Russia economic. Report november 2007

1. Russia Economic Report November 2007

2. Main Messages

Robust growth supported by high energy prices, large capital inflows, rising
domestic demand and prudent macroeconomic management
Short-term challenges:
–
–
–
–
Control inflation
Limit rapid real exchange rate appreciation
Manage large capital flows
Maintain prudent fiscal policy
Medium-term challenges:
–
–
–
–
Sustain productivity growth
Close the infrastructure gap
Boost private investment
Promote economic diversification
2

3.

I. Recent Economic
Developments
3

4. Rapid Output Growth Driven by Booming Domestic Demand

Contributions to GDP Growth, in %
GDP growth, %
12
9
8
7
6
5
4
3
2
1
0
10
8
6
4
2
0
-2
-4
-6
H1-2006
2001
2002
2003
2004
2005
2006
2007-9M
Final consumption
H1-2007
Capital formation
Net exports
• Economic growth remains robust. Having grown by 7.9 percent in 1H-2007, Russia
is likely to post full-year GDP growth of over 7 percent
• Output growth was driven by rising domestic demand, in particular, buoyant
household consumption (9.8 percent growth in 1H-2007) and business investment
(21 percent growth in 1H-2007)
• Negative contribution of net exports to GDP growth is explained by rapid import
growth and weak export performance, affected by the real appreciation of the ruble
4

5. Non-Tradable Sectors Continued to Boom

Output Growth by Sectors, 2006-2007
Transport
Retail trade
9M-2007
Construction
9M- 2006
Electricity, gas, water
2006
Manufacturing
Extraction of mineral resources
Agriculture
Base industries and sectors
-5
0
5
10
15
20
25
• Sectors servicing domestic demand continued to boom in 9M-2007: construction
(23.5 percent) and retail trade (15 percent)
• Manufacturing also grew at healthy 10 percent in 9M-2007, driven by the steady
performance of a few sectors (machines and equipment, electro- technical, and
transportation equipment)
5

6. Manufacturing Growth: Strong But Tapering Off

Quarterly growth in Russia Manufacturing
(relative to the same period of the previous year)
18.0
16.0
14.0
12.0
10.0
y = -0.1776x + 9.7795
8.0
6.0
4.0
2.0
0.0
IQ
2003
II Q
2003
III Q
2003
IV Q
2003
IQ
2004
II Q
2004
III Q
2004
IV Q
2004
IQ
2005
Manufacturing growth rate, %, y-o-y
II Q
2005
III Q
2005
IV Q
2005
IQ
2006
II Q
2006
III Q
2006
IV Q
2006
IQ
2007
II Q
2007
III Q
2007
Linear (Manufacturing growth rate, %, y-o-y)
•While still strong, manufacturing growth is decelerating. The impressive growth
posted in early 2007 was driven by temporary factors (warm winter, low output level in
Q1-2006 and unusually high investment demand in machine-building sectors)
6

7. The downward trend in manufacturing might be associated with the erosion in competitiveness in non-fuel, non-metal tradable sectors

Unit Labor Costs in Manufacturing
Manufacturing ULC index (US dollars), 2002 = 100
220
Russia
200
180
160
140
120
100
80
2002
2003
Russia
Slovak Republic
2004
Czech Republic
Euro Area
2005
Hungary
United States
2006
Poland
Parts of manufacturing that service domestic demand with limited competition
from imports may continue to thrive in Russia’s booming domestic market
But the real appreciation of the ruble, without commensurate increases in
productivity, drives up unit labor costs, hindering competitiveness in tradable
sectors (outside resources and metals)
7

8. Russia continues to experience an investment boom

Capital investment growth, % to previous year
2007*
2006
2005
2004
2003
2002
2001
2000
22
20
18
16
14
12
10
8
6
4
2
0
•The aggregate fixed capital investment grew by 21.2 percent in 9-M of 2007
(from 11.8 percent growth in the same period in 2006)
•While capital investments decelerated in September 2007 they still posted
double-digit growth rates (16.1 percent, relative to the same month in 2006)
8

