover, real wages grew much faster in the resource extracting sectors and in the public sector than elsewhere in the economy. These are also the two sectors that account for the bulk of investment. It appears that resources continue to be drawn into the most competitive of Russian industries (natural resource exports), and to the public sector. If growth is to be sustainable it becomes even more urgent to create the conditions and institutions for diversifying the economy. Industrial production and composition of output According to Goskomstat s latest and still preliminary figures, the negative month-to-month growth rate of industrial production, which dominated the macroeconomic debate before the summer, has reversed itself. Having fallen from October through February, industrial output on a month-to-month basis grew by 3.2 percent in the first half of this year, and growth accelerated over time from 2.6 percent in the first quarter to 4.0 percent in the period January through September However, a number of caveats are appropriate. The aggregate growth rate for 2002 remains lower than last year, with GDP growth reported at 3.9 percent in the first half of the year, compared to 5 percent in the same period last year. Second, although seasonally adjusted by Goskomstat, the preliminary time series data show again a strong cyclical component, with the economy hibernating over the winter (after low oil prices in the Fall) and growth picking up in the summer (figure 1). The Ministry of Economic Development and Trade thus revised its GDP Source :Goskomstat Figure 1: Index of Industrial Production (SA, Dec99=1) Dec-99 Jan-00 Feb-00 Mar-00 Apr-00 May-00 Jun-00 Jul-00 Aug-00 Sep-00 Oct-00 Nov-00 Dec-00 Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Table 1: Growth Rates by Sectors, % 2001 Q1-02 Jan-Sep 2002 Industry Construction Transport Agriculture Communication * Retail trade Source: Goskomstat * data for January-August 3

4 growth estimates only marginally, from 3.8 percent to 4 percent, and we would concur with this assessment. In line with rapidly rising real incomes, growth continues to be driven by consumer demand. However, the aggregate data obscure important differences in the pace of expansion between export oriented sectors and sectors producing mainly for the domestic market. One convenient way of tracing these differences is to disaggregate the biggest component of GDP, i.e. the category industry, into subsectors. The number of all sub-sectors that reported an increase in production grew from 9 (out of 15) in the first quarter to 12 in the period January through September. Grouping together sub-sectors which are concerned either with natural resource exports or produce mostly for domestic markets also reveals that the average growth rate in resource oriented industries accelerated over the course of the year (from 5.4 percent January through September 2001 to 6.5 percent this year), whereas output growth in the manufacturing sector decelerated (from 5.5 percent to 3.3 percent in the same period). 1 Thus the weight of natural resource based activities in total industrial output has increased in 2002, just as one would have assumed, based on the previous investment allocation. Moreover, real wage increases in the natural resource sectors outperformed those in the domestic manufacturing sector by a considerable margin. If adjusted by the size of the sectors, wages grew by 16.2 percent in the natural resource sectors versus 11.6 percent in the domestic sector in real terms (August 2001 to August 2002). Together with the persistent focus of investment on the natural resource sectors, this decomposition gives a first indication of the continued dependency of industrial growth and, ultimately, of GDP growth on oil prices. Disaggregating the growth rate of GDP itself shows that all major sectors of the economy, with the exception of transport, reported lower growth rates January through August 2002 compared with all of 2001 (table 1). Agriculture (before the harvest) and construction, which historically mimics investment closely, fell the most. In addition to high prices for Russia s key exports, a decline in domestic real energy prices may have helped to improve industrial production in the second and third quarter. Nominal gas prices were relatively flat from April through September, allowing the real price to drop by 9.5 percent during that period (Figure 2). Real prices for electricity decreased by 1.1 percent during the same period but then went back to their April level Source: Goskomstat Figure 3: Capital investments, % increase over previous year Jan-01 Feb-01 Mar-01 Apr-01 May- Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov- Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May- Jun-02 Jul-02 Aug-02 Sep-02 Source :Goskomstat Figure 4: Non-cash Settlements as % of Total Sales Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Source: Goskomstat Figure 2: Prices of Gas and Electricity Deflated by PPI, July 98=100 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 electricity index Figure 5: Net flow of Overdue Payables as % of Total Sales. Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep Source: Goskomstat, staff estimates gas index Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 1 Bank estimates. The resource oriented industries include fuel and energy, non-ferrous metals and wood. The manufacturing sector includes electricity, ferrous metals, chemicals, machine building, light industry, food, construction materials and other. 4

