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Russia Economic Report November 2007 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 I. Recent Economic Developments 3 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 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 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 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 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 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 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 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 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 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 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) 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 II. Productivity Growth in Russia 16 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 What are the drivers of the productivity surge? • Capacity utilization • Sectoral shifts • Firm dynamics 18 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 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 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 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 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 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 III. From Red to Gray: The Third Transition of Aging Population in Russia 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 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 Thank you for your attention 29