Russia Economic ReportNovember 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

Contributions to GDP Growth, in %

-6

-4

-2

0

2

4

6

8

10

12

H1-2006 H1-2007

Final consumption 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

GDP growth, %

0

1

2

3

4

5

6

7

8

9

2001 2002 2003 2004 2005 2006 2007-9M

5

Non-Tradable Sectors Continued to Boom

Output Growth by Sectors, 2006-2007

-5 0 5 10 15 20 25

Base industries and sectors

Agriculture

Extraction of mineral resources

Manufacturing

Electricity, gas, water

Construction

Retail trade

Transport

9M-2007

9M- 2006

2006

• 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

y = -0.1776x + 9.7795

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

I Q2003

II Q2003

III Q2003

IV Q2003

I Q2004

II Q2004

III Q2004

IV Q2004

I Q2005

II Q2005

III Q2005

IV Q2005

I Q2006

II Q2006

III Q2006

IV Q2006

I Q2007

II Q2007

III Q2007

Manufacturing growth rate, %, y-o-y 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)

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)

80

100

120

140

160

180

200

220

2002 2003 2004 2005 2006

Russia Czech Republic Hungary Poland

Slovak Republic Euro Area United States

Manufacturing ULC index (US dollars), 2002 = 100

Unit Labor Costs in Manufacturing

Russia

8

Russia continues to experience an investment boom

02468

10121416182022

2000

2001

2002

2003

2004

2005

2006

2007*

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

H1-2006(% of total)

H1-2007 (% of total)

Agriculture, hunting, forestry 3.7 4.7Extraction of mineral resources 19.5 20.4Manufacturing 18.7 17.5

Food & tobacco 3.2 3.2

Coke and oil products 1.9 1.6

Machine building 0.8 1.1

Transportation devices 0.9 1.1

Chemical products 2.3 1.9Other non-metal mineral products 1.3 1.4

Metallurgy and metal products 5.3 4.1

Electricity, gas, water 6.3 6.9

Construction 3.6 2.9

Retail Trade,Wholesale Trade, Repair 2.8 2.9

Transport and communication 25.7 23.3Railways 4 4

Communication 4.5 4.5Real estate 11.1 12

2006 H1-2007% total % total

Agriculture, hunting, forestry 1.4 0.6

Extraction of mineral resources 33.1 70.6

Manufacturing 19 11.1

Electricity, gas and water 0.4 0.2

Construction 2 2.9

Retail & wholesale Trade, Repair 6.1 4.1

Hotels and restaurants 0.2 0.1

Transport and communication 2.8 1Finance 11 4

Real estate 23.5 5.2

Total Fixed Capital Investment by Sector Foreign 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

10M-2006 10M-2007

CPI inflation, % 7.5 9.3

Core CPI Inflation, % 6.5 8.9

PPI inflation, % 15.2 * 17.0*

M2 growth, % 28.0* 27.8*

• 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

Price change (end period) weight in CPI

10M-2007 10M-2006 Meat products 10.28 6.4 4.5 Milk and milk products 2.68 22.7 5.8 Bread and bakery products 2.23 21.3 9.0 Fruit and vegetables 3.83 9.0 3.7 Alcohol 6.63 6.0 8.3 Clothing 5.27 6.0 5.9 Footwear 2.55 5.9 5.4 Construction materials 2.07 15.0 9.9 Housing utility services 8.83 13.5 17.1 Transportation services 3.26 8.2 11.3 Communication services 3.19 10.7 1.9 Education services 2.5 14.2 14.4

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

Changes in prices of the main components of the CPI

3.00

5.00

7.00

9.00

11.00

13.00

15.00

17.00

Jan -2006

Feb -2006

Mar -2006

Apr -2006

May -2006

June-

2006

July -2006

Aug -2006

Sept-

2006

Oct -2006

Nov -2006

Dec -2006

Jan -2007

Feb -2007

Mar -2007

Apr -2007

May -2007

June-

2007

July -2007

Aug -2007

Sept-

2007

CPI, p-o-p, % Food CPI, p-o-p, %

12

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

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

500000

01.01.05 01.04.05 01.07.05 01.10.05 01.01.06 01.04.06 01.07.06 01.10.06 01.01.07 01.04.07 01.07.07 01.10.07

Gross foreign reserves, mln USD Stabilization fund, mln USD

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 2006. 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

2004 2005 2006 9M-2006

9M-2007*

Current Account Balance 58.6 83.8 94.5 79.7 57.1 Trade Balance 85.8 118.4 139.2 111.2 94.1

Capital and Financial Account

-6.3 -13.6 11.9 -5.1 59.5

Errors and Omissions -7.1 -8.8 1.1 1.5 -10.2

Change in Reserves 45.2 61.5 107.5 76.2 106.4

•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

2006 9M-2006 9M-2007 Q3-2007

Total net capital inflows to the private sector 40.1 26.3 56.8 -9.4 Net capital inflows to the banking sector 27.5 15.7 37.6 0.7 Net capital inflows to the non-banking sector 12.6 10.6 19.2 -10.1

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)

