Document of the

World Bank

FOR OFFICIAL USE ONLY

Report Number: 49119-RU

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

INTERNATIONAL FINANCE CORPORATION

MULTILATERAL INVESTMENT GUARANTEE AGENCY

COUNTRY PARTNERSHIP STRATEGY PROGRESS REPORT

FOR

THE RUSSIAN FEDERATION

FOR THE PERIOD FY07 – FY09

July 30, 2009

Russia Country Unit Europe and Central Asia Region

This document has restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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The date of the last Country Partnership Strategy was December 14, 2006

CURRENCY EQUIVALENTS (as of July 1, 2009) USD1 = 31.12 RUB

FISCAL YEAR (January 1 to December 31)

WEIGHTS AND MEASURES Metric System

ABBREVIATIONS AND ACRONYMS

AA Agency Agreement AAA Analytic & Advisory Activities ACS Activity Completion Status AIDS Acquired Immunodeficiency Syndrome APG Associated Petroleum Gas BBB Better Business Bureau BEEPS Business Environment and Enterprise

Performance Survey BHPP Bratsk Hydro Power Plant BOP Balance of Payment CBR Central Bank of Russia CCA Central Customs Administration CIDA Canadian International Development

Agency CIF Cultural Investment Facility CIS Commonwealth of Independent States CPPR Country Program Portfolio Review CPS Country Partnership Strategy DAC Development Assistance Committee DFID UK Department for International

Development DIA Deposit Insurance Agency EBRD European Bank For Reconstruction and

Development ECA Europe and Central Asia ECD Early Childhood Development EE Energy Efficiency EMP Environmental Management Project ERPA Emission Reduction Purchase Agreement ERUs Emission Reduction Units ESMAP Energy Sector Management Assistance

Program ESW Economic and Sector Work EU European Union EurAsEc Eurasian Economic Community EXT External Affairs Vice Presidency FBS Fee Based Services FC Finance Committee FM Financial Management FMS Financial Management Specialist FIAS Foreign Investment Advisory Service

FOB Free on Board FSAP Financial Sector Assessment Program FTP Federal Targeted Program FTS Federal Tariff Service FY Fiscal Year GDLN Global Development Learning Network GDP Gross Domestic Product GHG Greenhouse Gas GoR Government of Russia GPP Gas Power Plant GVEP Global Village Energy Partnership HCS Housing and Communal Services HE Higher Education HEIs Higher Educational Institutions HIPC Enhanced Heavily Indebted Poor Countries

Initiative HIV Human Immunodeficiency Virus HPP Hydro Power Plant HRIP Health Reform Implementation Project IBRD International Bank for Reconstruction and

Development ICR Implementation Completion Report ICT Information and Communication

Technology IDA International Development Association IFC International Finance Corporation IFIs International Financial Institutions IFRS International Financial Reporting

Standards IPO Initial Public Offering IT Information Technology JSDF Japanese Social Development Fund KIA Kazan International Airport MDRI Multilateral Debt Reduction Initiative MFC Multifunctional Service Center MIGA Multilateral Investment Guarantee Agency MOED Ministry of Economic Development MOES Ministry of Education and Science MOF Ministry of Finance MOHSD Ministry of Health and Social

Development

FOR OFFICIAL USE ONLY

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

MOT Ministry of Transport MWWP Municipal Water and Wastewater Project NPAF National Pollution Abatement Fund NPLs Non-Performing Loans NW North West NWCA North-West Customs Administration ODA Official Development Assistance OECD Organisation for Economic Co-operation

and Development PER Public Expenditure Review PIRLS Progress in International Reading Literacy

Study PISA Programme for International Student

Assessment PPP Public Private Partnership PR Progress Report R&D Research and Development RER Russian Economic Report RSEFP Russia Sustainable Energy Finance

Program RTA Reimbursable Technical Assistance RUB Ruble

SD Social Development SEZs Special Economic Zones SFD Southern Federal District SMEs Small and Medium Enterprises SVET Secondary Vocational Education and

Training TA Technical Assistance TB Tuberculosis TF Trust Fund TI Transparency International TIMSS Trends in International Mathematics and

Science Study UES Unified Energy System of Russia USD United States Dollar VEB Vnesheconombank (State Corporation

Bank for Development and Foreign Economic Affairs)

VET Vocational Education System WBG World Bank Group WBI World Bank Institute WHO World Health Organization WTO World Trade Organization

IBRD IFC MIGA Vice President: Shigeo Katsu Jyrki Koskelo Izumi Kobayashi Country Director: Klaus Rohland Snezana Stoiljkovic Frank Lysy (Director

and Chief Economist) Task Team Leader: Marsha McGraw Olive Lisa Kaestner Daniel Villar

COUNTRY PARTNERSHIP STRATEGY PROGRESS REPORT

RUSSIAN FEDERATION

TABLE OF CONTENTS

I. INTRODUCTION AND OVERVIEW .............................................................. 1

II. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS ................... 2

III. PROGRESS IN THE PARTNERSHIP PROGRAM ....................................... 5

IV. THE DEVELOPMENT AGENDA IN FY10-11 ............................................... 9

V. PROPOSED BANK GROUP ASSISTANCE IN FY10-11............................. 12

VI. RISKS.................................................................................................................. 13

VII. CREDITWORTHINESS ................................................................................... 14

ANNEXES: Annex A1: Progress in Russia during the CPS Period Annex A2: Russian Federation: Summary of the Government’s “2020 Development Strategy” Annex A3: Russia as a Donor Annex A4: Summary of WBG Contributions by CPS Pillar Annex A5: CPS Results Matrix Annex A6: Fee-Based Service Activities Annex A7: Russian Federation: Subnational Lending Annex A8: Russian Federation: Carbon Finance Annex B1: Country at a Glance Annex B2: Selected Indicators of Bank Portfolio Performance and Management Annex B3: IBRD lending program Annex B3: IFC Program and MIGA Guarantees Annex B4: Summary of Non-lending Services Annex B5 Russian Federation Social Indicators Annex B6: Key Economic Indicators Annex B7: Key Exposure Indicators Annex B8: IFC Portfolio Annex B8: IBRD Portfolio MAP: IBRD 33470

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COUNTRY PARTNERSHIP STRATEGY PROGRESS REPORT RUSSIAN FEDERATION

I. INTRODUCTION AND OVERVIEW

1. The Country Partnership Strategy (CPS) developed a new framework for cooperation based on innovative delivery mechanisms. Completed on June 30, 2009, the CPS remains valid and is proposed for extension to June 30, 2011. The strategy aimed to expand the relationship between the Russian Federation and the World Bank Group (WBG) through a significant shift in traditional approaches.

• First, demand increased for IBRD analytical and advisory activities (AAA). Given Russia’s strong macroeconomic fundamentals and significant international reserves, the Government refocused the partnership strategy away from finance to global knowledge services. In the context of a constructive dialogue between IBRD and the Russian Government, joint AAA aimed to modernize public finance and administration, prepare public-private partnerships (PPPs) in infrastructure, and improve social service delivery.

• Second, delivery mechanisms more appropriate to an advanced middle-income country were devised. At the federal level, the Government and IBRD are designing a framework for a new mechanism of project implementation, without recourse to sovereign borrowing, that could be supported by fee-based advisory and analytical services by IBRD. At the subnational level, the Government encouraged the WBG to develop cooperation programs directly with regions, where development needs are greatest. Accordingly, the WBG initiated a regional program of fee-based services and subnational lending without a sovereign guarantee to support regional development strategies.

• Third, the WBG used these mechanisms to meet regional development objectives, primarily in education, health, social assistance, public administration, and infrastructure. The International Finance Corporation (IFC) also focused on frontier regions to reach small and medium enterprises (SMEs) through its financial sector clients and to lay the foundations for new products, such as mortgage and energy efficiency finance. Joint IFC-Bank subnational loans enabled several regions to finance critical social infrastructure.

• And fourth, in response to Government interest in capacity-building, substantial progress was achieved in raising Russia’s profile as a donor through joint initiatives to address global issues, such as diseases (malaria), the food price crisis, educational quality, financial literacy, and more recently, the financial crisis.