5 Investment, credit and capacity utilization The growth rates of fixed capital investment recovered from their troughs earlier this year but remain lower than in 2000 or Through September this year, the average growth of fixed capital investment was 2.5 percent, compared to 7.5 percent last year (figure 3). The bulk of investment expenditures (more than 60 percent) was in the fuel and energy sectors, or in sectors driven by government demand, such as transportation, public housing and the utilities. While it became evident that relatively modest oil prices in late 2001 and early 2002 had adversely affected fixed capital formation in the economy as a whole, the growth rate of investment expenditure this time remained modest even after the prices for Russian oil had recovered and went above 20 $/brll in the second quarter of Capacity utilization rates in the main industrial sub-sectors remained flat in 2002, after the rapid post-crisis recovery since Reported utilization rates tend to be low likely reflecting capital on the books that has become physically obsolete over the last ten years. It appears, however, that large parts of industry operate at full capacity. In line with this assessment, financial intermediation shows signs of improvement. According to the latest CBR estimates, the share of long and medium-term bank credits (above one year maturity) increased from 10 percent in the first half of 2001 to 27 percent during the same period of 2002 (table 14). Real lending rates recovered enough to enter positive territory, moving from negative 0.7 percent in 2001 to 2.5 percent in the first half of Despite this increase in lending costs, total net credits to the private sector increased by 17 percent in nominal, or 7.3 percent in real terms. While still tiny, the share of consumer credits in total credits increased from 4.7 percent at the end of 2000 to 7.1 percent in June Why then, after three years of high growth, with an economy running at full capacity, with private sector demand for real credits at a record high and a good macroeconomic environment, has investment demand not improved? Part of the answer appears to be that a prolonged period of real income growth has led to an income effect, where imported consumer goods are being substituted for domestic production, even as real exchange rate appreciation has slowed down. Russian consumers are switching to better quality imports as their real incomes increase. A survey conducted by the Center for Economic Analysis, for example, concludes that the share of middle class consumers who buy TV sets produced in Russia has dropped to only 2.6 percent in 2002 (from 7.4 percent in 2001). Imports of Source: Goskomstat Source: IMF Jan-98 Jan-01 Source: Goskomstat Figure 6: CPI and PPI inflation, % Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 CPI PPI Figure 7: Real Effective Exchange Rate 1995=100 Jul-98 Mar-01 Jan-99 Jul-99 Jan-00 Jul-00 Figure 9: Average wage, $ per month 2000 Jan-01 Feb-01 Mar-01 Apr-01 May-01 Jun-01 Jul-01 Aug-01 Sep-01 Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Source: Goskomstat, staff estimates Jan-01 Jul-01 Figure 8: Oil Prices and Trade Balance May-01 Jul-01 Sep-01 Crude oil price, $/brll (left scale) Nov-01 Jan-02 Mar-02 May-02 Jan-02 Jul Trade Balance, $ bln (right scale) 5

6 clothing in 2002 continued to increase at above 50 percent annually. Imports of cars picked up by 42 percent in the fist half of 2002, and imported furniture by 17 percent. Imported goods have increased from USD 4.2 billion per month in the first three quarters of last year to USD 4.7 billion for the same period this year. There is evidence that more capital goods are being imported as well, to improve domestic supply. The volume of imports in machine building grew 18.1 percent in the first half of 2002, down from 31.7 percent in the previous year. At the same time, the capacity utilization rates in machine-building and light industries were the lowest among all major industries. These were also the two industries where growth rates dropped the most in 2002, from 9.7 to 2.8 percent and from 5.7 to 0.3 percent respectively. Wages, productivity and structural change Another part of the explanation for low investment demand is that the impressive macroeconomic figures hide limited structural change. It has already been mentioned that the same export oriented energy sectors which attract a majority of domestic investment are the sectors which pay the highest wages. In addition to these sectors, it was public services, i.e. the government payroll, that provided for the strongest real wage increases albeit from a very low level. In addition, however, rather than new industries, it has also been the government which increased (registered) employment and provided new jobs. With the most active economic sectors and the budget both dependent on natural resource prices, it would be hard to argue that the external vulnerability of Russia s economy has diminished. Table 2: Growth of Employment, Wages and Output by Sectors Wages in August 2001 Wages in August 2002 Employment, Aug-02 / Aug- 01, % nominal, rubles % of average level nominal, rubles % of average level Change in real wage, Aug-02 / Aug-01 Growth rates, Jan-Aug 02 / Jan- Aug 01 Implied Productivity Gains, % Industry Fuel and energy gas oil extraction Machine building Light Food Construction Agriculture Transport Communication Trade and Catering Financial services n/a n/a Public services Health n/a n/a Education n/a n/a Culture and arts n/a n/a Source: Goskomstat, Bank s staff estimates Table 2 details the changes in main economic variables of composite GDP and provides a more detailed account of the changes at the enterprise level. The interpretation is straight forward: Real wage increases are most pronounced in oil extraction and in the government sector. Financial services and communication are examples of new, dynamic and growing sectors which occupy a middle rank, but all other sectors have seen more modest increases. Their ranking aside, real wage increases exceed (measured) productivity advances in all sectors. 6

