RD Interview: Dr. Birgit Hansl, the World Bank’s lead economist for the Russian Federation, analyzes the key findings of the World Bank’s recent report on the Russian economy and explains what steps the Russian government needs to take next.

"Uncertainty is having a real impact on economic decision-making and most likely in a negative way in terms of postponing decisions for consumption and investment." Photo: RIA Novosti

A year has passed since the West imposed sanctions on Russia over its policy in Ukraine and almost a year since global oil prices plummeted. Since then, the Russian economy has been adjusting to the new reality and trying to function under the changed rules of the game. Opinions have been mixed as to whether Russia’s economy has been successful in addressing these factors or not.

With that in mind, Russia Direct got in touch with Dr. Birgit Hansl, the World Bank’s lead economist for Russia, and talked with her about the main findings of the new economic report the World Bank recently released.

Russia Direct: What are the main findings of the World Bank’s latest report on Russia?

Birgit Hansl: It has really four key messages. First, that we see that Russia is balancing a very difficult economic adjustment. As you know, it resulted in the first half of 2015 in the recession deepening in Russia, which had a severe impact on Russian households.

So we also see that the economy is still adjusting to the 2014 trade shocks - in this intense geopolitical context, which then resulted in economic growth dropping in the first half of the year to minus 3.5 percent. And this was mainly because of an accelerated contraction in consumption. This is related to the really high level of inflation that the economy still faces and that is, in turn, eroding real wages and incomes and makes households simply more vulnerable.

However, the [second] key message is that we still think that the policy response of the authorities during this first half of the year after the major shocks to the economy happened was very well balanced and helped to stabilize the economy.

The clear example here is successful transition to the free float exchange rate, which relieves pressure on external balances and helped the adjustment of the external balances. You can see that Russia still has a positive current account balance, which is quite an achievement and a very good macroeconomic adjustment.

On the other hand, there are remaining key challenges - the high inflation rate and completion of the fiscal adjustment. The fiscal adjustment is very important and it has to follow through shrewd budget policy, which is a big challenge. Also we should not forget about financial market restructuring, which addresses financial market risks.

The third key message is that Russia’s economic growth prospects for this and the next year are still negative in our view. So we project minus 3.8 percent growth this year, which is based on the current low oil price of about $53 per barrel, and we project for the next year minus 0.6 percent growth.

Also read: "With its grand past and difficult present, Russia's future still unclear"

But what is really more important in our view is that, due to the severity of this projected contraction of Russia’s economic growth, we expect that the poverty rate is to increase very sharply this year to over 14 percent, compared to 11.2 percent in 2014. Most noticeably this is going to be the first significant increase in the poverty rate since the 1998-1999 crisis.

Thus, this negative growth outlook has a really severe impact on households, not just on the extreme poor. It is also going to stall the growth of the middle class.

And finally if we look at the current economic policy challenges, it is very interesting that the policy challenges that we originally thought more of a long-term issue (like Russia transforming its economy structure away from the natural resource sector, the growth of the fiscal impact of Russia’s demographic transformation of an aging and shrinking population) are becoming much more pressing to tackle. So, overall it seems like this short-term adjustment process is really a good opportunity to fast-forward this general transformation process.

RD: It is been already a year since the sectoral sanctions against Russia are in place. What are the main changes in the Russian economy? Are their negative or positive?

B.H.: The economic impact of the sanctions is, of course, included in this recession story that we see for Russia. It is impacting Russia because it makes access to capital more expensive or restricts access to capital for certain parts of the economy outright – and this is not good news overall for investment activities because investments are based on capital.

So, a more limited pot of capital is naturally making investment more difficult or at the same time having more expensive capital also is negatively impacting investment. And this is in essence confirming the story we had in our previous report where we looked very deeply into the economic impact of sanctions in other countries that experienced them. That is ultimately impacting your investment profile and your investment level over time.

Video by Pavel Gazdyuk

In addition, the longer the sanctions will remain in place, the more they will clearly have an adverse impact on investment.

RD: What do you see as the main challenges of the Russian economy?

B.H.: Well, I think at the moment the Russian economy still faces very adverse external conditions compared to previous years when we had really high oil prices, which helped to compensate for economic setbacks. And we see globally that trade is recovering much slower than the overall economic growth, which makes it very difficult we think for Russia to become competitive as a manufacturing exporter.

Thus, external challenges remain but it is not just them that we see impacting the growth path, but increasingly it is policy uncertainty that becomes a serious challenge to short-term growth.

When you look for instance at the business confidence indicators released by the business survey of Rosstat [Russian Federal Statistics Service] you can see that over the last half a year in 2015 compared to the same period of 2014 uncertainty about economic policy became a key constraint mentioned by businesses.

So it is not just that there is a weak domestic demand, which is of course expected in this difficult adjustment process, but it is now this uncertainty that businesses and households are not sure where the economy is going, what are main policies choices will be. One example here is the longtime uncertainty around budget decisions for the next years.

Recommended: "August 2015 is just as ominous as August 1998"

It creates a lot of uncertainty for households because many of them receive transfers from the government in the form of social benefits, pensions, and if they do not know what they can expect (because it is often a substantial part of their income), it makes it very difficult for them to make informed consumption decisions and most likely holds back consumption.

And the same is for the firms and companies. If they have contracts with the government (for some companies state contracts are a very important part of their business) and if there is no budget framework, it is also very unclear for these economic actors if they are to have, for instance, an income stream or if they are going to be profitable over the next years. It also makes them very cautions in terms of whether they should expand their capacity, should they invest.

Therefore, this uncertainty is having a real impact on economic decision-making and most likely in a negative way in terms of postponing decisions for consumption and investment or scaling back original plans for investment and consumption. And if you have less investment and consumption, you ultimately have less growth. That is the reason why it is the key issue. So, it is not just a question of confidence, it is ultimately reflected in real data.

So therefore what needs to be fixed in the first place is for the government to be clear about policy choices, to have a clear strategy what is the key policy for the next years which will give companies and households an opportunity to know what they can expect from the government’s economic policies. So it is really an issue about signaling what are the strategic choices in a very difficult period of uncertainty.

RD: Recently Russian Prime Minister Dmitry Medvedev unveiled the new Strategy 2030, which is concentrated on four priorities: investment activity, import substitution, the quality of state governance, and budgetary policy. How timely do you think this new strategy is for the Russian economy?

B.H.: I think it addresses really the main constraints and issues the Russian economy faces. Of course the revival of investment activity is a priority but it is not just about the amount of investment, it is more about investment quality. And this issue is related to the decision-making around investment: Is there a vetting process that is transparent, what is the quality of public investments management, etc.? So, it is hopefully addressing the issue of not just how to increase investment as such but how to improve their quality, which is a very important task.

Recommended: "Russia’s unemployment rate resilient to economic crisis"

The quality of state governance and budgetary policy are without any doubt key issues that need to be part of the government priorities in Russia.

As for import substitution, it is an interesting concept but I think we should be very cautious about what kind of policies need to be created by the state for import substitution. In essence what you see in Russia is that now due to the weaker ruble, there is a greater advantage for local producers to become more competitive, at least in terms of relative prices. This raises the question of the necessity of additional state support, especially when budget and public resources are so constrained. So this is the area that is less grounded in economics, I would say.