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World Bank Report on Russia
7 December 2006
World Bank Report on Russia

Russian Economic Report
The World Bank
 Moscow Office Economics Unit
December 2006

Full report available at: http://ns.worldbank.org.ru/files/rer/RER_13_eng.pdf

I. Recent Economic Developments

A booming domestic market continues to drive strong economic growth in Russia. Substantial net capital inflows have now joined receipts from resource exports in fueling domestic demand. In this context, the pace of economic growth has accelerated since the second quarter of the year. Annual GDP growth could reach 7.0 percent. Fixed capital investment and FDI have also exhibited impressive growth. The economic expansion continues to be concentrated primarily in non-tradable sectors of the economy that have profited from a stronger ruble. Stagnating production, high investment needs, and rapidly-growing domestic demand are raising increasing concerns about the state of the Russian energy sector.

Following the stabilization of oil prices, Russias large current account surplus has finally begun to contract. Yet a stronger capital account has somewhat compensated for this trend, supporting the continued accumulation of foreign reserves, albeit at a slower pace. Rapid growth in money supply and higher federal expenditures in 2006 have been largely absorbed by higher-than-expected economic growth. Inflation has slowed considerably in the second half of the year. The planned 2007 budget foresees an expansion of federal expenditures of 0.9 percent of GDP, with priorities in additional expenditures going to the state apparatus, investment and social programs.

Real incomes of the population, wages, and retail trade have been growing in double digits, significantly outpacing GDP growth. Consistent with this picture, import growth soared to 29 percent for the first three quarters of the year.

Recent policy initiatives of the government include a planned package of measures aimed at promoting diversified growth and the innovation economy and new legislative initiatives on migration. A long awaited bilateral agreement with the United States could pave the way for Russias accession to the WTO in the near future...

GDP and Industrial Production

A slowdown in output growth at the beginning of 2006 gave way to an accelerated expansion of economic activity in the second and third quarters of the year. GDP growth in the second quarter reached an estimated 7.4 percent, bringing the figure for the first half of 2006 to 6.5 percent. The growth in Russia remains concentrated primarily in the production of non-tradable services and goods for the domestic market. Almost fifty percent of the GDP expansion in the first half of 2006 came from trade and construction.

Russian industry exhibited somewhat more rapid growth (4.3 percent) in the first 10 months of 2006 than during the same period in 2005 (3.7 percent). Within industry, energy and utilities have exhibited somewhat higher growth than in 2005, while the expansion in manufacturing has continued to slow down.

The rapid real appreciation of the Russian ruble (8 percent in the first three quarters of 2006) and double digit increases in real labor costs continue to challenge Russian firms in competition on international markets. Machine building as a whole has not fared well in 2006. The production of machines and equipment has stagnated (0.5 percent growth in the first 10 months of the year), while the production of electro-technical equipment has fallen (-1.5 percent growth). Chemicals grew at only 1.2 percent. Growth in most other sectors of manufacturing was somewhat stronger. Several industries reported increases in their growth rates for the first ten months of 2006 relative to the same period of 2005. Metallurgy continued to exhibit strong performance, growing at 10.2 percent. The food industry (5.3 percent), coke/oil processing (6.0 percent) and cellulose-paper and publishing (6.8 percent) also exhibited higher than-average growth in manufacturing. The long decline in light industry may have finally bottomed out, with rapid growth reported in textiles and sewing (7.8 percent) and the production of shoes and leather products (13.2 percent). Plastic and rubber products also expanded by an estimated 11.1 percent. Textiles, sewing, plastics, and rubber products together account for only 4 percent of manufacturing, however, and their growth is from a very low base.

Increasing attention has focused on the Russian gas and electricity sectors, where a combination of rapidly growing demand, stagnating supply, and the depletion of existing fields have raised prospects of additional price increases and possible future shortages. The government has acknowledged the seriousness of the situation, and recently approved a package of measures to increase domestic gas prices and promote the more rapid growth of alternative energy sources (nuclear and coal) for electricity. Against this backdrop, there has also been a certain revitalization of discussions for introducing more competition into the gas industry, particular in gas production, as several oil companies have unrealized potential for producing gas. Under the most recent plans, the government will increase domestic gas prices for enterprises by 15 percent in 2007, and between 25-27 percent annually from 2008-2010. Relative increases in gas prices are projected to continue until the profitability for domestic sales and exports is equalized. This does not imply the equalization of Russian and EU tariffs net of transportation costs, however, as the Russian government can use the gas export tax to regulate the profitability of exports. This is a valuable tool, given the fact that export gas prices include rents that Russia receives due to its market power in natural gas.

The question of providing sufficient investment in gas and electricity over the medium term remains one of the most critical questions for Russias future development. In this regard, Russias cautious attitude toward foreign investment in the energy sector increases the share of this needed investment that will most likely need to be financed internally through higher tariffs or other means. Higher energy tariffs may become another increasingly limiting factor in the expansion of Russian manufacturing.

Investment

Given Russias needs in capital and modernization, the government has placed a high priority on increasing fixed capital investment rates beyond the current 19 percent of GDP. 2006 has witnessed at least some important progress on this front. Fixed capital investment growth accelerated to 12.6 percent during January-October 2006, as compared to 9.9 percent growth in the first 10 months of 2005. Inflows of direct foreign investment increased by an estimated 55 percent during the first three quarters of the year, and reached US$ 10.3 billion. Along with high profits in the energy sector, the strong ruble and booming domestic market have helped make Russia increasingly attractive to private investors.

The lions share of investment in Russia is still going to energy, transportation, real estate and services. Other than metals, manufacturing received only 13 percent of fixed capital investment in the first three quarters of 2006. A similar picture of concentration emerges for foreign direct investment. In 2004-2005, manufacturing technically received 30-45 percent of FDI, but much of this was concentrated either in metals or oil processing (from the sale of Sibneft in 2005). Net of those two sectors, Table 4 shows that the share of FDI in other areas of manufacturing has consistently amounted to about 17 percent during those three years. In 2006, the financial sector has attracted a notably higher share of FDI than in previous years....

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