7 Employment has declined in non-competitive traditional sectors as production facilities have been closed or restructured. Employment has declined even more in oil extraction, the sector with the highest increase of productivity. And (registered) employment is increasing in a few new sectors which are expanding while they restructure (such as food, transport, communication, trade and financial services). Parts of the released workforce has been employed in the public sector. A look at their average salaries shows that this is a safety net for poor regions and employees. Others will be working in the shadow economy, with unknown consequences for income distribution. Productivity advances across the economy s main sectors mirror real wage growth fairly accurately. With a few exceptions, most notably oil extraction (where workers often enjoy location premia), machine building (where those protected inside large old enterprises may still command wage protection), and transport (where much output is not reported), labor markets within sectors seem to be competitive. Large wage differentials emerged across sectors. As of yet, there is little (registered) new firm creation or new firm growth, which would show up as a larger expansion of employment in the more successful sectors. Instead, the public sector and the black economy appear to provide a safety net. Productivity growth is uneven. Table 3: Growth of Employment, Wages and Output by Industrial Sub-Sectors Employment, Aug-02 / Aug-01, % Wages in August 2001 Wages in August 2002 nominal, rubles % of average level nominal, rubles % of average level Change in real wage, Aug-02 / Aug-01 Growth rates, Jan-Aug 02 / Jan- Aug 01 Implied Productivity Gains, % Non-ferrous metals Fuel and energy Wood and processing Electricity Chemical Ferrous metals Machine building Construction materials Light industry Food Source: Goskomstat, Bank s staff estimates A glance at table 3, which disaggregates the industry sector as the largest component of GDP, confirms the underlying dilemma. Real wage increases are highest where productivity advances are highest, namely in the fuel and energy sectors, which (together with sectors dependent on the budget) also attract the highest rate of investment. Labor markets are competitive within industries but seem segmented across industries, with large wage differentials. There is little evidence of domestic industries expanding fast enough to cushion against the danger of a decline in the energy or budget sectors. Enterprise Finance At the aggregate level, this year s slow down in economic growth was accompanied by a slight deterioration in enterprise finances and payment discipline. Caution needs to be applied, though, as in many respects it is too early to assess the situation comprehensively (figures 4 and 5). Non-cash settlements, which averaged 18.3 percent from January through May 2002, increased to 21.5 percent in June, in what seems to have been a one-off event. At the same time, the net flow of arrears which was negative since August 2001, turned positive again in February, with more overdue payables created than paid. During the period from February to August 2002 the net accumulation of new arrears amounted to 43.4 billion rubles. The share of non-cash settlements in Gazprom s sales rose sharply in the third quarter. 7

8 More worrisome is a decline in average enterprise profitability which fell to 17 percent from January through August 2002, compared to 28 percent a year ago. Partially, this decline may have been caused by changes in corporate profit tax accounting, although Goskomstat makes allowances for this change. However, the drop in profitability was accompanied by an increase in the share of loss-making companies, from 38.6 to 42.7 percent in August 2002 compared to a year earlier (table 14). Table 4: Changes in Productivity and Relative Prices, % H Productivity growth Real gas prices Real electricity prices Real appreciation Real wages Source: Goskomstat, Bank estimates Table 4 draws together the most important cost factors and how they have affected enterprises in the aggregate over the last two and a half years. It also shows how labor productivity growth decelerated over this period. 2 This, together with the enormous increase in real costs which enterprises had to absorb, demonstrates the overwhelming importance which spare capacity had in enabling firms to cope with cost increases. As this buffer disappears, however, and if it is not replaced by efficiency enhancing and capacity creating investment, enterprise profitability will continue to suffer. Producers may find themselves in a situation where cost increases continue while, if demand does not keep pace, they fail to command the resources necessary to invest into restoring their competitive position. To the extent that the demand for better quality goods translates into a high demand for imports, the cycle of poor competitiveness, low investment and even lower competitiveness will hurt the economy as a whole. Enterprises reported lower profits and as noted above, perhaps have allowed payment discipline to