2. The global recession altered Russia’s growth outlook. As in many other countries, the economic and social consequences in Russia are severe. Real Gross Domestic Product (GDP) growth swung from positive 8.1 percent at the end of 2007 to possibly negative 7.9 percent in 2009. The fiscal deficit may exceed 7 percent of GDP, and international reserves may be significantly lower by end CY09. These changes have created new requirements in the short-term to overcome the crisis. In the context of a recovery program, the Government in CY10 may finance the fiscal deficit through its Reserve Fund and external borrowing. At the same time, the recession revealed long-standing weaknesses that the Government must address in the structure of the economy, the structure and efficiency of public expenditures, and dependence of the banking sector on external financing.

3. Uncertainty in global and national economic conditions requires flexibility in responding to the rapidly changing environment. We propose to extend the CPS until the end of FY11. If conditions change, we will come back to the Board of Executive Directors earlier with a new CPS. Until such time, we conclude that, overall, the strategy as outlined in the CPS provides sufficient flexibility to pursue long-standing structural and social objectives while adjusting to new conditions.

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4. Going forward, WBG activities will advance the objectives in the current CPS pillars while simultaneously meeting new needs stemming from the crisis. In response to Government demand, the WBG will use traditional as well as new instruments developed during the CPS period (budget-financed investments with fee-based implementation services, fee-based knowledge services, subnational lending, and carbon finance).

• Should global economic conditions and oil price developments result in a decision by the Government to borrow in CY10 from IBRD, we would be ready to respond with an appropriate combination of lending operations (guarantees, investment, fast-disbursing). These may support anti-crisis programs to improve the efficiency of public and social expenditures, particularly to protect the most vulnerable, as well as longer-term investments to diversify and modernize the economy, including infrastructure. To be prepared for this possibility, we propose a CPS envelope of up to USD4 billion phased over the CPS period. Individual lending operations would be agreed, contingent on IBRD's financial capacity at the time.

• Similarly, the crisis has decreased access to long-term debt for the private sector, raising demand for IFC financing. IFC has an integrated investment and advisory approach with an immediate priority to assist existing clients with crisis management, meeting liquidity needs with trade finance and working capital, and providing tools to manage non-performing loans (NPLs) and improve competitiveness. IFC’s selective longer-term strategy is to contribute to climate change mitigation, support development of infrastructure (transport, logistics and municipal) and increase access to finance, in particular to SMEs, with an overall focus on reaching poorer regions of Russia. Subject to capital constraints, IFC expects to commit up to USD1.4 billion in FY10-11.

• IBRD and IFC will cooperate on analytical, technical and/or financial support to the banking sector as well as on subnational lending.

• The Multilateral Investment Guarantee Agency (MIGA) will take a prudent and selective approach to providing political risk guarantees in priority sectors in view of its current high level of exposure. In principle, based on the merits of the case, MIGA can support foreign direct investments into Russian majority-owned corporations operating on a commercial basis.

5. The importance of Russia as a donor will grow, despite fiscal constraints in Russia. Russia is committed to expanding its aid program markedly, drawing on IBRD expertise in establishing development institutions and delivering assistance. As a donor and the regional engine of growth, it may rely on WBG experience in creating a cooperation framework for Central Asia and in developing mechanisms for the USD10 billion Eurasian Economic Community (EurAsEc) anti-crisis facility. In cooperation with the Organisation for Economic Co-operation and Development (OECD), IBRD will support Russia in preparations for the 2010 conference of emerging donors in Russia.

II. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS

6. Presidential elections in 2008 went smoothly; the new political leadership has confirmed the economic development strategy. The political transition was accompanied by organizational changes and responsibilities of governmental agencies and reshuffling of ministers. The new political framework is stable and the division of responsibilities between the head of state and head of government has been established. In November 2008, the Government spelled out its vision for the country in 2020, linked to widely-tracked indicators (see Annex A2). Three overarching priorities for 2012 are: growth and economic diversification, improvements in human development, and regional development.

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7. With robust economic growth, Russian citizens enjoyed gains in living conditions until autumn 2008. The economy grew briskly during the CPS period at about 7 percent annually on the heels of high oil prices, robust domestic demand, sound fiscal management and strong macroeconomic fundamentals (see Table 1). The Russian Federation advanced to become a top-ten world economy in terms of dollar GDP. International reserves peaked at USD584.4 billion in August, 2008 (about USD400 billion in July 2009), the third highest in the world, nearly equal to the total external debt. Strong growth raised employment, wages and income for most of the population. Unemployment reached a record low of 5.4 percent, while the national headcount poverty rate was nearly cut in half from 2002 to 2007, bringing a better life to 12.5 million people. Not surprisingly, therefore, the Life in Transition Survey in 2006 found Russians had a more optimistic outlook than at any time since 1991.

Table 1. Main macroeconomic Indicators in Russia, 2004-08 2004 2005 2006 2007 2008 GDP growth, % 7.2 6.4 7.7 8.1 5.6 Industrial production growth, y-o-y, % 8.0 5.1 6.3 6.3 2.1 Fixed capital investment growth, %, y-o-y 13.7 10.9 16.7 21.1 9.8 Federal government balance, % GDP 4.3 7.5 7.4 5.5 4.0 Inflation (CPI), % change , e-o-p 11.7 10.9 9.0 11.9 13.3 Current account, billion USD 58.6 84.2 95.6 76.6 98.9 Unemployment, % (ILO definition) 8.2 7.6 7.2 6.1 6.3 Reserves (including gold) billion USD, e-o-p 124.5 182.2 303.7 478.8 427.1

Sources: Rosstat, CBR.

8. Behind this performance were policies that created more certainty for the macro-economy and business. A vibrant and pragmatic technical debate in government, public institutions and academia framed major policy decisions. These built on lessons from the 1998 financial crisis. In particular:

• Sound policies contributed to maintaining macroeconomic stability. Russia has saved large oil windfalls in a Reserve Fund (capped at 10 percent of GDP) and a Fund for Future Generations (accumulating oil surpluses beyond the Reserve Fund) to help avoid the ‘Dutch disease’ dilemma that plagues many oil-rich countries. The Ministry of Finance (MOF) managed to maintain healthy fiscal surpluses against pressures for larger spending and lower tax rates. And Russia repaid a significant portion of its external debt, thereby reducing external vulnerabilities.

• Fiscal reforms improved budget planning and execution. Federal and regional executive agencies prepared medium-term budgets with performance targets. Local self-government was adopted. Municipalities received budgetary autonomy, and public participation in decision-making increased.

• Transparency and client service improved in tax collection and customs administration upon adoption of e-government and new service performance standards.

• The Central Bank of Russia (CBR) made progress in strengthening the banking sector by upgrading prudential regulations, introducing risk-based supervision, and increasing transparency of bank ownership. In early 2008, Russia’s banks enjoyed relatively sound financial indicators, with strong solvency (average capital adequacy ratio of 15.5 percent), high profitability (return on equity of 22.7 percent), low non-performing loans (2.5 percent of total loans)1 and adequate liquidity (short term liquidity ratio of 72.9 percent).

9. Since mid-2008, three channels transmitted the global crisis to Russia. Strong macroeconomic fundamentals helped policymakers deal with the impact. First, oil prices collapsed by 70 percent from

1 Note, however, that NPLs in Russia are defined as debt-service charges overdue by more than 60 days, excluding refinanced and restructured loans.

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their peak in July 2008 to December 2008. This, along with high-profile corporate disputes, undercut confidence in the energy-dominated stock market. Along with other markets around the world, it crashed in September 2008, losing about USD1 trillion in wealth. Second, capital inflows that were largely directed to the oil and gas sector reversed, leading to capital outflows of about 14 percent of GDP between 2007 and 2008-09. Third, liquidity tightened dramatically in emerging markets. Russian banks, which relied on external debt and petro dollars for financing, faced sharply higher repayment and rollover risks. Smaller regional banks in particular suffered from limited access to international capital markets and Central Bank funds. The size of these shocks were much larger than during the 1998 crisis, but Russia’s fiscal and macroeconomic policy fundamentals this time were stronger and policymakers were better prepared to deal with the new crisis (Figure 1).

Figure 1. The Macroeconomic Impact of the Crisis

-10-8-6-4-202468

Real GDP Growth, % Net Capital Flows, % GDP Fiscal Balance, % GDP

2008 2009 (Estimate)

Sources: Rosstat, CBR, World Bank staff calculations

10. The impact on the real economy was swifter and deeper than expected. The decline in global demand, the fall in commodity prices, and the tightening of credit have accelerated Russia’s economic slowdown since the fourth quarter of 2008. A deep recession began in 2009 with an across-the-board negative output growth. With few exceptions, all sectors reported declines in output in the first quarter of 2009 (construction, manufacturing, and transport each contracted by more than 18 percent). Many of Russia’s regions, including those relying on heavy industry and exports, are facing sharply lower revenues and leaner budgets. According to current World Bank estimates, Russia’s economy is likely to contract by 7.9 percent in 2009. The recovery is likely to be slow, with only a modest 2.5 percent growth in 2010 from a significantly reduced base and in the context of sluggish global demand. Current growth projections suggest that real GDP in Russia will reach the pre-crisis high level only at the end of the third quarter of 2012 (Figure 2).

