#17 - JRL 8082 - JRL Home
TITLE: PRESS CONFERENCE WITH CHRISTOF RUEHL, CHIEF ECONOMIST OF THE WORLD BANK, RUSSIA
[INTERFAX, 12:00, FEBRUARY 18, 2004]
SOURCE: FEDERAL NEWS SERVICE (http://www.fednews.ru/)

Moderator: Good morning. Let us begin our press conference. Our guest is a representative of the World Bank. I would like to introduce chief economist of the World Bank for Russia Christof Ruehl and we are being joined by Julian Schweizer, the World Bank vice director for Russia. I give the floor to Christof Ruehl and he will present to you the seventh report of the World Bank on the Russian economy. In particular, he will speak about recalculating the structure of the country's GDP.

Ruehl: Thank you. As most of you know, we do these reports regularly, every three or four months. This time it took a little bit longer because we were working on some other big research project which we will introduce later on in March. So, the last report was from August and it's time now to sum up the year.

As all these reports, it consists of three different parts. The first part is an economic overview of recent economic developments. In this particular case we are summing up what has happened in the year 2003.

The second part is some summary of the recent research we have done. In this particular case what we were trying to do was to get a more accurate assessment of the composition of the gross domestic product of Russia, in particular the share of oil and gas in GDP in Russia. I will come back to this in a second, but the basic idea is that official statistics underestimate the share of oil and gas and overestimate the share of services in GDP.

And as always then we have a third part which summarizes recent papers published by the World Bank and available on the web site. In this case what we try to summarize is a paper discussing the prospects for mortgage and housing financing reform in Russia.

I'll go through these three parts briefly and I will be especially brief, I think, with the first part because most of you are aware what has happened economically in the last year. And then we will open it up for discussion.

As all of you know, I suppose, by now we had in the year 2003 a year of very high growth and a year of not too many reforms. Growth in the aggregate was 7.3 percent and it was fairly balanced between services and industries and it was also close through most of the regions and most of the sectors. So, there is a broadening of economic growth shown in the statistics.

Looking at this high growth there is two things I want to point out which are of particular relevance from our perspective. The first is that investment took off after very low levels last year, came in at over 12 percent and for the first time since the year 2000 actually fixed capital investment grew faster than consumption.

The second is that growth more than in previous years reached the poor. So, there is a rising tide and the more it rises, the more it lifts all boats. The incidence of poverty declined from about 27 percent at the end of last year to 21 percent by now. Now this is interesting because different from previous years real income grow and real wage growth are still higher than the growth rate, but the difference is not as much. So, real income growth slowed down and still more people got lifted out of poverty.

What it basically shows is that the strategy announced by the President that high growth would be good in the fight against poverty is true and the reason for this is that to a large extent poverty is still shallow with a lot of people living shortly below the official poverty line and therefore being lifted above this poverty line by a little bit of growth.

But there are a lot of improvements to be done because even 21 percent poverty translates into more than 31 million people living below the poverty line. And income distribution in Russia, the difference between the rich and poor people continues to be much larger than in almost all of the transitional economies.

Let me just highlight briefly three more developments of the aggregate economy which we think are important in this year, this last year. First, the dependency of Russia on oil and gas exports, on external environment. The Russian economy of course has not changed much in this short period of time, it remains very dependent on the price of oil and gas.

What we have observed is further increase in the price for Russian oil by 15 percent in 2003. And this was very unevenly distributed through the year because the increase in the first six months was 27 percent surrounding the Iraq war and the increase in the second half was 7 percent.

In the last economic report we calculated that of the 7.2 percent growth in the first six months of 2003, 3.2 were due to the very steep increase in the price of Russian oil. This means that for the first six months an underlying trend growth of about 4 percent and by trend growth the growth that had occurred had the oil price not changed.

The increase in the oil price slowed down in the second half, but the production still we would maintain that, we think the underlying trend growth rate of the Russian economy remains somewhere between 4 and 5 percent. And I would just like to repeat this observation that historically the Russian economy since 1991 has never grown by more than 5 percent if the oil price did not grow as well. In the year 2001 it was 5.1 percent but that's the only exception.

And that gives a rough idea together with these calculations in the last economic report of this corridor between 4 and 5 percent which is achievable if the oil price remains constant. And of course, that's a strong statement because the oil price is now at an extremely high level. It's more likely at some point to come down which will then imply a slow down in Russian growth rates.