deteriorate in Experience would suggest that when Russian enterprises face liquidity problems, they tend to default on wage payments first. In fact, according to Goskomstat, wage arrears grew by 18.3 percent from January to September this year (or 7.3 percent in real terms) while wage arrears of local governments increased by 17.5 percent in nominal or 6.5 percent in real terms (following public sector wage increases mandated by the federal authorities). Inflation Inflation remains under control, increasing cumulatively by 10.3 percent for the first three quarters, compared to 13.9 percent for the same period last year. Foreign reserve accumulation by the CBR continues to be the major instrument by which inflation dynamics are controlled, in particular after electricity and gas tariffs were last raised in February. Year on year inflation is forecast for 2002 at around 14 percent. Exchange Rate and Trade Balance Over the last three years, the cumulative real appreciation of the ruble has amounted to more than 30 percent. The rate of appreciation against a weighted average of currencies of Russia s main trading partners slowed down considerably in the first quarter of 2002, when the real effective exchange rate (REER) appreciated by only 1.4 percent. From March to June, the ruble depreciated by 2.5 percent in real terms (figure 7). The sharp appreciation of the Euro against the Dollar during the second quarter of 2002 partially explains this turnaround. 3 2 Productivity in table 2 is calculated as the ratio of GDP (at constant prices) to the average number of employees in any given period. 3 The stronger Euro translated into a devaluation of the Ruble against the Euro, of 16.7 percent (nominal) and 5.0 percent (in real terms). Despite a 6 percent real appreciation of the Ruble against the dollar, the rate of REER 8

9 The decline in monthly exports due to lower oil prices in the first quarter has reversed itself in the wake of growing oil prices in the second quarter. Through September, exports of goods totaled a monthly average of $8.3 billion, compared to $7.3 billion in the first quarter and $8.6 billion in January-September Average monthly imports also increased, to USD 4.7 billion (still below the 1998 level of USD 5.8 billion). Although the trade balance improved in the second quarter of the year, it is not as strong as last year. The current account surplus fell accordingly, to USD 21.1 billion in Jan-Sep 2002 from USD 28.1 billion a year ago. The balance of payment position remained stable, with the Central Bank continuing to build up foreign currency reserves (table 14). Capital outflows diminished. The sharp decline of outflows observed last year (USD 17 billion against USD 25 billion in 2000) continued in the first half of 2002 when, according to preliminary estimates based on CBR statistics, capital outflows fell to USD 5 billion, with monthly outflows averaging USD 0.8 billion (compared to USD 1.4 billion in 2001). This improvement is even more evident in relative terms: as a share of the resource balance, capital outflows stood at 27 percent in the first half of 2002, compared to 44 percent in Investors are more likely now to keep a larger share of the available resource balance in the country, as opposed to investing the money abroad. In parallel, Russian companies find it easier to access finances abroad. Budget According to preliminary estimates of the Ministry of Finance, the overall fiscal surplus on a cash basis was 3.1 percent of GDP in Jan-Aug 2002, with a primary surplus of 5.5 percent. The federal budget revenue amounted to 20.4 percent of GDP, while expenditures totaled 17.3 percent of GDP. The execution of the 2002 budget has been characterized by increasing transfers to the regions to cover contingent liabilities, either arising from an inability of local authorities to pay wages to their employees, or from natural calamities. The State Duma passed the 2003 Federal Budget in the second reading on October 18, The draft budget stipulates revenues and expenditures of 18.5 and 18 percent respectively (allowing for a surplus of 0.5 percent of GDP, compared to 1.6 percent in the 2002 Budget). The oil price is assumed at 21.5 dollar per barrel, compared to 23.5 dollar per barrel in this year s budget. The difference in the 2003 Budget from that of last year is that the government intends to increase real expenditures by 2 percent, while the effective tax burden for the real sector will be decreased. The positive development, in our view, is that the Government has now set clear priorities for budget financing: for 2003 the priority areas are law enforcement, national defense, the judicial system, and science. The budgeting process, however, is still not properly linked to the costs of the structural reform agenda and expenditure increases remain largely unrelated to reform priorities. Income, Labor Market Indicators and Poverty As has been pointed out already, real income and real wages continued to grow unaffected by the decelerating rates of economic growth. Real disposable income, for example, grew by 7.1 percent from January through September 2002, faster than the 6.0 percent increase in Real wages increased by 17.9 percent during that same period (the average monthly dollar wage was $144 in September, compared to $120 a year ago, figure 9), while the unemployment rate (ILO definition) fell to a post-crisis record low of 7.6 percent in September (table 14). A fraction of this increase can be attributed to the gradual removal of wage payments out of the shadow, although Goskomstat makes allowances for non registered payments. appreciation, reflecting a weighted average between the rate of appreciation of Euro and Dollar against Ruble, was considerably lower. 9