9. Despite Investment Boom, Domestic and Foreign Investments Went to A Few Sectors

Total Fixed Capital Investment by Sector
Foreign Direct Investment by Sector
H1-2006
(% of total)
3.7
19.5
18.7
3.2
H1-2007
(% of total)
4.7
20.4
17.5
3.2
Coke and oil products
1.9
1.6
Machine building
0.8
1.1
Transportation devices
Chemical products
Other non-metal mineral products
Metallurgy and metal products
0.9
2.3
1.3
5.3
1.1
1.9
1.4
4.1
6.3
3.6
2.8
25.7
4
4.5
11.1
6.9
2.9
2.9
23.3
4
4.5
12
Agriculture, hunting, forestry
Extraction of mineral resources
Manufacturing
Food & tobacco
Electricity, gas, water
Construction
Retail Trade,Wholesale Trade, Repair
Transport and communication
Railways
Communication
Real estate
2006
% total
H1-2007
% total
Agriculture, hunting, forestry
1.4
0.6
Extraction of mineral resources
Manufacturing
33.1
70.6
19
11.1
Electricity, gas and water
0.4
0.2
2
2.9
Retail & wholesale Trade, Repair
6.1
4.1
Hotels and restaurants
Transport and communication
Finance
0.2
2.8
11
0.1
1
4
Real estate
23.5
5.2
Construction
• Resource sectors and Non-Tradable Sectors (retail and construction) remain the
favorite direction for domestic and foreign investments.
• In Manufacturing, most investments went to the food and metal sectors
9

10. Inflation is Rising, Driven by Food Prices and Monetary Factors

CPI inflation, %
Core CPI Inflation, %
PPI inflation, %
M2 growth, %
10M-2006
10M-2007
7.5
9.3
6.5
15.2 *
28.0*
8.9
17.0*
27.8*
*Data for 9 months. Source: CBR
• Inflation increased since April 2007 to reach 9.3 percent over 10M-2007 (compared to
7.5 percent in the same period of 2006)
• Most likely, end-of-year inflation will reach 11 percent (Dec/Dec)
10

11. Food prices increased, but prices of non-tradable goods and services also increased…

17.00
15.00
13.00
11.00
9.00
7.00
5.00
3.00
Jan - Feb - Mar - Apr - May - June July - Aug - Sept Oct - Nov - Dec - Jan - Feb - Mar - Apr - May - June July - Aug - Sept
2006 2006 2006 2006 2006
2006 2006
2006 2006 2006 2007 2007 2007 2007 2007
2007 2007
2006
2006
2007
2007
CPI, p-o-p, %
Food CPI, p-o-p, %
Changes in prices of the main components of the CPI
weight in CPI
Meat products
Milk and milk products
Bread and bakery products
Fruit and vegetables
Alcohol
Clothing
Footwear
Construction materials
Housing utility services
Transportation services
Communication services
Education services
10.28
2.68
2.23
3.83
6.63
5.27
2.55
2.07
8.83
3.26
3.19
2.5
Price change (end period)
10M-2007
10M-2006
6.4
22.7
21.3
9.0
6.0
6.0
5.9
15.0
13.5
8.2
10.7
14.2
4.5
5.8
9.0
3.7
8.3
5.9
5.4
9.9
17.1
11.3
1.9
14.4
11