11. Households are feeling the crisis through job and wage cuts. The speed of adjustment in Russia’s rather flexible labor markets has been dramatic. Unemployment increased from a record low of 5.4 percent in May 2008 to 9.9 percent in May 2009. World Bank estimates suggest that aggregate unemployment will increase to 13 percent and real wages will fall by 4.1 percent in 2009. The poverty impact will be significant. The number of poor in Russia may rise to 24 million (headcount poverty of 17.4 percent), wiping out part of the gains in reducing poverty in recent years.

12. Broadly successful crisis management staved off a run on banks, prevented a currency crisis, and eased impact on households and the real sector. After the stock market collapsed, authorities responded swiftly and massively by reversing the earlier monetary tightening and committing substantial fiscal resources to shore up the banking system and ensure liquidity in financial markets. The Central Bank was willing to spend considerable internal reserves to have a smooth transition to a new equilibrium level of the exchange rate that reflected the changed fundamentals. International reserves went down by about USD200 billion from early September to about USD380 billion by end-January. In the process, the CBR has made exchange rate policy more flexible and by February 2009, the ruble regained stability and international reserves stabilized with CBR limiting its interventions in the foreign exchange market. CBR’s interest rate policy also played a key role in stabilizing the exchange rate. Importantly, this difficult period was managed with no currency crisis. No major banks failed, and most banks managed to

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repay external short-term obligations. Deposit withdrawals from the banking sector stopped and the CBR has now significantly restricted its interventions. More recently, with oil prices beyond USD60 per barrel at end-June, international reserves increased above the USD400 billion mark as CBR began to accumulate reserves to ease appreciation pressures on the ruble.

Figure 2: The impact of the crisis on the long-term development objectives in Russia: dynamics of GDP level in Russia 2007-2020, (q1-2006=100)

Source: World Bank projections. Strategy 2020, Government of Russia.

13. Russia’s early fiscal policy response has been larger than that of many other G-20 countries and greater than the internationally-recommended 2 percent of GDP. The total fiscal cost of measures implemented in 2008 and planned for 2009 amounts to over 2.9 trillion rubles (around USD90 billion), or about 7 percent of GDP. Overall, the size of anti-crisis measures seems appropriate given Russia’s much larger growth deceleration compared to other G-20 countries, relatively weaker automatic stabilizers and large fiscal reserves accumulated in the Reserve Fund, which makes it possible to finance even a larger fiscal deficit emerging in 2009. The fiscal policy response has so far largely focused on supporting the financial sector and (large) enterprises. But there was rather limited support to households or SMEs relative to the scale of social dislocation. With deeper unemployment and poverty impact, additional fiscal stimulus directed to support households, SMEs, and infrastructure is now being considered.

14. Going forward, the major problem for the Russian banking system appears to be rising credit risk, NPLs and possible bank insolvencies. To address the problem, the CBR introduced programs to recapitalize banks through a combination of direct capital injections to state banks and government subordinated loans to private banks when matched by private equity increases. However, non-transparency of credit risk across the banking sector makes it hard to judge real solvency. Furthermore, the increasing credit risk premium is being reflected in the rising cost of finance and difficulties for corporates and households to service their debt. The need to rollover debt is especially large for corporates as their borrowing is typically very short-term, between 6 to 12 months maturity. There has been a significant drop in lending to corporates and households in early 2009. While the government has not announced any program for corporate loan restructuring, a program to restructure distress mortgage loans of lower-income households has been introduced through the State Agency for Home Mortgage Loans. It is expected that economic activity will be low throughout 2009 and that NPLs will increase substantially. The Government has allocated in the 2009 budget 540 billion rubles (USD18 billion; equivalent of about 1.3 percent of GDP) for additional support to the banking sector.

III. PROGRESS IN THE PARTNERSHIP PROGRAM

15. With the exception of economic diversification and targeting of social assistance, Russia was making good progress in its medium-term development strategy prior to the crisis. Annex A1 details thematically the progress in Russia during the CPS period. Living standards, human development

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indicators, and regional development all exhibited positive gains. The Russian Federation considerably enhanced its global role by doubling its commitment to the International Development Association (IDA), embracing multilateral principles for development assistance in a new national strategy, and acceding to the Kyoto Protocol (see Box 1). Nevertheless, strong economic growth and the concomitant growth in prosperity from 2000 to 2008 weakened the focus on structural reforms and diversification of the economy through promotion of entrepreneurship. Efforts to improve the investment climate notwithstanding, corruption continues to be a serious impediment and administrative barriers in public governance remain substantial. Moreover, lax accounting and provisioning rules, among other regulatory and supervisory shortcomings, contributed to excessive foreign borrowing in the banking sector. Social assistance is poorly targeted. The Government is intent to strengthen the federal policy framework and regional implementation in each of these areas in light of the crisis.

Box 1. Russia’s Role as a Donor

In 2007, the Government adopted a strategy that aims to develop an Official Development Assistance ( ODA) system along the lines of internationally recognized principles as established by the Development Assistance Committee (DAC) of the OECD. Since then, Russia increased its assistance to IDA and supported a number of global development initiatives by contributing to the IBRD-managed Trust Funds. These Trust Funds support the quality of education through the Education for All Fast Track Initiative program (READ Trust Fund), the Malaria Booster Program in Africa, access to clean energy in Africa, global financial literacy initiatives, and the Global Food Crisis Response Program (See Annex A3). Despite the financial crisis, Russia intends to increase its assistance through pledges to multilateral (World Bank Rapid Social Response Program) and regional support mechanisms (Eurasian Economic Community USD10 billion Anti-Crisis Fund), for which the World Bank will provide advice and assistance.

IBRD is cooperating to provide advisory services at the request of the Government to help Russia develop an effective national ODA system. Policy workshops informed the design of the National Concept of Development Cooperation and assisted in the identification of capacity gaps. In conjunction with OECD, IBRD will advise the Government on the preparation of a conference for emerging donors to be convened in Moscow in early 2010. Among other topics, the conference will examine the role of emerging donors in addressing the decline in private capital flows to developing countries in the wake of the financial crisis.

16. The CPS selectively targeted key development needs in the Government’s three overarching priorities: economic growth and diversification, human development, and regional development. Annex A4 summarizes the WBG contributions by CPS pillar. IBRD, IFC and MIGA2 maintained modest programs in relation to Russia’s sizeable economy (USD1 trillion in 2007). By focusing on policy and institutional advice with broad macro and microeconomic impact, regional investments with strong demonstration effect, mobilization of other funds, and new markets underserved by the private sector, the WBG was more catalytic than the size of financial transfers may suggest.

17. Overview by Portfolio. As anticipated in the CPS, the IBRD portfolio wound down from 22 to 14 projects for total commitments of USD1.391 billion. New federal borrowing was limited to support for judicial reform and state statistics.3 In contrast, demand for fee-based services exceeded expectations and, as expected, both IFC and MIGA expanded their portfolios, keeping Russia in their top exposures4. WBG portfolios are complementary. IBRD is devoting 60 percent by lending volume to public

2 IBRD disbursements for active loans totaled USD552.45 million against a portfolio of USD1.39 billion. IFC invested more than USD1.8 billion in 60 projects in Russia’s private sector during the CPS period. As of May 31, 2009, IFC’s outstanding portfolio was USD1.9 billion in 111 projects. As of May 31, 2009, MIGA’s outstanding gross exposure in Russia was USD924 million. Besides, the Board approved in May and June 2009 new guarantees in the financial and manufacturing sectors of up to USD150 million, which have not been signed yet. 3 The Housing and Communal Services loan, approved by the Board in February 2008, has been cleared for signature by Government. 4 As of May 31, 2009, Russia is IFC’s second largest outstanding country exposure. As of May 31, 2009, Russia was MIGA’s second largest country exposure.