10 On the aggregate level, this means a continued shift of the distributive shares: Table 5: Composition of GDP by Income (in percent) Q1-99 Q1-00 Q1-01 Q1-02 Wages Profits Net taxes Source: Goskomstat, Bank calculations Table 5 shows the distributional effects of the wage increases since The potential downside of this development is that enterprises will be squeezed on the cost side and profitability eroded at least those enterprises, that is, which fail to adjust their quality and continue to produce the type of goods Russian consumers choose to abandon as soon as they can afford to do so. The poverty numbers reported by Goskomstat, on the other hand, suggest only rather modest improvement the share of the population living on incomes below the subsistence level (R1804, or USD57 per month at the end of 2001) fell from 32.6 percent in the first half of 2001 to 30.2 percent in

11 II. Regional Diversification An important dimension in assessing the sustainability of growth in Russia is the impact of investment on the economic development of Russia s regions. In per capita income terms, the regions are moving further and further apart from each other, and domestic investment has been the motor of these changes. The following provides a snapshot of these developments Per capita income Expressed in terms of per capita income, a ranking of Russian s 89 regions reveals increasing inequality over time. If regions are split into quintiles, the majority of them shifted between quintiles since 1994, and the position of many regions moved by more than one quintile. If the ranking is done by domestic investment per capita, volatility increases, as more of the regions move between quintiles over time. If the ranking is done according to foreign direct investment inflows, it shows less volatility than domestic investment, but more than the ranking by per capita incomes. Table 6: Regions Clustered by per capita Income Capital Investment 1994 Share in Total GRP per capita (in 1994 prices) Share in Total Capital Investments Share in total population quintile quintile quintile quintile quintile Russia Federation Source: Goskomstat, Bank staff s estimates Table 6 clusters 79 regions by per capita income (for this data, the year 2000 is the latest available). It shows how the share of total income accruing to the richest 20 percent of the regions has increased from 38 percent in 1994 to 53 percent in At the same time, the poorest 40 percent of these regions commanded only 13 percent of aggregate income in 2000, compared to 18% six years earlier. In similar fashion, the share of domestic fixed capital investment has increased for the top 40 percent and fallen for the lowest 40 percent. Investment and income changes move in the same direction, away from poor and toward the richer regions. Partially, the per capita effects have been mitigated by population movements. Table 7: Regions Clustered by per capita Fixed Capital Investment Capital Investment Share in Total Share in Total per capita (in 1994 Capital Investments Foreign Investment prices) Share in total population : H : H : H : H1 1 quintile quintile quintile quintile quintile Russian Federation Source: Goskomstat, Bank staff s estimates Table 7 shows more recent developments, by clustering the same regions according to domestic fixed capital investment per capita. Just as before, the share of total domestic investment allocated to a relatively small number of well-to-do regions increases, while relatively poor 11

12 regions receive less and less of the total over time. Foreign investment appears to follow the same pattern, and is heavily concentrated in Moscow, St. Petersburg and the Moscow and Leningrad Oblasts. 4 A more detailed econometric analysis of the data confirms that the observed pattern of regional income diversification is driven by domestic fixed capital investment. Domestic investment in turn, is attracted by resource rich regions. Foreign investment is not contingent on oil and gas reserves, but follows the regional pattern of domestic investment and the resulting pattern of per capita income. A peculiarity of the Russian data (with a relatively low share of FDI in total investment inflows) is that other investment inflows, such as trade credits and portfolio investment, have some influence, whereas FDI is too low and does not yet influence per capita growth across regions. In conclusion, (i) increasing regional income diversification; (ii) the dependence of this divergence on domestic investment flows; (iii) the clustering of FDI in a few of the richest regions; and (iv) the observation that FDI does not yet have an impact on the overall distribution of income across regions, are econometrically robust results. 4 A more detailed analysis of FDI s regional distribution is contained in 12