12. Keeping inflation in check is becoming increasingly difficult with large capital inflows

Accumulation of Foreign Reserves and the Stabilization Fund
500000
450000
400000
350000
300000
250000
200000
150000
100000
50000
0
01.01.05
01.04.05
01.07.05
01.10.05
01.01.06
01.04.06
01.07.06
Gross foreign reserves, mln USD
01.10.06
01.01.07
01.04.07
01.07.07
01.10.07
Stabilization fund, mln USD
•Unlike oil revenues, capital inflows are not absorbed by the Stabilization Fund, driving
rapid money expansion and exerting upward pressures on the ruble.
• Given the limited monetary instruments for sterilization, one policy response would be
gradually allowing more rapid nominal appreciation of the ruble.
•The pace of nominal appreciation this year was slower than in 2006. The rubble
appreciated by 6 percent against the USD in nominal terms in 10M-2007 (compared to 7
percent in 2006).
12

13. BoP continued recording surpluses: weaker C/A was more than offset by stronger Capital Account

•Balance of Payments (USD billions)
Current Account Balance
Trade Balance
Capital and Financial
Account
Errors and Omissions
Change in Reserves
2004
2005
2006
9M2006
9M2007*
58.6
85.8
83.8
118.4
94.5
139.2
79.7
111.2
57.1
94.1
-6.3
-13.6
11.9
-5.1
59.5
-7.1
45.2
-8.8
61.5
1.1
107.5
1.5
76.2
-10.2
106.4
• The surge in capital inflows pushed the BoP surplus to record highs, becoming an
important source of foreign reserve accumulation (gross foreign reserves: 447bn)
• Large capital inflows reflected acceleration in foreign borrowing by state
corporations and the banking sector. Net capital inflows to the private sector
amounted to 56.8 bn in 9M-2007 (compared to 26.3 bn in the same period last year)
• Russia has weathered well the global financial turmoil. By October 2007 Russia
received a net inflow of capital of about 10 bn
Total net capital inflows to the private sector
Net capital inflows to the banking sector
Net capital inflows to the non-banking sector
2006
9M-2006
9M-2007
Q3-2007
40.1
27.5
12.6
26.3
15.7
10.6
56.8
37.6
19.2
-9.4
0.7
-10.1
13

14. Fiscal surpluses continue, but recently fiscal policy has become more accommodative

Three year budget plan
Federal budget
surplus reached 7.1
percent of GDP (9M2007 )
Revenues
Expenditures
Of which:
General state management w/o
interest expenditure
National defense
National security, law enforcement
National economy
Housing and communal Services
Education
Culture, mass media
Health and sport
Social policy
Interbudgetary transfers
Transfers to extrabudgetary funds
Total non-interest expenditure
Interest payment
Oil and Gas Transfer
2007 Budget
Law
(approved)
Federal
Budget with
amendment
2007
22.3
17.5
2.1
2.6
2.1
1.6
0.2
0.9
0.2
0.7
0.7
2.5
3.4
17
0.5
2008
2009
2010
23.19
19
18.8
18.1
20.35
18.8
18.8
18.1
3.0 (0.7)*
2.6
2.1
2.3 (0.6)*
0.9 (0.7)*
0.9
0.2
0.9
0.9
2.8
3.3
19.9
0.5
2.1
2.7
2.2
2.1
1.9
2.7
2.3
2
1.8
2.7
2.2
1.2
0.9
0.2
0.6
0.8
2.6
3.8
18.2
0.5
6.1
0.8
0.2
0.6
0.9
2.3
3.8
18.2
0.5
5.3
0.8
0.2
0.6
1
2
4.1
17.5
0.6
4.5
(..)* capitalization of development institutions: Bank for Development, Russian Nanotechnology Corporation,
Investment Fund, Fund for Housing reform support
• The approved 3-year budget entails fiscal relaxation (that might reduce the budget surplus to 0.2 % of
GDP by 2008). Recent revisions to the 2007 federal budget entail additional fiscal easing (that would
reduce the budget surplus to 2.8 percent by end 2007).
• The bulk of the planned increase in public expenditures goes to infrastructure and social spending
with a view of boosting growth.
• Two cautionary notes:
(i) raising public investments might not be enough to achieve a sustained impact on economic
growth. Keeping up private investments and improving the efficiency of investments will be as
important;
(ii) the pace of fiscal policy needs to be studied carefully to avoid exacerbating tensions in the
14
macro mix (additional fiscal stimulus might increase pressures for ruble appreciation)

15. Prospects

• Growth is likely to remain robust. With energy prices set
to remain high, booming domestic demand will continue to
translate into strong growth in services and manufacturing
• However, growth might slowdown if medium-term
challenges are not addressed….
– Sustain Productivity Growth (which can also help alleviating
pressures from the real appreciation of the exchange rate)
– Promote Economic Diversification
– Boost Private Investment
15

16.