2007 Budget Law

(approved)

Revenues 22.3 23.19 19 18.8 18.1

Expenditures 17.5 20.35 18.8 18.8 18.1

Of which: General state management w/o interest expenditure National defense 2.6 2.6 2.7 2.7 2.7 National security, law enforcement 2.1 2.1 2.2 2.3 2.2 National economy 1.6 2.3 (0.6)* 2.1 2 1.2 Housing and communal Services 0.2 0.9 (0.7)* Education 0.9 0.9 0.9 0.8 0.8 Culture, mass media 0.2 0.2 0.2 0.2 0.2 Health and sport 0.7 0.9 0.6 0.6 0.6 Social policy 0.7 0.9 0.8 0.9 1 Interbudgetary transfers 2.5 2.8 2.6 2.3 2

Transfers to extrabudgetary funds 3.4 3.3 3.8 3.8 4.1

Total non-interest expenditure 17 19.9 18.2 18.2 17.5

Interest payment 0.5 0.5 0.5 0.5 0.6

Oil and Gas Transfer 6.1 5.3 4.5

1.82.1 3.0 (0.7)* 2.1 1.9

Three year budget plan

Federal Budget with amendment

2007 2008 2009 2010

(..)* 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-2007 )

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

Sources of Growth: Russia and Comparators (1999-2005)Contributions of K, L, and TFP Growth to Aggregate Growth

-1

1

3

5

7

9

RUSSIA China Industrial EU10

(%)

TFPGr

LgrCont

KgrCont

GDP Index (1989=100): Russia, ECA, and EU-10

EU10

ECA

RUSSIA

40

50

60

70

80

90

100

110

120

130

140

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

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

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

Sources of Growth in Russia: 1999-2005Impact of Adjustment for Capacity Utilization

0

2

4

6

8

No Adjustment forCap. Util.

Adjusting forCapacity Utilization

(%)

TFP

L

K

• 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

Sectoral Shares in Russia

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1990 2005 1990 2003

Total Value Added Total Employment

Agriculture Industry Services

Labor Productivity Growth, 1999-2004

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

RUSSIA EU15 EU10

within reallocation

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 1999-2004 grew by :

4.4 percent in agriculture, 4.7 percent in industry and 6.4 percent in services

22

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

Sources of Productivity Growth in Russian ManufacturingContribution rates (in %)

0

5

10

15

20

25

1998-2001 2001-2004

Within Net entry Reallocation

RUSSIA: Decomposition for Manufacturing, Contributions to Aggregate Productivity Growth 2001-2004

-30

-20

-10

0

10

20

30

40

50

60

70

80

MA

NU

Food

Text

iles

Gar

men

ts

Lea

ther

Wood

Pape

r

Print

ing

Chem

ical

s

Rubbe

r/P

lastic

s

Min

era

ls

Basi

c M

etals

Fabr

icate

d M

eta

l

Mac

hiner

y

Ele

ctr

onic

s

Ele

c. M

ach

.

Pre

cis

ion

Tools

Mot

or V

ehi

cle

s

Oth

er T

ranspo

rt

Furn

iture

NACE Industry Code

Gro

wth

Rat

e (

%)

Within Reallocation Net Entry

Highest Productivity Growth in ICT

sectors

23

Firm turnover plays a smaller role than in other advanced economies

0

10

20

30

40

50

60

UK USA Canada Mexico Korea Taiwan Slovenia Hungary

Firm Entry rates Firm Exit rates

RUSSIA

•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)

-0.5

0.0

0.5

1.0

1.5In

cu

mb

en

ts' P

rod

uctivity G

row

th

-1.0 -0.5 0.0 0.5 1.0 1.5Net Entry Productivity Growth

Note: Excluding Brazil and Venezuela. Outliers Excluded.

Correlation Coefficient: 0.5800***

Five-Year Differencing, Real Gross OutputCountry and Industry Time Averages

Labor Productivity - Pooled ManufacturingRussia

-100

-50

0

50

100

150

-40 -20 0 20 40 60 80 100

Net Entry Contribution

Incumbent Prod GrowthIn 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…

Share of Medium and High Tech Products in Total Exports (%)

0

5

10

15

20

25

30

35

40

RUSSIA EU-10

1995-1998 1999-2005

% of Discovery in Total Exports, 1995-2005

0.0

0.2

0.4

0.6

0.8

1.0

1.2

RUSSIA EU-10

Source: Bank staff calculations; UN-Comtrade, 2007

25

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

Impact of Policy Improvements on Productivity Growth:Catching Up with the Median Industrial Country

-1

0

1

2

3

4

5

RUSSIA ECA EU-10

(in

per

cen

tag

es)

Education Financial Development Trade Openness Institutional Quality Infrastructure Stock Infrastructure Quality

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, 2000-2025

-12%

- 30%

- 20%

- 10%

0%

Russia

17 million17 million

% of over-65 population, 2000-2025% of over-65 population, 2000-2025

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 15-39 age group

12%

18%

0

2

4

6

8

10

12

14

16

18

20

2000 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)

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, 1998-2005

58%32%

10%

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