13 III. Monitoring the Impact of Deregulation on Small Enterprises Many studies have shown that the relatively low number of new private companies in Russia, in particular of startups and small and medium enterprises (SMEs), can be explained in part by administrative barriers imposed at different levels of government. An array of administrative procedures, as well as discretionary powers of bureaucrats to intervene in the activities of firms have resulted in the creation of significant barriers to entry and high costs of doing business in Russia. To reduce this regulatory burden, the government has begun to implement a comprehensive set of new laws -- a Deregulation Package -- designed to set clearer boundaries on bureaucratic intervention, which targets four areas: registration, licensing, certification and inspections. Yet, as past experience with reform has demonstrated, the gap between sensible laws and effective implementation can be considerable. Obstacles are particularly serious in the area of deregulation: most regulations are drafted by the federal government, but have to be implemented by officials at the regional or municipal levels who may benefit from the existing status quo. Information is key to this implementation problem. The Federal Government needs to monitor accurately the performance of different regions and regulatory agencies to check whether the new laws are actually applied and, if so, whether they have the desired effects. To address this information gap, the World Bank and the Center for Economic and Financial Research (CEFIR) at the request of the Ministry of Economic Development and Trade jointly designed a mechanism to monitor the implementation of the Deregulation Package and its impact on small businesses. A series of surveys will be carried out over the next three years to provide a more accurate measurement of the extent and dynamics of administrative barriers across Russia s regions. The first of these surveys, implemented from March to April 2002, establishes a benchmark to measure the costs to the firm of registration, licenses, certifications and inspections before the deregulation laws come into effect. 5 This first survey provides some powerful insights into the factors impeding the development of small business in Russia. The Status Quo From the outset, the survey confirms that small enterprises are not the main drivers of economic growth in Russia, as they have proven to be in the more advanced transition economies in Central and Eastern Europe. While other studies have shown that the share of SMEs in the Russian economy is substantially lower than in other advanced transition economies, this survey also demonstrates that existing small firms have not been growing as fast as larger firms. In 2001, while the Russian economy expanded at a rate of 5 percent, 55 percent of the small businesses in the survey had either stagnant or declining output in the second half of the year (table 8). The situation is worse in terms of employment growth: only 22 percent of the firms reported an increase. Since new small firms in transition economies generally demonstrate more efficient resource use than firms that developed from the old command economy, the survey evidence suggests that the transfer of resources from old firms to more dynamic small firms is still at an early stage Russia. 5 The survey is based on face-to-face interviews at 1,998 small businesses (with a median firm size of 10 workers) in 20 oblasts. Randomly selected and evenly distributed across the okrugs, this is a representative sample of the main sectors across the Russian Federation. Two questionnaires were used one for newly registered firms to measure the constraints on opening a new business, and the other for already established firms to measure existing regulatory barriers. This project is carried out with financial support from USAID. The results of the survey are publicly available in an easy-to-use format at the website 13

14 This may well impact negatively on future sustainable growth. 6 The regional growth picture is even more revealing (figure 10). The nominal growth of small business output significantly exceeded the nominal growth of industrial output in only 6 of 20 regions. In nearly half of the regions, output of small businesses grew more slowly than regional industrial output. While earlier small business surveys suggested that corruption and criminal rackets were among the key constraints on their development, this survey suggests a sharp drop in the impact of these problems. When asked to rank the main obstacles to their business, corruption and criminal rackets ranked at the lowest level of impact (table 9). Instead, small businesses complain most about problems faced by businesses everywhere excessive paperwork, taxes and government regulations. Nevertheless, more than two-thirds of the surveyed firms identified one regulatory problem that had a severe impact on their performance or even threatened the very existence of their firm. Small firms in Russia face inconsistent and particularized harassment from individual government agencies. Efforts at deregulation will need to be targeted, therefore, not only at reducing Table 8: SME sales and employment growth Second Half 2001 Sales Employment # of firms % # of firms % Decreased Stayed the same Increased Figure 10: Small business growth is not the main engine of Russian economic growth Krasnoyarsk Primoriye Kurgan Sakhalin Cheliabinsk Khabarovsk N.Novgorod Smolensk Moscow city St.Petersbur Perm Samara Kaluga Saratov Rostov Komi Novosibirsk Altai Amur Moscow Nominal growth of industrial output in 2001 (Goskomstat) Nominal growth of small business output in 2001 (based on survey results) Table 9: General Problems of SMEs average Problem score tax level 2.48 tax administration 2.90 macro instability 2.72 Regulation 3.10 level of competition 3.38 access to credit 3.36 anticompetitive barriers 3.73 Corruption 3.90 Criminal Rackets 4.67 Scale 1-5 the overall regulatory burden, but at reigning in the discretionary authority of bureaucrats to harass particular firms. Although the Government s deregulation package is designed to set clear and reasonable limits on various regulatory tasks, the survey highlights how difficult it will be to implement these new guidelines. A huge gap exists between existing regulatory practices on the ground and the benchmarks set in the new laws. Firms were asked to provide precise estimates of the time and expense of the main regulatory tasks they face as well as the frequency of inspections by various government agencies. Table 10 compares responses with the mandates written in the new deregulation laws, most of which were passed but not enacted at the time of the survey. Less of a Problem 6 The report Transition. The first Ten Years provides evidence that growth in transition economies is driven by the segment of new firms established after the beginning of reforms. It is available at the following web-site 14