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administration reforms and 20 percent to social and communal services that support better institutions and services for citizen welfare and business growth. IFC targeted about half (USD835 million) of the investments during the CPS period to banks, which in turn increased access to finance for entrepreneurs, particularly for SMEs and in underserved regions. IFC’s remaining portfolio represents investments in private enterprise across real sectors with a focus on infrastructure and value-added manufacturing, often paired with advisory services and supporting energy efficiency and cleaner production. MIGA issued nearly USD581 million in new guarantees during the CPS period. In particular, MIGA supported various investments of global financial institutions into their banking, mortgage and leasing subsidiaries in Russia. MIGA focused on financial institutions committed to expanding their operations at the regional level and to improving the range and quality of their financial products, including to consumers and SMEs.

18. Risk ratings increased in IBRD’s portfolio. Reasons varied by project. Fundamentally, however, implementation delays derived from a slow-down in decision-making prior to the parliamentary and presidential elections and to agency restructuring thereafter. Project age did not correlate with performance rating. Several older projects continued to deliver important developmental benefits (e.g., Capital Markets Development Project) while those that did not are being closed down (e.g., Sustainable Forestry). Procurement was protracted in a few projects with information technologies, and these required more intensive supervision. Joint Working Group meetings will be held more frequently in the next two years to bring portfolio issues to the attention of senior officials. With respect to financial management (FM) issues, the residual FM risk in the portfolio remained acceptable according to supervision mission reports of the country Financial Management Specialist (FMS).

19. The CPS introduced six distinctive features to WBG engagement. Given Russia’s vast territory and strong financial position, the CPS developed the following new engagement approaches (see Box 2).

• Regional focus. With encouragement from the Federal Government, IBRD selectively served several of Russia’s 83 regions. Instruments and thematic priorities are customized by region. Similarly, IFC prioritized poorer frontier regions for investment and advisory services, increasing the proportion of annual commitments in frontier regions from 24 percent in FY07 to 54 percent in FY09.

• Fee-based services. All services were provided on a demand-driven basis in line with Bank guidelines, quality control procedures, and support from network anchors. Full cost recovery will be achieved. The projects require IBRD to be highly flexible and timely in delivering services. Demand covers a wide range of activities that are well-aligned with Russia’s development challenges, from human development to social assistance, to PPPs and to capacity-building for ODA. Total contract values of all 21 completed and signed projects for the period from FY07 through FY10 are approximately USD9.5 million. In December 2008, a fee-based service agreement between the Russian Federation and IBRD of USD3.0 million went into effect to increase capacity for Russian donor assistance in education quality. Results from recently completed activities are in Annex A6.

• Capacity-building for donor aid. By helping Russia to adopt international principles and best practices, IBRD is contributing to a unified approach on development cooperation. The importance of Russia’s support increased during the global food price crisis and the global recession, for which Russia has committed approximately USD1.9 billion for hard-hit developing countries, with a focus on Central Asia.

• Joint realization of projects on the basis of new cooperation mechanisms. As expected, beginning in CY10, it will be possible to put in practice a new mechanism for project implementation, without sovereign borrowing, based on IBRD advisory and technical services. The first example will be the Financial Literacy Project at the federal level. Regulations are under development by Russia and IBRD to enable this process. Several other

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projects (Microfinance, PPP TA, Cultural Heritage and the Southern Okrug Local Initiatives Project) are ready to be appraised for implementation through this new modality but may also be considered for implementation through traditional IBRD lending, depending on Government’s decision at the time of negotiations.

• Subnational lending without sovereign guarantees under the joint IFC/Bank facility. These loans (see Annex A7) meet a vast, heretofore unmet demand for essential investments in infrastructure services in regions with limited access to long-term commercial finance. Endorsed by the IBRD and IFC Boards in 2006 as a three-year pilot (FY07-09), the program created a successful operational partnership in Russia by combining IFC financial analysis and Bank sector expertise. In Russia, six operations for a total investment of USD116 million are completed or disbursing; several others are in the pipeline. By qualifying for these commercially-priced loans, subnational authorities become increasingly creditworthy and financially self-reliant. In most cases the qualifying regions were beneficiaries of previous Bank assistance to strengthen fiscal and financial management.

• IFC and MIGA supported a growing private sector through significant investment, complemented by advisory activities. IFC also played a catalytic role, mobilizing additional private investment – including USD674 million in loan syndications – into priority areas. IFC also significantly increased the proportion of equity in its portfolio in order to strengthen its role in client relationships.

Box 2. New Initiatives in the Russian Federation: What Have We Learned?

Early lessons from three initiatives – fee-based services, IFC/Bank subnational lending without sovereign guarantees, and donor capacity-building – carry institutional connotations for future development work in advanced economies.

Fee-Based Services. Though processed like standard AAA, teams working on fee-based services see several critical differences: response time is shorter, recommendations are more specific, cooperation between Network Anchors and Regions is more critical, and client expectations for quality are higher. The result is an entirely new product, unique to the client, yet rich with insights for broader sector policy. For example, the request for advice on how to build a world-class university generated the development of a benchmarking tool by the education anchor, which was then applied to several universities in Tatarstan. While recommendations are specific to the university, analysis of findings suggests new strategic directions for education policy at both the regional and federal level. Bank teams engaged in these knowledge services are highly motivated to see development impact, delivered efficiently.

Subnational Lending. Test cases of non-sovereign lending illustrate the challenges and benefits of marrying the institutional strengths of IFC and the Bank into one project team. IFC brought expertise in financial due diligence and pricing and structuring deals while the Bank contributed operational strengths in appraising and supervising sector investments. After overcoming differences in institutional culture and bureaucratic processing, the teams have developed an efficient working protocol and on-the-ground cooperation. The beneficiaries are subnational entities. By qualifying for these commercially-priced loans, subnational authorities become increasingly creditworthy and financially self-reliant. In most cases the qualifying regions were beneficiaries of previous Bank assistance to strengthen public financial management (PFM) or sector policy. Both were present in the Chuvash Republic: the first subnational loan exclusively for health care capital expenditures followed successful implementation of PFM reforms and the Health Reform Implementation Project. Russia as a Donor. This is the first example of fee-based knowledge services for developing donor capacity following DAC principles. Cooperation follows a learning-by-doing approach. By channeling development assistance through WBG instruments, Russian specialists become active participants in addressing urgent human development needs in Africa (malaria control, access to energy, quality of primary education), reducing the risks of infectious disease in Central Asia, and in producing tools for public policy analysis. Over the medium-term, trust funds managed by the World Bank for Russia will contribute new international methods to measure education quality and financial literacy. These products will contribute in turn to the effectiveness of Russian Government and World Bank programs in sectors that underpin development prospects globally.

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20. In response to the changed environment, the WBG adjusted its strategy and provided just-in-time support for the Government and private sector clients.

• First, IBRD stepped up crisis-related macroeconomic monitoring, policy analysis, and response options including increasing public expenditure effectiveness, primarily through Russian Economic Reports and the upcoming Public Expenditure Review (PER). Russian Economic Reports have been put on a quarterly cycle and are widely read and commented upon by policy-makers and the general public, internal and international. The March 2009 report, for example, called for a shift in anti-crisis policy focus from banks and firms to households and recommended spending one percent of GDP to top-up some existing, social assistance instruments that are known to better target assistance to poor and vulnerable households (i.e., low-end pensions, unemployment benefits, and child allowance).

• Second, at the federal level, IBRD initiated a dialogue on social assistance targeting, labor market monitoring, and active labor market programs that will provide additional resources and information for policy-makers in selecting cost-effective interventions.

• Third, IBRD began a new dialogue with federal and regional governments to support infrastructure finance under constrained conditions, including through guarantees and bond issuance, and to help maintain and accelerate the momentum on structural reforms.

• Fourth, IFC is responding on multiple levels.

• At the outset of the crisis, IFC conducted stress tests of each client and customized support to improve client adjustment to current conditions. IFC is providing short-term liquidity, in particular trade finance, as well as guarantees, quasi-equity and subordinated debt to its investment clients across sectors and is assisting the banking sector with the management of NPLs and risk management through investment and advisory services. Crisis-related advisory programs have already reached more than 220 private and public sector participants through seminars on crisis management. In FY09, IFC provided USD200 million to 7 banks in Russia in the form of trade finance (USD80 million), equity (USD43 million), and senior and subordinated loans. In addition IFC mobilized USD545 million in syndications through partner banks.

• IFC advisory and investment programs in energy efficiency and cleaner production increased cost competitiveness to help businesses weather the crisis. IFC advisory programs currently under development will assist real sector companies with crisis management.