With respect to the external environment and the ever present threat of real exchange rate depreciation and how the high oil price translated into real exchange rates movement we can say that Russia and its Central Bank in principle got lucky for the third year in a row. There was a period of a few years after the crisis when the economy became remonetized and barter transactions were replaced by monetary transactions and the economy therefore was able to absorb a lot of these money inflows without real exchange rate appreciation.

There was a second period in about the year 2002 when again the inflows became slowed and absorbed better because now many people took their cash holdings from under the matresses and deposited them in banks and for banking deposit rose and this leads to a decline in the velocity of money and again prevents real exchange rate appreciation.

And now in the year 2003 we had a third event preventing too much pressure on the real exchange rate which was the appreciation of the euro against the dollar. That makes Russian imports which are denominated in euros more expensive and Russian exports which are denominated in dollars cheaper and therefore relieves some of the pressure of having too much surplus in the current account.

As a result, we have a very strong appreciation against the US dollar of about 19 percent and a very modest real appreciation against the currency basket of Russia's most important trading partners of about 4.1 percent.

Let me just make one more point which has to do with the financial situation of domestic enterprises and with the really very dramatic increase in the supply of credit in the economy. When you look at the statistics, there are still lots of publications point out the amount of arrears in the economy and they point to a large share of loss-making enterprises. But there are plenty of reasons to suppose that these statistics are a bit misleading and they are essentially coming about because the information is collected from old and partially state-owned enterprises.

One good indication is given here in this report in Figure 6 where you see the decline in non-cash settlements. It's very, very dramatic and steep and keeps on continuing. These are mostly settlements between old enterprises and even there non-cash settlements are almost disappearing. But a more concrete hint is given when you look at the publications of the Central Bank and you see that credits to the private sector have increased by 27 percent in real terms last year. This is a very large increase given that the growth rate is only 7 percent and it indicates that to an increasing amount investment is financed through bank credit, as it should be.

Now, an even steeper increase was registered by consumer credits which are still low on average, but they increased by 79 percent in real terms. So, they shot up like a rocket. Consumer credits are still limited to a few cities and therefore limited to about 10 percent of the total credit volume but the growth rates are really impressive, indicating again the size of the economy and the number of transactions which are not recorded in the official numbers.

Let me also conclude this part because I am just preempting some questions on the consequences of the Yukos affair and its relation to capital growth. We have the situation that the numbers of capital flows and on investment and on direct investment which are recorded by the Goskomstat and by the Central Bank differ from each other. This could also give rise to some confusion. This forces economists to discuss these questions for a long time.

What is clear at this point is that there was a decrease in the capital flows or according to some slight capital outflow in the third quarter of 2003 and that in the fourth quarter capital inflows again went up.

What is important is that there was that dip in the third quarter but we don't know what caused it. And the reason for this is that the Central Bank was deliberately following a low interest rate policy at the beginning of the year to deter portfolio capital inflows of which there are too many last year ... (inaudible)... So with these interest rates and that of course with a time lag of about six months, which is what happened with portfolio investment. At just about the time when this effect was visible, the arrest of Mr. Khodorkovsky happened and so we are not able to say which of these two events caused a greater reaction.

What we are able to say is that there are no lasting consequences and no sudden reaction to either of these two events.

Let me just to the second part of this report. We attempted reconfiguring the composition of Russia's GDP. This was motivated by research that will be published at the beginning of next month. And that research in turn was motivated by a number of questions I would beg many of you also at some point or another ask yourself. For example, if you look at the official national accounts of Russia as they are published by Goskomstat, you will see that the share of oil and gas in GDP is only about less than 9 percent. So, let me ask why is everybody so upset about it.

At the same time Russia looks like a very modern service economy with about 60 percent of production of all the GDP arising from the production of services and only 40 percent from the production of goods. And it looks as if the state has almost disappeared in Russia because when you look at it in terms of percentages of GDP, non-market services are only 11 percent officially and market services are 49 percent. And there are other surprises. You see that as I said oil and gas is only 9 percent of GDP but export revenues from oil and gas are said to be 20 percent of GDP. And when you look more closely at this service sector as to why it is performing so well in the official statistics, you see that mainly it is performing so well because it is dominated by the trading sector.

In Russia trade accounts for almost 30 percent of GDP and for almost 50 percent of the profits generated in the economy. So, these some of the highlights which I think many people have looked at and I have looked at for three years and when I ask myself why is this, then I didn't get very far and so I ultimately decided there must be some problem with the statistics but it is not worth bothering about.