15 Table 10: Cost of Regulation and the New Legal Targets Required Under the Actual Mean, Second New Law Half of 2001 Share of Firms Not Meeting the New Mandate Registration Time to obtain 7 days 27 days 83% Cost 2000 rub % License Term of validity 5 years 2.46 years 89% Cost 1300 rub 5500 (median) 82% Inspections Frequency Transparency of Fines * Data for planned inspections not yet available 1 planned in 2 years % 74.2 % 36% (firms that had at least 2 inspections in second half of 2001)* 29.2% (firms that had at least one fine with no transparent explanation) Registration. Both the time to register a new business and the fees charged are far from the targets mandated by the new law (which came into force on July 1, 2002). More than 83% of the firms newly registered in 2001 report waiting more than 7 days to obtain registration, with the average rate reaching nearly a month. The total costs of registration currently reach nearly three times the rate mandated in the new law. Though the new law creates a one-stop window for registration, this will require a significant change from current practice. More than 69.6% of the firms registered in 2001 visited multiple government agencies in order to register. Licenses and permits. The challenge is even greater in the area of licenses and permits. The new law reduces sharply the range of activities subject to licenses and permits, while lengthening the validity of licenses to a minimum of 5 years. But firms are currently being pressured to obtain licenses and permits for activities that are not legally required under existing law. Of the 700 licenses identified in the sample, 37% were for activities not requiring a license under existing legislation. The situation is worse for permits more than 77% of the 336 permits in the sample were not required. The evidence suggests that officials have been exercising considerable discretion in forcing firms to obtain licenses and permits. In addition, the average term of validity of these licenses falls far short of the benchmark set in the new law more than 89% of the firms surveyed hold licenses that are valid for less than 5 years, and the vast majority of them are valid for less than 3 years. Firms are also paying more for licenses than the new law envisions: 82% of the firms surveyed paid more than the 1300 rubles fee set in the new legislation. Inspections. The new law on inspections, which came into force in the summer of 2001, limits planned inspections by each agency to no more than one every two years, though the number of unplanned inspections (i.e. those that result from a report or suspicion of a violation) is not regulated. The number of actual inspections often significantly exceeded the benchmark established by law, in particular by sanitary, fire safety, police and certification officials. In addition, when firms were asked to compare the number of inspections in the second half of after the new law had come into force -- with the number in the first half of 2001, inspections had actually increased by each of the agencies identified. More than 96.1 percent of the firms claimed that the burden of inspections had either stayed the same or become worse. While this may be due to an initial surge in inspections after the new law came into force, the preliminary evidence shows no sign of improvement. In addition, as Figure 11 shows, a substantial number of firms believed that the rules regulating inspections and the fines levied were not transparent or predictable. Of those fines, between one third and one half were not 15

16 based on an official schedule and explanations of the violations were not clear. The biggest offender in this respect is the police almost half of their fines did not have a clear explanation. The survey results also suggest an unusual pattern of inspections. While many small firms managed to avoid inspections in 2001, the firms that did get inspected were highly likely to face multiple inspections by the same agency. For example, while the police came only to 18 percent of all firms, 54 percent of these experienced multiple inspections in the second half of Similarly, nearly a third of the firms inspected by the fire-safety, sanitary, administrative-technical and tax officials faced multiple visits. These results confirm the highly individualized nature of bureaucratic harassment. More importantly, they suggest that once a firm appears on the radar screen of a regulatory agency, it is likely to face multiple visits. Figure 11: A significant fraction of fines during inspections are not determined transparently Labor protection Ecology Administrative-technical Certification Fire safety Licensing Police Sanitary Tax police Tax inspection 0% 15% 30% 45% 60% Fines not based on official scale Explanation of fine not clear Though