• Jointly with the Foreign Investment Advisory Service (FIAS) and IBRD, an IFC advisory team is also reviewing the legal framework for distressed assets management in order to make policy recommendations. IFC’s technical assistance programs to the banking sector are providing a wide range of risk management services and expertise in managing real estate and construction exposures.

IV. THE DEVELOPMENT AGENDA IN FY10-11

21. Russia’s economic recovery and subsequent growth is vital to the regional and global economy. Russia is the regional engine of growth, both as the major destination of exports and migrant labor from the Commonwealth of Independent States (CIS) countries.5 Russia is also among the top five remittance-

5 Russia is the largest migrant destination after the United States, with over 12 million immigrants accounting for about 8 percent of the population.

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sending countries, most of which are destined to CIS countries (remittances from Russia account for about half of annual GDP of Tajikistan, a third in Moldova and a fifth in the Kyrgyz Republic). With unemployment surging in Russia, jobs for migrants are now at risk. The pace of growth in total remittance receipts for the CIS region had already decelerated to only 7 percent in 2008, compared with record growth of 75 percent in 2007, with further decline expected this year. Russia is also a major player in the global economy as the world’s largest exporter of natural gas, the second largest oil exporter, and the third largest wheat exporter. Finally, pristine territory in Russia’s vast landmass represents about 22 percent of the world’s undisturbed ecosystems. These have global value and significance for biodiversity protection, carbon sequestration and other environmental functions. At the same time, Russia is the world’s third largest emitter of greenhouse gases. As a result, how Russia responds to the crisis and invests in sustainable development is critical to regional economic recovery and growth.

22. The Government is intent upon improving social systems and modernizing the economy in line with its 2020 goals.6 There is general agreement in Government that policy actions during the crisis should also aim to modernize the Russian economy for the post-crisis period.7 The WBG may provide support in all these areas.

• Broadly, the Government aims to increase the effective use of public expenditures, with a specific focus on the social sectors (health finance, pensions, and families) and protection of vulnerable groups.

• A second major area would be actions to diversify the economy and increase competitiveness, especially through greater energy efficiency.

• A third area would be infrastructure investments to remove bottlenecks for longer-term growth.

23. Improvements in the effectiveness of public expenditures, especially social expenditures, are necessary for recovery and longer-term economic growth. Demographic trends project the workforce will decline by one million persons per year from 2011 to 2020, dampening economic activity and growth. The net effect of demographic trends is that public expenditures on pensions, health and education are likely to increase significantly by 3-4 percent of GDP under any long-term economic scenario. As expenditures rise, comprehensive policies are vitally needed to: i) improve targeting of social assistance to the most needy; ii) improve health status and life expectancy; iii) develop globally competitive skills for productivity from a smaller labor force; iv) develop effective migration policies; and v) secure the pensions of retirees, who will form a significant proportion of the population of Russia. IBRD is developing a work program in response to Government requests for assistance in these areas based on recent long-term fiscal analysis, technical workshops on social assistance targeting pension system options, and sector work on demographic policy.

24. To modernize the economy, Russia must employ its energy wealth more efficiently and open space for innovative entrepreneurs. According to a joint IFC-Bank study, Russia is the most energy-intensive country among the ten largest economies, and can save as much energy annually as is consumed by France. Without better energy conservation and investment in more cost-effective production, transportation, and consumption, Russia may soon have to choose between exporting oil and gas and using it domestically. Infrastructure investments will need to incorporate more energy efficient technologies for the economy to become more competitive and less energy intensive. Outside of the immediate crisis response, IFC’s top priority in Russia will remain commercial and residential energy

6 The Government has already revised substantially its 2009 budget to reflect much lower oil prices and dramatically worse international environment. It is also expected to revise its medium term growth outlook. 7 In November 2008, prior to the full onset of the crisis in Russia, the Government issued its vision for the country in 2020 (see Annex A2). In April 2009, the Duma approved the Government’s anti-crisis agenda and revised budget, which identifies seven priorities, including protecting vulnerable groups, increasing economic diversification, reducing barriers to SME development, and maintaining sound macroeconomic policies.

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efficiency and cleaner production, in order to increase the efficiency of the Russian economy and to alleviate effects on climate change. Based on a joint study, IBRD and IFC are collaborating on advisory and financial services to expand adoption of energy efficient technologies (see Box 3). In response to demand from regional authorities, IBRD will provide technical advisory services on early-stage innovation so that start-ups and small enterprises can conduct more R&D (research and development) for a broader base of potentially marketable innovation.

25. Infrastructure investments serve anti-crisis and longer-term growth objectives. The Ministry of Transport (MOT) indicated that lack of sufficient transport infrastructure constrains economic growth while also resulting in disproportional development in regions8. Bottlenecks result from limited access both to all-season roads and rail service. In 2008, the Government announced plans for a large 7 year spending package valued at cumulative 13.9 trillion rubles (USD570 billion or about 4.8 percent of GDP annually) to revamp transportation infrastructure across the country. Fiscal constraints will delay this strategy. Likewise, several PPPs to close the investment gap are now on hold due to private capital constraints and growing government deficits. IBRD is developing a range of financial options for railways and transport and is offering advisory services to help restructure PPPs, develop and prioritize projects to better respond to the crisis, increase the efficiency of services, and attract private investment when the situation improves. In particular, IBRD is continuing its close relationship with the City of St. Petersburg on four major PPP projects that were initiated prior to the financial crisis. IFC will continue to support private participation in infrastructure, particularly where IFC can play a strong catalytic role, including mobilizing investment from other International Financial Institutions (IFIs), private sources, and the Russian government. In June 2008, the WBG signed a memorandum of understanding with the VEB for broad cooperation on infrastructure development, among other objectives. In FY09, IFC invested with VEB and others in a USD500 million infrastructure fund focused primarily on Russia and Kazakhstan.

Box 3: Energy Efficiency for Climate Change Mitigation for the Public and Private Sectors

Russia, a signatory of the Kyoto Protocol, has significant potential to reduce greenhouse gas (GHG) emissions and is thus a potentially important market for carbon finance. Russian oil major Rosneft and the World Bank signed an Emission Reduction Purchase Agreement in 2008 to reduce GHG emissions resulting from gas flaring by 5.3 million tons, by selling these emission reduction units (ERUs) to the European Union (EU)-based funds for trading in compliance with the Kyoto Protocol or the EU Emissions Trading Scheme. The World Bank will formalize the transactions with ERUs and monitor and control compliance. IFC has done one carbon finance project in Russia (purchasing ERUs from destruction of nitrous oxide in a fertilizer plant) and is considering developing specific Carbon Delivery Guarantee transactions.

The Russia Sustainable Energy Finance Program (RSEFP), a joint IFC/ IBRD initiative, works with private sector banks, energy auditors, project developers and vendors to develop a marketable energy efficiency product for the industry. Building on the methodology and successful outcomes of the energy efficiency study, which increased political and commercial awareness of Russia’s energy efficiency potential, the RSEFP team is also helping regional authorities improve energy efficiency through private and public investments in energy efficient (EE) projects. IFC has committed USD150 million to Russian banks for EE lending to date, generating an annual reduction of 500,000 tons of CO2 emissions and energy cost savings of USD60 million annually for companies. IFC has also launched a Cleaner Production Advisory Program whose key activities will engage financial institutions, real sector clients and policy-makers in generating at least USD200 million in cleaner production investments in industry, resulting in reduction of emissions and cost and energy savings. IFC also promotes renewable energy and cleaner technologies through direct investments; for example, in FY09 IFC provided financing to Nitol Solar, which produces components for solar panels. Finally, IFC and IBRD are jointly developing programs to enable sustainable markets in renewable energy and residential energy efficiency.

8 Reported by the Minister of Transport in a Government meeting on April 24, 2008.

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V. PROPOSED BANK GROUP ASSISTANCE IN FY10-11

26. The four pillars in the current CPS are broadly relevant for FY10-11, with results to be monitored in the context of specific operations. The four objectives are to: (a) diversify the economy for sustainable development and growth (formerly, “Sustaining Rapid Growth”); (b) improve public sector management and performance; (c) improve the delivery of communal and social services; and (d) enhance Russia’s global role. At this stage, it is not possible to be more specific in designing a results matrix for FY10-11. Consequently, outcomes will be monitored by: i) program actions under fast-disbursing operations (should the Government wish to opt for such instruments); ii) results in specific investment projects and guarantee operations; and iii) the quality, relevance and sustainability of analysis and policy options in knowledge services. Fee-based services will be subject to standard quality and evaluation reviews.