One comes to a quite plausible and logical explanation for this. And this explanation has to do with the transfer pricing which is undertaken by many large companies in Russia, in particular by the oil and gas industry. We can discuss this later but the basic mechanism, as you know, is that a company producing some product has a trading subsidiary and sells the product for below market price to that trading subsidiary. And that trading subsidiary sells the product at market prices to the final customers.

Why is this done? It is because most of the time the trading subsidiary sits in some remote regions and pays less taxes than the production part of the company. There are legal ways of minimizing taxes. Until the first of January of this year local authorities could lower their component of the profit tax. And there are illegal ways of investing. In many cases shell companies are founded. They carry out as many transactions as fast and as they can and then they disappear without paying any taxes. Now from the point of view of national and economic accounting what it does -- it transfers profits in the economy from the production sector to the trading sector.

And at the trading sector they are not corrected by the Goskomstat and so the Goskomstat publishes data on the trading sector which looks as if it has a lot more value added created and a lot more profits created, than it actually did. So, in principle this is easily corrected, how to transfer these artificial profits back to where they originated, to the production sector. In practice this is very difficult because you have to go through input-output tables and you have to identify how much to transfer back.

We did make estimates on the average performance of other sectors in Russia. We did it by comparing it with ... (inaudible)... We did it by comparing the trade margins with the United Kingdom. You see the tables in the text. Whichever way we did it, the result was always pretty much the same. I would not like to get into technical discussion. Therefore we have constructed a very simple illustration of what happens.

Basically what you see is that this is GDP according to Goskomstat. There you have a share which is surrounded by this black ring which contains ... This is the industry, this is the production of goods and the other, the larger half is the production of services. And you see according to Goskomstat total services are about 60 percent of GDP of which about 30 percent is trade. The green segment is precisely the trade. The yellow one -- 40 percent is production of goods and 9 percent is oil and gas. The yellow segment.

Reducing this and converting it to standards using the estimates of the United Kingdom, changes the picture. You see oil and gas jumping up from 9 percent to 25 percent. Consequently, the production of goods and industrial production are becoming again much larger and therefore more important for growth than the service sector. And also within the service sector, because trade now shrinks a lot, the relationship between market services and non- market services changes, with non-market service becoming more important. Now, if I traveled around in Russia or even in Moscow, I find it very hard to believe that 60 percent of this economy should be services and that services are completely dominating the market services as the official accounts have it.

It seems to me therefore pretty plausible and realistic and it has a lot of consequences. The first one concerns economic growth. There is the simple observation that of course if oil and gas is 25 percent of GDP and thus the 9 percent of the economy is much more vulnerable to the fluctuations in the international price. That's obvious. But there are also not so simple observation that now when you adjust the productivity numbers following the same procedures, the productivity increases which you see in figures 12 and 13 that the productivity increases in the industry sector -- and these are indeed productivity advances which have driven economic growth since the crisis.

It was industrial production that contributed most to growth and not the shift in the services economy as it is sometimes claimed. Now that is a very important conclusion for economic policy making. Because if the economy was driven after the crisis first as many people including us maintained by the underutilized capacity which could be increased very fast so that the economy could expand very fast. And if even now after capacities by and large freely utilized the productivity increases in the industrial sector are much stronger. The revenues are higher, the increases are higher than in the service sector.

So, the policies which are aiming at increasing long-term GDP or doubling GDP in so many years are very well advised to target at the industrial sector and not to rely too much on this sometimes somewhat mythical shift into new areas or services which do not exist at the moment.

So in the Russian economy it's the production of goods which matters and services have more or less still in supporting function. One should not wait for services to take the lead in propelling economic growth forward very rapidly. This follows for growth prospects in the long term and as I've mentioned, of course, if the share of oil and gas is so much larger then for the short term it means that the Russian economy is indeed very much exposed to international price fluctuations as many have pointed out.

There is a second implication of this exercise which concerns the impact on the budget. We've seen that the reason why statistics are recorded this way is that people behave in a certain way and this behavior is driven by attempts at tax avoidance. Also, about 20 percent of the GDP is being shifted from trade to industry, the sums involved must be very large.

And now of course the obvious question will be how much taxes are avoided, how large are these sums? And the sad truth is that we haven't calculated and we cannot calculate it based on the aggregate data. The reason is that we know how much profits have been transferred from oil and gas to trade, but we don't know how much of that was not taxed appropriately because the tax savings will differ from company to company and from region to region.