the legislation to reduce the regulatory burden on small firms is still at an early stage, the benchmark survey shows the large task of administrative restructuring which will be required to meet the mandates of the new laws. Existing regulatory practices are quite far from the new guidelines. In the one area where the new legislation has already gone into effect inspections the preliminary evidence shows no sign of improvement. Structural Change, Economic Growth and the Regulatory Burden What are the implications of these regulatory burdens for economic growth and the process of structural change? The survey reveals some important trends that need close monitoring. The data reveal a clear linkage between firm size and the costs of regulatory burdens. Firm size is the single most important determinant of the extent of the regulatory tax faced by the firm. As firms grow, they appear to hit a regulatory glass ceiling beyond which they face significantly higher regulatory costs. The smallest firms in the survey micro-enterprises with less than 5 officially registered employees face fewer regulatory obstacles across the board. They pay less for such services as licenses and registration, face shorter administrative delays, devote less management time to regulatory tasks and face a lower risk of inspection. They also perceive these regulatory burdens to be much less threatening to their business than larger firms (table 11). 7 The factors that determine the extent of regulatory costs can be analyzed through statistical regressions that control for such characteristics as the sector, location and age of the firm. Taking the median firm of 10 employees as a benchmark, the analysis shows that, for each additional worker hired by the typical firm, the regulatory costs increase significantly across the 7 Recall that the sample of this survey consists of only firms that were successful in entering the market. Firms that were prevented entry in the first place due to hard regulatory requirements might have very different perceptions of the impact of these requirements on their business. 16

17 board. For example, each additional worker brings a 6 percent increase in the time spent by the firm s management on inspections as well as a 2 percent increase in the costs of licenses and certificates. Moreover, larger firms claim that regulatory burdens are a greater threat to their business and are associated with higher incidences of corruption. Beyond employment, other growth factors also appear to spark higher regulatory burdens. For example, firms that reported introducing a new product in 2001, faced higher administrative costs (controlling for other key firm characteristics) such as a 12 percent increase in the number of inspections, 20 percent increase in the time to obtain a certificate, and a 10 percent increase in the costs of a license. Such higher costs create disincentives for innovation. This evidence would suggest that it is not only hard to establish a small business in Russia, but there are strong regulatory obstacles preventing small firms that do manage to enter the market from growing into medium sized firms. Small firms thus face a double bind in the form of entry barriers and growth barriers. While the smallest firms under 7-8 employees manage to stay off the radar screens of regulatory agencies and officials, their further growth and innovation attract unwanted attention resulting in higher monetary costs, more time spent with government officials, and higher risks of harassment from regulatory agencies. The survey also demonstrates the negative impact of a high concentration of employment or production (at the level of municipalities) on the ease of market entry across Russia. In municipalities with more concentrated production, the time and costs of registration and licenses are higher. Yet for those companies which have already entered these concentrated local markets, the administrative burden in particular the risks of inspections is significantly lower. This is consistent with the view that in some municipalities, administrative interventions are used to block market entry and to create protected positions for incumbent firms. Such incumbent firms could be those with close ties to local political elites, with dominant positions in the local labor market, or they could be financial industrial conglomerates (FIGs) and regional monopolists with highly concentrated ownership rights. The regulatory glass ceiling for small firms seriously distorts the structure of this sector. Anecdotal evidence provided in the interviews suggests that many small businesses seek to avoid attracting the attention of regulatory authorities by using alternative employment relationships such as temporary workers, complex networks of sole proprietorships, or scattered production sites. Consequently, small businesses are not serving to absorb to their full capacity labor from restructured or downsizing state and privatized firms a key component of the transition process. Such mechanisms also reduce the transparency of the firm s activities and further complicate the capacity of small businesses to attract capital. Table 11: Smaller firms face lower costs of regulatory burdens Number of employees >20 average payment, rubles Licensing Certification Inspections Registration time needed to acquire, days average time spent by management, person-days average payment, rubles time needed to acquire, days average time spent by management, person-days share of working time spent by management, % time to register, days average payment, rubles