II. Productivity Growth
in Russia
16

17. Russia has experienced a productivity surge, propelling economic growth

Total factor productivity growth (5.8 percent) drove GDP growth (6.5 percent) over (1999-2005)
Real income per capita (constant $2000,PPP) rose from $5,964 in 1998 to $9,650 in 2005
GDP Index (1989=100): Russia, ECA, and EU-10
Sources of Growth: Russia and Comparators (1999-2005)
Contributions of K, L, and TFP Growth to Aggregate Growth
140
130
9
EU10
120
110
7
ECA
100
5
(%)
TFPGr
3
90
LgrCont
80
KgrCont
70
RUSSIA
60
1
50
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
EU10
1992
Industrial
1991
China
1990
RUSSIA
1989
40
-1
But capital and labor
accumulation played little
role in total output growth
17

18. What are the drivers of the productivity surge?

• Capacity utilization
• Sectoral shifts
• Firm dynamics
18

19. Higher capacity utilization explains part of the productivity surge

• Utilization of excess capacity yields ‘easy’ productivity gains in a growth rebound after a deep recession
• But higher capacity utilization only explains part of the productivity surge
Sources of Grow th in Russia: 1999-2005
Im pact of Adjustm ent for Capacity Utilization
8
(%)
6
TFP
4
L
2
K
0
No Adjustm ent for
Cap. Util.
Adjusting for
Capacity Utilization
Even after adjusting for capacity utilization,
TFP growth still accounts for 4.15
percent of total GDP growth (of 6.5
percent)
19

20. The productivity surge is also explained by major sectoral shifts in the economy

A substantial reallocation of resources toward services
Labor Productivity Growth, 1999-2004
Sectoral Shares in Russia
Agriculture
Industry
Services
within
8%
100%
reallocation
7%
90%
80%
6%
70%
5%
60%
4%
50%
3%
40%
2%
30%
1%
20%
0%
10%
- 1%
0%
1990
2005
1990
Total Value Added
2003
Total Employment
- 2%
RUSSIA
EU15
EU10
Efficiency gains ‘within sectors’ had more impact on total
productivity growth than cross-sector shifts
Labor productivity over 1999-2004 grew by :
4.4 percent in agriculture,
4.7 percent in industry and
6.4 percent in services
20

21. Firm dynamics

Productivity growth came mostly from efficiency gains
within firms -but reallocation & net entry also mattered
Sources of Productivity Growth in Russian Manufacturing
Contribution rates (in % )
Within
Net entry
Reallocation
25
20
15
10
5
0
1998-2001
2001-2004
Highest Productivity
Growth in ICT sectors
RUSSIA: Decomposition for Manufacturing, Contributions to Aggregate
Productivity Growth 2001-2004
80
Within
70
Reallocation
Net Entry
60
40
30
20
10
0
-10
NACE Industry Code
Furniture
Other Transport
Motor Vehicles
Precision Tools
Elec. Mach.
Electronics
Machinery
Fabricated Metal
Basic Metals
Minerals
Rubber/Plastics
Chemicals
Printing
Paper
Wood
Leather
Garments
Textiles
-30
Food
-20
MANU
Growth Rate (%)
50
22