27. The Government has already stated its desire to extend the current program through more intensive use of new instruments that leverage the WBG’s knowledge, project management skills, private sector expertise and its AAA rating. In particular, the use of guarantees is expected to support borrowing by selected entities in capital markets for public financing of infrastructure. Discussions with VEB (State Corporation Bank for Development and Foreign Economic Affairs) and Russian Railways are already taking place in this regard. The Federal Government also proposes to avail itself of fee-based Bank support throughout key phases of the project cycle, namely for appraisal and supervision according to IBRD’s operational policies, for Government-financed projects.

28. New IBRD assistance will be selective, with choice of instruments aligned with the Government’s modernization priorities and external position. In this uncertain environment, IBRD must remain flexible to respond quickly, according to client needs. In 2009, the Russian Federation will use the Reserve Fund to finance its budget. Should the global crisis continue to exert pressure on Russia’s fiscal reserves and external position beyond 2009, the Government may wish to access IBRD funds as part of an international borrowing strategy. Government decisions to this effect will be made in light of further development on revenues, especially from oil. To be prepared for this eventuality, we propose a CPS envelope of up to USD4 billion phased over the CPS period. Should there be a request to borrow from IBRD to finance the budget, individual lending operations would be agreed contingent upon IBRD’s financial capacity at the time. In consultation with the Government, operations would be identified in line with the stated priorities to modernize the economy, increase the efficiency of public expenditures, and strengthen the position of Russia in the post-crisis period.

29. Subject to capital constraints, IFC expects to commit between USD1.0-1.4 billion in Russia over the next two fiscal years. Given capital constraints, IFC will take a selective approach to new investments, maximizing mobilization from other IFIs as well as private and other sources. Priority areas include climate change mitigation, infrastructure (transport, logistics, municipal), and access to finance, particularly for SMEs, with an overall focus on less developed regions and economic diversification. MIGA will take a prudent and selective approach to new operations in Russia, given its already existing high level of exposure and depending on the availability of capacity in the reinsurance market. MIGA expects to issue in early FY10 new guarantees of up to USD120 million supporting long-term shareholder loans of a foreign financial institution to its banking subsidiary in Russia. These facilities will strengthen the subsidiary’s liquidity and capitalization.

30. The WBG is in a strong position to help the authorities address fundamental weaknesses in the banking sector, including: i) excessive discretion by banks in determining their levels of loan provisioning; ii) high lending concentration, especially with respect to extractive industry and construction sectors; iii) large related-party lending (despite recent efforts of the CBR to curb such lending); iv) weak risk management capacity in the banks and at the CBR; v) weak corporate governance, including lenient credit underwriting standards; (vi) poorly functioning and inefficient credit reporting systems; and vii) a large unbanked population with limited access to modern financial services. The WBG can help Russia address these weaknesses while adding depth and breadth to public and private

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capital markets. Deeper capital markets, through development of the bond market, would channel Russian savings towards Russian development, particularly in support of infrastructure financing, while creating an essential building block for Russia's long-term goal to become an international financial center.

31. The regional focus will remain. Substantial development challenges remain in a large number of Russian regions. As in the previous CPS, the Federal Government has asked the WBG to deepen its direct involvement in the regions. Correspondingly, a central focus of the extended CPS will continue to be in select regions, including economic analysis (growth and business environment diagnostics), regional development strategies, migration, and more effective use of social expenditures. Demand for subnational borrowing and new fee-for-service arrangements for investment and policy advice will depend on fiscal and liquidity constraints in specific regions. Encouragingly, however, recent developments demonstrate continued interest in these instruments. Subnational lending will focus on relatively small but highly developmental investments, with significant replication potential, in less economically developed regions. IFC and MIGA will support financial institutions interested in regional expansion throughout the country and in the provision of consumer and SME credit and services.

32. Our support to Russia’s ODA system will continue as Russia expands its aid program markedly. IBRD will focus on three priorities: i) preparation and implementation of a broader framework agreement for Russian development cooperation with Central Asia; ii) together with OECD, support for Russia at the February 2010 conference of emerging donors in Moscow; and iii) capacity and institution-building for Russia’s emerging development aid institutions.

VI. RISKS

33. The main risk to the Russian economy would be a prolonged slowdown and protracted economic recovery in the wake of the global economic and financial crisis and its attendant social, financial and economic impact. This risk stems from uncertainty about the timing and shape of global recovery of demand and capital flows, and, specifically, the demand for Russia’s export products, including oil. However, given Russia’s very low debt, large international reserves, and strong fiscal management, such risk is deemed moderate. In particular, three specific risks arise in the context of the crisis environment over the next 2-3 years; the Government is aware of these risks and is taking corresponding measures in each area.

34. First, the deeper and more prolonged economic crisis is likely to have a major social impact with increases in associated social tensions. Unemployment and poverty are expected to rise rapidly and some regions with already high unemployment and poverty will be particularly hard hit. The unemployment rate could exceed 13 percent compared with average of 6.3 percent in 2008. Poverty is estimated to increase to 17.4 percent by end-2009 from 13.2 in 2007. The high level of decentralization, combined with low implementation capacity in some regions hardest hit by the crisis, increases the chances that social tensions are not addressed in a timely manner, thus undermining the credibility of the overall policy response. The Government is mitigating this risk through a series of measures, including recent increases in unemployment benefits and pensions, and commitment to ensure full payment of social obligations during the crisis despite fiscal pressures.

35. Second, the financial sector remains vulnerable to second-round effects of adjustments in the real economy. A sharp rise in the NPLs, combined with limited access to external financing and low liquidity, is likely to raise the risk of specific bank failures. In addition, the deterioration of the banking system might require additional government support measures resulting in a further worsening of the government’s fiscal position. The revised 2009 budget contains an allocation of 540 billion rubles (USD18 billion) that could be used to finance such additional needs, but there is a risk that such costs could increase and put additional strain on the budget.

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36. Third, there are policy risks associated with the departure from strong macro fundamentals and delay in the implementation of the anti-crisis fiscal measures. Russia faces a balancing act of limiting the social impact of the crisis while not losing control of public finances. While Russia’s large fiscal reserves provide a financial cushion during the crisis that many other countries do not have, there is a possibility of weakening macro policy stance under expenditure pressures during the crisis. Although policy response is likely to remain flexible and timely, there is also risk of increased protectionist measures that give preferential treatment to select market participants. A delay in the World Trade Organization (WTO) accession could undermine benefits for Russia from a rules-based international trading regime, as well as postpone improvements in policies and institutional capacity that come with integration into the world economy.

37. Finally, Russia also faces external risks arising from a prolonged depression of global demand and reduction in commodity prices. The global outlook remains extremely uncertain, with declines in world global output and trade, and very limited capital flows to developing countries in 2009. World oil prices are likely to remain in the USD56-63 range during 2009-10. Structural weaknesses in the banking sector, reliance of the private sector on external financing, and a limited economic base make Russia vulnerable to highly correlated, multiple shocks of a decline in oil price, a sudden reversal in capital flows, and a drop in the market sentiment. A further drop in oil prices would renew pressures on the ruble. In these two areas—risk of macro policy easing and the implications of a prolonged depression in global demand—the Government’s experience with sound macroeconomic management so far suggests that the authorities would aim to counter those risks with appropriate policy adjustments under a difficult external scenario. For example, the federal budget for 2009 was prudently based on USD41/barrel oil price.

38. In each of these areas, the Government has taken various policy steps to mitigate these risks, however, should such risks materialize, IBRD would reassess its strategy with a view to formulating and implementing appropriate mitigation measures in collaboration with the authorities.

VII. CREDITWORTHINESS

39. Russia is creditworthy for IBRD lending and will remain so under short- to medium-term scenarios. In contrast to many developing countries hard hit by the crisis, it also has maintained an investment grade sovereign debt rating (BBB by S&P). Reflecting the government’s prudent fiscal strategy, the foreign debt exposure of the Federal Government has decreased in recent years and currently stands at less than 2 percent of GDP (USD27.2 billion at Q1 2009) and less than 6 percent of total exports (total exports in 2008, USD471 billion free on board (FOB)). Combined with a sizable foreign exchange reserves at 23 percent of GDP (USD404 billion at the end of May 2009), the Russian government, with flexible monetary-exchange policy, will be able to meet its debt obligations even with a significant oil price shock.