So, it's not possible to make an aggregate inference on the numbers. You have to go company by company to do that. But the sums involved are large and we have a little example in there. And please I don't want any one to write that these 2 percent which are quoted here are the actual tax evasion. It's an example of what can happen, about the order of magnitude. The example is that if the profit tax and VAT combined as about 40 percent of revenues and if companies lower that by 10 percent then the damage, the lost taxes will be 2 percent of the GDP.

If companies manage to lower it by 15 percent, it will be 3 percent of the GDP, by 20 percent, 4 percent and so on. Okay, so, you don't write two or three or four percent, but the magnitude is large.

There is one last implication, a third one of this exercise which I will quickly point out. Obviously, this behavior affects state owned as well as private companies. And because the sums involved are so large, I think it is reasonable to suspect that there is a large group of business people from both sectors who have an interest in maintaining these kind of non-transparent relationships.

So, from point number two, that the tax evasion is large, follows that you can understand the government trying to eliminate these tax loopholes as they have done with the profit tax.

And from point number three, that the interests involved are also probably rich and powerful, follows that it will not be an easy task.

Let me switch to the third part and again be brief. This is a summing up, as I said, of a paper which looks in detail on housing and mortgage reform in Russia. We've picked this because in general we have the picture of a very high growing economy, but also a standstill in reforms. There is not much that's been happening in the last 18 months.

Here you have a reform which would be sensible because it affects more than only one area and which is also stuck and didn't move very fast. Housing reform is important because it not only improves the living conditions of people directly, but especially in Russia because it would help capital market development, including opportunities for long-term investments such as the famous pension funds.

The paper which is summarized here and I'll be very brief, concentrates on two issues: on primary market, that is the question why there is so little mortgage market in the sense that mortgages are not easily available for people by just going to a bank or to a specialized lender. And the answer is, number one, there are too many administrative barriers which make transaction costs very high, notary fees very high and the process very cumbersome.

And number two there is a social contract, including that you don't have the right to evict people, families which have children and so on, which makes it very difficult and which in our view essentially shows that there are subsidies in this market which are targeted the wrong way. It's the same issue as often the subsidies, these are subsidies targeting quantities, people who are not allowed to be removed and so on, they should be targeting prices, that is, financial support to people so that they are not evicted in the first place.

And the second and last question, why is there no secondary market to developing, and again I'll be very short. It is mostly also an issue of subsidies because if you have subsidized mortgages then banks will find it impossible to buy them and therefore we are not engaged in trading them. So we believe that if interest rate subsidies are providing a disservice by preventing secondary trading for mortgages and the logical conclusion from this is that the so- called German model where you have specialized lenders and closed circuit lenders who are subsidized through interest rates is not a model which is workable anywhere else and should probably not be copied.

You see, I am hurrying through the third part which is a shame because it is actually an interesting topic and I encourage you to read it. But we have too many interesting topics because we have not produced a report in the last six months.

And therefore at this point I would just like to throw it open for questions.

Q: Russky Kurier. What is your attitude to the government's policy aimed at increasing the share of the manufacturing sector at the expense of the raw materials sector? Does such a policy exist and what measures can be taken?

Ruehl: So far there has not been such a policy. Just the opposite. Russia actually started out in 1990 which a manufacturing sector that was much, much bigger than in any comparable country. And Russia lost a lot of employment in the manufacturing sector. If you look at Figure 3 in this report, employment in industry went down from almost 32 million people to 20 million. So it was rather a question of how to shrink the sector while protecting it in such a way that the most productive enterprises survived.

And this is not a process which one does by asking the government to transfer money to the sector. This is a process which one does by enforcing competition and hard budget constrains on the sector. And to some extent this has worked.

Let me also add one footnote because this is not a specific Russian phenomenon that industry is more productive in terms of labor productivity than services. This is generally the case. It would be indeed very strange if Russia were the one exception where market services are very productive and take over the whole economy. And in that sense the adjusted GDP figures reflect a degree of normality, I think.

Q: I was asking you not about industry, but the processing industries as opposed to the mining industries, oil and gas.

Ruehl: I don't think it requires particular incentives. I do think it requires two things. I don't think it requires transfers. It requires two other groups of regulations and incentives. For once it requires conditions under which new enterprises which are more productive can originate, people can find it easy to raise money and to have a business and can grow. This is what we have talked about for a long time, it requires the removal of administrative barriers to have new enterprise growth.

