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

3 I. Recent Economic Developments

4 Rapid Output Growth Driven by Booming Domestic Demand 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

5 Non-Tradable Sectors Continued to Boom 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)

6 Manufacturing Growth: Strong But Tapering Off 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 Q and unusually high investment demand in machine-building sectors) Quarterly growth in Russia Manufacturing (relative to the same period of the previous year)

7 The downward trend in manufacturing might be associated with the erosion in competitiveness in non-fuel, non-metal tradable sectors 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) Unit Labor Costs in Manufacturing Russia

8 Russia continues to experience an investment boom Capital investment growth, % to previous year 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)

9 Despite Investment Boom, Domestic and Foreign Investments Went to A Few Sectors Total Fixed Capital Investment by SectorForeign Direct Investment by Sector 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

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

11 Food prices increased, but prices of non-tradable goods and services also increased… Changes in prices of the main components of the CPI

12 Keeping inflation in check is becoming increasingly difficult with large capital inflows Accumulation of Foreign Reserves and the Stabilization Fund 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 The rubble appreciated by 6 percent against the USD in nominal terms in 10M-2007 (compared to 7 percent in 2006).

13 BoP continued recording surpluses: weaker C/A was more than offset by stronger Capital Account Balance of Payments (USD billions) 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

14 Fiscal surpluses continue, but recently fiscal policy has become more accommodative 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 macro mix (additional fiscal stimulus might increase pressures for ruble appreciation) (..)* capitalization of development institutions: Bank for Development, Russian Nanotechnology Corporation, Investment Fund, Fund for Housing reform support Federal budget surplus reached 7.1 percent of GDP (9M )

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

16 II. Productivity Growth in Russia

17 Russia has experienced a productivity surge, propelling economic growth Total factor productivity growth (5.8 percent) drove GDP growth (6.5 percent) over ( ) Real income per capita (constant $2000,PPP) rose from $5,964 in 1998 to $9,650 in 2005 But capital and labor accumulation played little role in total output growth

18 What are the drivers of the productivity surge? Capacity utilization Sectoral shifts Firm dynamics

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 Even after adjusting for capacity utilization, TFP growth still accounts for 4.15 percent of total GDP growth (of 6.5 percent)

20 The productivity surge is also explained by major sectoral shifts in the economy A substantial reallocation of resources toward services Efficiency gains ‘within sectors’ had more impact on total productivity growth than cross-sector shifts Labor productivity over grew by : 4.4 percent in agriculture, 4.7 percent in industry and 6.4 percent in services

21 Firm dynamics Decomposing total productivity growth into three components: ‘within’: accounts for productivity growth within existing firms ‘reallocation’: reallocation of labor across existing firms ‘net entry’: entry of new firms and exit of obsolete firms

22 Productivity growth came mostly from efficiency gains within firms -but reallocation & net entry also mattered Highest Productivity Growth in ICT sectors

23 Firm turnover plays a smaller role than in other advanced economies 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) Russia Net Entry Contribution Incumbent Prod Growth 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

24 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…

25 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

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

27 Shrinking and Rapid Aging Population % Population Decrease, million % of over-65 population, These demographic trends will affect labor supply: Declining and aging labor force: labor force will decline by 3 percent (about 11 million people). Over 95 percent of the decline will come from the age group 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) Russia’s population will shrink by 12 percent (over 17 million people) by 2025

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) Russia, Growth decomposition, Share of growth due to higher: Labor productivity Employment rates Working-age population But growing older does not have to mean growing slower

29 Thank you for your attention