22. Productivity growth came mostly from efficiency gains within firms -but reallocation & net entry also mattered

Firm turnover plays a smaller role than in
other advanced economies
In advanced market economies 5-20 percent of firms enter and exit the market every year.
In Russia, only about 5 percent of firms were created or destroyed during the last decade
60
50
40
30
20
10
0
UK
USA
Canada
Mexico
Korea
Firm Entry rates
Taiwan
Slovenia
Hungary
RUSSIA
Firm Exit rates
•Private entrants are less productive than state-owned peers (suggesting barriers to entry and exit)
• Entrants do not promote productivity of incumbents (suggesting weak market competition)
Labor Productivity - Pooled Manufacturing
Incumbent Prod Growth
Russia
Five-Year Differencing, Real Gross Output
Country and Industry Time Averages
150
100
50
0
-40
-20
0
-50
20
Incumbents' Productivity Growth
1.5
Correlation Coefficient: 0.5800***
1.0
0.5
40
60
80
100
0.0
-0.5
-1.0
-100
Net Entry Contribution
-0.5
0.0
0.5
Net Entry Productivity Growth
Note: Excluding Brazil and Venezuela. Outliers Excluded.
1.0
1.5
23

23. Firm turnover plays a smaller role than in other advanced economies

Challenges Ahead
In spite of the productivity surge, Russia’s income per capita remains low (at 28
percent of EU-15 average)
Rapid productivity gains were ‘easy’ to achieve in the first years of the growth
rebound
But now with the economy growing close to potential, sustaining productivity
gains will be more difficult.
Capital and labor accumulation must play a greater role
Economic diversification including higher export sophistication also needs to
be promoted…
Share of Medium and High Tech Products in Total Exports (%)
1995-1998
40
% of Discovery in Total Exports, 1995-2005
1.2
1999-2005
1.0
35
30
0.8
25
0.6
20
15
0.4
10
0.2
5
0.0
0
RUSSIA
EU-10
RUSSIA
EU-10
Source: Bank staff calculations; UN-Comtrade, 2007
24

24. Challenges Ahead

Sustaining Productivity Growth Calls For Policy Reforms
that Accelerate Reallocation of Resources towards More
Efficient Uses
Russia has most to gain from policy catch-up
Impact of Policy Improvements on Productivity Growth:
Catching Up with the Median Industrial Country
5
(in percentages)
4
3
2
1
0
-1
RUSSIA
Education
Financial Development
ECA
Trade Openness
Institutional Quality
EU-10
Infrastructure Stock
Infrastructure Quality
25

25. Sustaining Productivity Growth Calls For Policy Reforms that Accelerate Reallocation of Resources towards More Efficient Uses

III.
From Red to Gray:
The Third Transition of
Aging Population in Russia
26

26.

Shrinking and Rapid Aging Population
Russia’s population will shrink by 12 percent (over 17 million people) by 2025
Russian population is also aging rapidly: by 2025, one person in every five will be over the age of 65.
(share of population over 65 will be 18 percent in 2025)
% Population Decrease, 2000-2025
% of over-65 population, 2000-2025
20
0%
Russia
18%
18
16
14
12%
12
- 10 %
10
- 20%
12
%
8
6
4
2
0
2000
2025
- 30%
These demographic trends will affect labor supply:
17 million
Declining and aging labor force: labor force will decline
by 3 percent (about 11 million people). Over 95 percent of
27
the decline will come from the 15-39 age group

27. Shrinking and Rapid Aging Population

But growing older does not have to mean growing slower
Aging is not a stop sign for growth:
Message 1) Address labor shortage through reforms to boost productivity
Message 2) Address fiscal risks associated with aging (pension, health & long care)
Russia, Growth decomposition, 1998-2005
10%
32%
58%
Share of growth due to higher:
Labor productivity
Employment rates
Working-age population
28

28. Aging is not a stop sign for growth: Message 1) Address labor shortage through reforms to boost productivity Message 2) Address fiscal risks associated with aging (pension, health & long care)

Thank you for your attention
29