And secondly, it requires conditions and policies of competition which make the conditions equal for all enterprises, in particular for the large enterprises and which would make it impossible that some enterprises gain unfair advantages at the expense of others. These two things should be enough to get control of the problem. Transfers I don't think are necessary. They haven't been successful anywhere.

Q: (Inaudible).

Ruehl: GDP is, I think, 24 billion dollars, times 29 or 28.5 for the average and that's 20 percent. You just take the numbers and make the divisions. The question was, can you put the ruble value on the shares.

Q: In the developed economy the service sector is usually not the most productive, but it is one of the most important. But we see that in Russia this transition to the more service-based economy, does it not worry you?

Ruehl: That's a good question, let me put some numbers on this. There are two things which concern me. One is that the number of people who are actually producing oil and gas is less than 1 percent of the total employment, of the total labor force in Russia. For that reason alone one will never be able to say that Russia can happily live only from oil and gas. The other reason which gives rise to concern is not so much that there is not enough movement to the service sector, there was actually quite some movement as we have seen the employment figures, in terms of employment out of industry and into services, there was not just as much in terms of value added.

But what is a bit worrisome is when one looks at the service sector and in particular at the split between market service and non- market service or government service. Because it is true what some of my more liberal Russian colleagues always point out, which is that over the last few years the non-market service sector has increased in terms of employment, and quite substantially at that. So, what we actually see if we compare Russia to the rest of the world, countries with similar incomes, as people are moving out of industry and that adjusts quite nicely to standards in the rest of the world.

People moving into market services, and that also adjusts quite nicely to the standards in the rest of the world. But a lot of people moving to non-market services, into public sector employment and that is much higher than in the rest of the world. And if one looks at what kind of people these are and what is going on there, then actually an interesting story emerges because contrary to what many believe, this is the number of bureaucrats that is constantly increasing or anything like that. What happens is that the number of public employees is actually increasing at the regional level. And what we see is that they start hiring people who otherwise would be unemployed -- as street cleaners, as janitors, as hospital workers, sometimes even as teachers.

And because it is the poorest regions, they very often can't even play their endspiel. And then they turn around to the central government, to Moscow, and ask for higher transfers. And what we see in the statistics -- because the non-market services expand -- is that they are actually getting these transfers to keep these people employed. And this is possible of course ultimately because of the very high oil revenues accruing to the federal government which are then transferred into transfers which sustain employment which is not very productive and it is probably not very beneficial for the people involved.

So, when one gets the numbers, these two things stand on. Very few people can make a living in oil and gas production and many people start to move into non-market service activities which are sustainable only with high oil and gas prices.

Moderator 2: We have time for the last question.

Q: Given the total dependence on oil and gas, what are the prospects of doubling GDP in the next decade?

Ruehl: As an economist, I can give you two answers. The first is about this target of doubling GDP. There have been so many revised definitions now, when do these ten years start to count that it is hard to really take that notion seriously to me. I would also give you a clear answer if it really starts to count in 2003 when that speech was made or even 2000, then the chances of meeting it are almost zero. Just arithmetically, it is almost zero. So, I would urge people not to get too excited about this notion of doubling it.

Now the second part of the answer is that, having said this, it makes to me a great deal of sense to put at the very center of development efforts in Russia an as rapid increase of GDP as possible. The reason is straightforward and it makes sense because it moves people out of poverty and it makes sense because actual structural changes are taking place, are happening and they are of course easier to make them happen in a growing economy than in a stagnant economy. And the faster it grows, the easier they are.

And in this context the absence of reforms over the last 18 months or so is a reason for worries, because it is a strange phase, with these high oil prices, the economy grows without the need for reforms. On the other hand, it's like an opportunity, you make hay when the sun shines, but it is not happening. Why is not happening now? The risk of complacency is of course setting in, so why is it not happening now? One cannot eliminate this underlying threat of volatility in world oil prices and dependency on world oil prices. So, there is the worry to push for reforms, now there is another one which is important.

There are no one to one transitions. Sometimes reforms which are necessary in the long run will have costs and even negative impact on growth in the short term. If you want to reform the education system, this is good for growth in the long term but costly in the short term and so, when asked to do it, the money should be there and the external environment smiling.

Moderator 2: Dear journalists, thank you very much. The press conference is over. If you have any questions, it is always our pleasure to answer. The best of everything.