40. Non-sovereign external debt, on the other hand, has increased very significantly over the last few years, reaching 25 percent of GDP in Q1 2009 (USD426.3 billion at Q1 2009). Although the overall debt appears low compared with the economy’s size, the large buildup of external debt of private financial corporations remains a concern. In particular, the rollover risk is expected to be high in 2009 because of a much weaker real economy and extremely tight liquidity. At the same time, this debt has been declining in the past two quarters as Russian banks and enterprises increasingly repaid their debt in the context of tighter access and new borrowing conditions.

41. From the external debt perspective, the proposed indicative CPS envelope of up to USD4 billion does not pose any significant burden on the country’s repayment capacity. Russia’s outstanding debt to the World Bank (USD3.6 billion) is currently less than 0.2 percent of GDP, less than 0.8 percent of total external debt, and less than 13 percent of total sovereign debt.

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Annex A1: Progress in Russia during the CPS Period

1. This summary highlights progress against three overarching Government goals for 2012: growth and economic diversification, human development, and regional development. WBG contributions follow in each area. Annex A4 summarizes WBG contributions by pillar. The CPS Results Matrix is at Annex A5.

2. Russian Progress: Growth and Economic Diversification. Strong economic growth and the concomitant growth in prosperity from 2000 to 2008 weakened the focus on structural reforms and diversification of the economy through promotion of entrepreneurship (see Figure 1). Russia’s international indicators on corruption (e.g., Transparency International (TI) and the Business Environment and Enterprise Performance Survey (BEEPS)) and on ease of doing business have deteriorated since 2007.9 Corruption continues to be a serious impediment even after many attempts since 2002 to improve the investment climate, particularly for SMEs. Administrative barriers in public governance remain substantial, especially related to protecting and enforcing property rights, facilitating competition, and strengthening judicial independence and transparency. Without better incentives for market entry and research aimed at technology commercialization, the high tech sector—a key area of Government focus to help diversify the economy—faces uncertain prospects. Authorities intensified efforts in 2008 at a series of reforms to streamline public administration, including federal laws “On Protection of Rights for Entrepreneurs”, “On Combating Corruption”, and “On Access to Information about Business-Government Relations.” Figure 1: Russia’s Increased Oil Dependence of the Budget (A) and Export Revenues (B)

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3. WBG Contributions: Growth and Economic Diversification. IBRD has contributed to policy debates and capacity building, evidence-based analyses of policies (e.g., Russian Economic Reports, Country Economic Memorandum on growth and Poverty Assessment) and technical support that helped strengthen sound macroeconomic policies and structural reforms. Notable contributions include advice and joint work with the MOF on long-term fiscal stability and economic diversification. IBRD, IFC, and FIAS helped promote private business development by strengthening the financial sector through lending

9 Similar to the situation presented in the BEEPS 2005, the recently released BEEPS 2009 survey identifies tax rates, access to finance, inadequately-educated work force, and corruption in business-government interactions as the top constraints for firm investment in Russia. According to BEEPS 2009, half of the business community in Russia identifies corruption as a major constraint to investment, compared to a regional average of about 33 percent.

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and advisory services for securities market regulation, financial sector strategy, insurance and banking sector supervision, SME finance, housing finance, and energy efficiency finance. The WBG also helped develop land and property markets (See Box 1). IFC contributed directly to economic diversification and international competitiveness through investment in infrastructure, value-added manufacturing, cleaner production and energy efficiency. IBRD shared best practices on methods to deepen the innovation sector in regional workshops.

Box 1: Development of Real Estate Markets: WBG Contributions

In the 1990s, Russia carried out the world’s largest property and land reform. Millions of new owners received public land parcels and real estate at nominal cost. Yet to turn this new private property into a source of wealth required the creation of land and real estate markets – everything from land laws, cadastral mapping, land titling and registration, tax assessments, collateral and credit, and mortgage banking to consumer and judicial protections for land tenure security. Each of these legal, institutional and investment needs were supported by expertise and financing from IBRD, FIAS and IFC.

To embed secure legal rights, IBRD and FIAS have supported the Government’s goal of reducing barriers and increasing the efficiency and transparency of registration process by institutional improvements and promotion of competition. The time required to register real estate objects declined from 4 months in 2004 to 20 days for individuals and 15 days for companies in pilot regions in 2008.

Based on more secure titles, IFC contributed to the growth of the mortgage industry, from a USD1.5 billion market in 2005 to USD40 billion in 2008, by helping to develop 11 legal and regulatory amendments adopted by the Russian authorities, 9 standard mortgage products used by 43 percent of the market, public information on mortgage lending and consumer rights, and by providing advisory services and lending to individual banks. As of end-2008, mortgage portfolios of IFC advisory project pilot banks consisted of 77,496 loans for a total of USD5.9 billion. Delinquent mortgage loan levels are 1.5 percent on average in IFC project banks; in the market overall, levels range from 1-5 percent depending on the institution. As the crisis continues, IFC is helping lenders preserve portfolio quality through seminars on portfolio management and through stress testing and diagnostics of client banks. IFC has also designed tools and informational materials to educate borrowers about loan restructuring options and help banks optimize restructuring scenarios. Building on this platform, IFC and IBRD are developing programs to address supply and demand-side barriers to realizing energy savings potential of Russia's housing sector.

4. Russian Progress: Human Development. As Russia’s population shrinks and ages, putting pressure on growth and social expenditures, the Government is taking measures to increase life expectancy through better health and to increase the productivity of the population through more globally competitive educational institutions. Since 2005, life expectancy increased impressively from 65.5 in 2005 to 68 years in 2008, primarily due to the reduction of premature death in males and females. Moreover, educational scores on international comparators increased markedly10. These positive trends notwithstanding, health and education expenditures are significantly lower, and outcomes weaker, than in other G-8 and MICs. Life expectancy lags G-8 countries by 16-19 years for men and 13-14 years for women. Higher and vocational education need significant reforms to provide more globally competitive skills. Moreover, the Government recognizes that social assistance programs remain poorly targeted and are committed to increase their impact on the most vulnerable segments of the society.11 Yet policy solutions to improve human development indicators also lie outside the social sectors. For example, poor environmental quality plays a large role in the health and productivity of 60 percent of Russians, which in turn reduces GDP by an estimated four to six percent. Air pollution in particular cuts average life

10 PIRLS: significant progress from 12th place (out of 37 participating countries) in 2000 to first place in 2006 (40 countries). 11 The World Bank’s 2009 Poverty Assessment for Russia notes that although noncontributory spending accounted for at least 2.6 percent of GDP in 2006, only a small part of the subsidies go to the poorest 20 percent of the population.

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expectancy by one year and up to four years in the most polluted cities12. And almost 220,000 road accidents in 2008 carried a death toll of nearly 30,000 people.13

5. WBG Contributions: Human Development. The WBG contributed to favorable trends in adult mortality and educational performance at both the federal and regional levels using the full range of its instruments; thereby addressing demographic pressures via higher labor productivity. The Education Innovation Project helped improve reading scores by modernizing curricula for primary school children, while the E-Learning Project resulted in Information and Communication Technology (ICT) competencies for rural children that are comparable to urban areas. The results tested in both projects were adopted nation-wide. Diagnostic studies and policy reports, prepared jointly with local experts, recommended new strategic approaches and built capacity for better early childhood, vocational and higher education in several regions. Lessons from across these projects are being assessed for application in other regions. The Health Reform Implementation and TB-AIDS projects both had systemic impacts on health services and reduced mortality from infectious and non-communicable diseases. National and regional health and finance officials benefited from widespread dissemination of the lessons from both projects at several World Bank Institute (WBI) and Global Development Learning Network (GDLN)-supported events. The outcomes are being incorporated into national targeted health programs. The WBG also tested new approaches to improving social assistance at the regional level, but in the absence of demand at the federal level, systemic impact of these pilots was limited.

6. Russian Progress: Regional Development. The Government aims to adopt policies that can provide a more even distribution of social welfare as growth leads to a more uneven landscape of economic activity. 14 Through better regional policies, including internal migration, more effective public administration that is responsive to citizens, and increased reliance on PPPs to finance vital infrastructure networks, the Government seeks to improve agglomeration economies and social and communal services throughout Russia’s vast territories. By some estimates the infrastructure backlog is about USD1 trillion over the next decade, or about 8 percent of GDP annually, for basic essential infrastructure: utilities (water, heating, sanitation, waste management, electricity) and transport (roads, bridges, airports, ports). The Government established the legal and regulatory framework for PPPs and the city of St. Petersburg championed PPPs at the subnational level, putting forward the first candidates for concessions. However, prior to the crisis, yearly PPP investment in Russia was much lower than in India, China, Mexico, South Africa and Chile15. With respect to social services, access to health and educational services has improved in rural areas, in part due to better performance in different regional health systems and expansion of high quality e-learning. Performance management tools are used at the federal and regional levels, and budget authority is decentralized to the local level, where public hearings are required. To underscore high-level commitment to address spatial disparities, Prime Minister Putin chairs the new Commission on Regional Development while Mr. Medvedev chairs the Council for the Development of Local Government.

7. WBG Contributions: Regional Development. Bank ESW, particularly the World Development Report 2009 on Reshaping Economic Geography and the Country Economic Memorandum, contributed to policy debates on regional policy. Lending supported the migration of poor residents out of underdeveloped northern territories. IFC helped develop the mortgage market in Russia, which is essential for labor mobility. Subnational finance, a joint IFC-Bank product, helped repair and upgrade

12 Russia Environmental Management System: Directions for Modernization, World Bank 2009 (forthcoming) 13 According to the National Inspection of Security of Road Traffic 14 In 2007, gross regional product per capita ranged from USD1,218 in the Ingush Republic in the Southern Federal Okrug to USD33,774 in Tyumen, a mineral-rich region in the Urals Federal Okrug. Source: Rosstat 2009. 15 Russian yearly annual PPP investments as a share of GDP from 2000-2006 averaged 0.11 percent compared to Chile (1.09 percent), China (0.34 percent), India (0.75 percent), Mexico (0.33 percent) and South Africa (0.52 percent). The financial crisis significantly reduced the private sector’s ability to raise long-term financing, resulting in most Russian projects being delayed or restructured.

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regional and municipal water/wastewater infrastructure and road networks in four regions. IFC also prioritized poorer frontier regions for its investments. In FY09 to date, 54 percent of IFC’s committed investment volume in Russia was in frontier regions, compared to just 24 percent in FY07. A notable IFC milestone was the completion of an advisory project in Magadan, a very remote region in the Far East, which extended the benefits of an IFC mining investment to the local SME community through increased access to finance and markets. WBG lending for municipal heating, water and wastewater raised the quality of services in participating cities while improving financial management and reducing housing subsidies in place of targeted social assistance. On the removal of infrastructure bottlenecks, demand was limited at the federal level but was developing at the regional level for PPPs and finance. In St. Petersburg, four fee-based service agreements prepared the legal and institutional framework for the country’s first concessions in the transport sector. More broadly, IBRD helped reorient public administration to serve citizen needs through support for performance-based management and budgeting, development of multi-service centers (one-stop shops), and fiscal and administrative decentralization to the municipal and village level.

8. Russian Progress and World Bank Contributions: Russia’s Global Role as a Donor. In June 2007, Russia adopted a new policy on ODA explicitly based on the principles of international cooperation as developed in the framework of DAC. Since then, Russian development aid increased to USD220 million annually, much of which is implemented jointly with international agencies. The World Bank has been involved in policy advice and capacity building for Russia development aid since the 2006 G-8 Summit in St. Petersburg. Cooperation follows a learning-by-doing approach. By channeling development assistance through IBRD instruments, Russian specialists become active participants in addressing urgent human and development needs in Africa (malaria control, access to energy, quality of primary education), reducing the risks of infectious disease in Central Asia, and in producing international tools for public policy (learning assessments tools and international methodology for measurement of financial literacy). The Government has signed a USD3 million fee-based service agreement with IBRD to build capacity for providing development assistance in education. With support from the UK Department for International Development (DFID), IBRD is also helping the Government develop critical policies and functions for effective donor assistance, such as monitoring and evaluation, statistical reporting, and communications. Annex A3 lists current contributions of the Russian Federation under administration by IBRD.

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Annex A2: Russian Federation: Summary of the Government’s “2020 Development Strategy”

“From a raw material export-oriented economy towards an innovative, diversified, and socially-oriented economy based on three factors: entrepreneurial freedom, social justice, and national competitiveness”

In November 2008, the Government of Russia approved the “2020 Development Strategy”, which identifies a series of performance criteria and development targets to ensure sustainable economic growth and strengthen national security.16 This strategy defines six main directions to move Russia towards an innovative, socially-oriented type of economic development:

• Develop Russia’s human potential through major improvements in education, housing, pensions, environment protection, among other areas

• Create a competitive institutional environment that stimulates entrepreneurial activity and attracts capital

• Diversify the economy through innovative technological change • Strengthen Russia’s global competitiveness in traditional economic sectors (energy, transport,

agriculture) and reduce the depletion of raw materials • Promote spatial development to decrease regional inequalities in living standards • Strengthen Russia’s external economic status as a main financial center and a contributor to

global public goods

The Government of Russia has committed to take the necessary measures as appropriate to ensure the achievement of specific targets in these areas.

Diversifying the Economy for Sustainable Development and Growth

1) Authorities are committed to maintaining fiscal discipline in the long-term, recognizing its importance for achieving higher savings and retaining investor confidence. The government aims to strengthen the role of the tax system by promoting economic diversification and increasing the tax base. The 2020 Strategy identifies five priority targets for macroeconomic policy: i) reduce inflation gradually to an annual average of 3 percent; ii) meet money demand by increasing liquidity (the Central Bank will help refinance commercial banks); iii) expand the tax base; iv) increase public expenditures to reduce infrastructure bottlenecks; and v) improve the efficiency of public expenditures (see further below).

Growth and Diversification

2) Traditional economic sectors (oil, gas, raw materials, agriculture, and transport) will remain the leading contributors to economic growth by 2020. In addition, the 2020 Strategy indicates that a new “economic sector” will emerge, called the “knowledge and high technologies sector”. In 2007, this sector contributed to about 10-11 percent of GDP. The objective is that it will be a leading source of grow, and the government expects it to contribute to 17-20 percent of GDP by 2020. The share of hi-tech products and knowledge services in Russia will reach 5-10 percent of GDP, and this production will be diversified across 5-7 productive activities. To promote innovation, public expenditures for research and development activities will increase from 1.1 percent of GDP in 2007 to 2.5-3 percent of GDP by 2020.

3) Regarding economic diversification, the government envisions investments in fixed capital formation to growth 4 times by 2020 compared to their 2007 level. Most of this growth will take

16 The government’s strategy is divided into two stages. The first stage (2008-2012) focuses on innovation in non-traditional economic sectors. The second stage (2013-2020) focuses on high-technology markets.

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place in non-traditional sectors. The share of investments in the extracting sector (oil and gas) will fall from 15.2 percent in 2007 to 11.2 percent by 2020. The Government will promote investments in transportation with the aim of decreasing inter-regional income inequality, expand trade markets, and promote economic mobility. The government will also study the development of regional clusters for economic development through investments in transport infrastructure.

Strengthening Public Sector Management and Performance

4) The Government is committed to reducing administrative barriers, improving regulation of businesses, and promoting public-private partnerships in leading economic sectors in order to achieve greater efficiency and attract capital. According to the 2020 Strategy, changes in the structure of the public budget (at the federal, regional, and municipal levels) will play a key role in increasing the efficiency of public expenditures. The government will raise transparency in the preparation, allocation, and execution of public budgets at all levels. In addition, budget decentralization efforts will continue. The government’s view is that decentralization of the decision-making process will lead to better-informed decisions on the use of financial resources. Particular focus will be put on developing municipal budget monitoring systems, and enlisting private companies to monitor target indicators of public programs.

Improving Delivery of Social and Communal Services: Social Sector Reforms and Financing to Protect Vulnerable Groups

Social Well Being

5) The 2020 Strategy sets outs ambitious targets for poverty and inequality. The headcount poverty level will fall from 13.4 percent of the population in 2007 to 6-7 percent by 2020. Income inequality between the top 10 percent and the bottom 10 percent of the income distribution will fall from a ratio of 16.8 in 2007 to a ratio of 12 by 2020. The share of the middle class is expected to increase to 52-55 percent of the population (up from 18 percent in 2006). Social allowances will reach the entire poor population (currently 70 percent of the poor participate in public social programs).

Education

6) Improvements in education will be