Russian Economic Report

1
Russian Economic Report

• December 2006

2
I. Recent Economic Trends
3
In comparison with the first half of 2006, the
general macroeconomic situation in Russia has
strengthened

• An acceleration in economic growth
• Lower inflation
• Significant investment growth, including FDI
• Higher real incomes

4
What explains the acceleration in growth?

• Record high oil prices
• A strong ruble and rapidly rising domestic demand
  have made the domestic Russian market much more
  profitable for investors

5
The growth in Russia remains concentrated
primarily in non-tradable sectors
Table 2 Output Growth by Sector 2005-2006

Source Rosstat
6
Figure 1 Growth Rates in Machine Building
()
Figure 2 Growth Rates in Chemicals and
Metallurgy ()
Figure 3 Growth rates in food and light
industry ()
Figure 4 Growth rates in wood and oil
processing ()
7
Investment remains concentrated in energy and
non-tradables
8
Total Fixed Capital Investment by Sector ( of
total)
9
Shares of Foreign Direct Investment by Sector of
the Economy ( of total)
10
Gas and electricity Stagnation in production,
rapidly growing demand, and huge investment needs

• Relatively cheap energy has been an important
  comparative advantage for Russia
• New government plans foresee significant increase
  in natural gas tariffs in coming years.
• Russias cautious attitude toward foreign
  investment in energy implies that a very large
  share of needed investment will need to be
  financed domestically, and partly though higher
  domestic prices.

11
Russias balance of payments is experiencing
important changes

• Following the fall in oil prices, the current
  account has begun to contract
• This trend will most likely continue (Import is
  growing very fast 29 percent in the first nine
  months of the year)
• The weakening of the current account has been
  compensated, to some degree, from high capital
  inflows

12
Balance of Payments (USD
billions)
Source CBR preliminary estimates
13
Under current trends, the current account will
steadily move toward deficit, and stability in
the balance of payments will depend more on
capital flows
14
Higher growth and a decline in money velocity
(associated with higher ruble savings) absorbed
much of the inflationary pressure from a strong
monetary expansion
15
A 26 planned (nominal) increase in government
spending in 2007 should contribute to
inflationary pressures next year
Federal budget ( GDP)
16
Monetary (exchange rate) policy is complicated by
large and unstable short-term capital flows
Net Capital Inflows to Banking sector, (bln USD)
and the Nominal Exchange Rate, (USD/Rub)
17
The Central Bank and the government have made
good progress this year in clarifying the basic
principles of monetary policy.

• The abolishment of an explicit target for the
  real exchange rate
• The confirmation of fighting inflation and
  preventing exchange rate volatility as the
  primary goals of monetary policy
• The gradual transition to a more flexible
  exchange rate policy

18
Changes in migration policies

• Migration to Russia from abroad is largely
  informal.
• Given the current demographic crisis in Russia,
  sustaining rapid growth in the country will
  depend on attracting a large number of external
  migrants
• The general announced policy directions are
  correct a liberalization of the formal regime,
  together with better enforcement.
• But Russia needs to be careful not to create much
  less favorable conditions on balance for
  migration to the country

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II. Fostering an innovation economy in Russia
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The model of Russian economic growth since the
second half of 2004

• Higher foreign inflows from resource exports
• Rapidly growing domestic demand
• Slowing growth in tradable sectors of
  manufacturing, and movement of labor to other
  sectors.
• High growth in non-tradable sectors

21
What are Russias medium term prospects under the
current model of development?

• The large size of Russias domestic market
  supports a wide range of activities that cannot
  be substituted easily by imports
• If oil prices do not fall drastically, and
  certain key structural problems are tackled
  (infrastructure, energy, labor supply
  (migration), the current model could be
  consistent with sustaining growth over the medium
  term

22
But this path of development is not optimal for
Russia

• Economic growth and welfare are constrained below
  potential Resource-dependent countries develop
  less successfully, countries with comparative
  advantages in high tech more successfully.
• High vulnerability to fluctuations in oil prices.

23
Initiatives for fostering a diversified and
innovation economy in Russia

• Industrial and regional policies government
  interventions that favor particular sectors of
  the economy or geographic areas (special economic
  zones, IT parks, venture funds, state development
  bank, differential tax policies, training and
  skills programs, export subsidies, direct
  government participation in the economy)
• Structural reforms aimed at improving the general
  conditions for private business and competition

24
The choice of industrial policy for Russia is a
complicated question

• World experience has been very uneven, and mostly
  negative
• The former role of industrial policy in East Asia
  was more connected to imitation than innovation
• Realizing such policies in Russia would be much
  more complicated given relatively high labor
  costs, WTO and other international agreements,
  and the new integrated nature of world markets.
  
• Stress is therefore place on the innovation
  economy as a means of creating high value added
  employment and specialization

25
What is needed in Russia to ignite the
innovation economy in Russia?

• As in other countries, the state can play an
  important role in education, and in encouraging
  innovation and training through matching grants
  and other programs...
• ...but world experience strongly suggests that an
  innovation economy thrives primarily on dynamic
  decentralized processes in the context of fierce
  international competition

26
The US experience importance of small business,
and market entry and exit
US Industrial RD Intensity by Firm Size (2002)
27
The importance of market entry and exist for
productivity growth has been also confirmed for
other countries
28
The experience of China illustrates that
fostering an innovation economy is possible even
in the absence of strong formal market
institutions

• In China, informal institutions play much the
  same role in supporting entrepreneurship, market
  entry and exit, and competition
• A key element of the Chinese model is autonomy
  and strong incentives at the provincial level to
  promote a healthy business environment and
  competition

29
Competition can be associated with higher levels
of innovation and technical progress

• This conclusion is reached in a number of recent
  empirical studies
• For Russia, strong evidence was found in a recent
  survey of 1000 manufacturing enterprises carried
  out as part of the Investment Climate Assessment
  (World Bank and Higher School of Economics)

30
Innovative Activity and Competition
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Is there enough competition and entrepreneurship
in Russia to support an innovation economy?

• In the Investment Climate Assessment survey 20
  percent of manufacturing enterprises feel little
  competitive pressures at all. Another 29 percent
  does not feel pressures coming from foreign
  competition
• At the regional level, mutual relations of
  support between incumbent enterprises and
  regional/local authorities are common
• Employment in small business and entrepreneurship
  (26 ) remains low in Russia despite the new
  simplified tax system that has made registration
  as a number of small enterprises (rather than a
  single large one) often advantageous.

32
The majority of RD in Russia is financed by
government, while investment in RD by the
private sector is quite low compared to other
BRIC countries.
Private (in-house) RD Expenditures as a Share of
Sales
33
What important policies are needed in Russia for
fostering an innovation economy?

• Completion of the structural reform agenda, as
  outline primarily in 2000 (including property
  rights, judiciary, competition policy, and the
  alleviation of various administrative barriers to
  business)
• Reform of the government itself. The climate for
  entrepreneurship and competition will unavoidably
  depend greatly on regional and local officials.
  They need good incentives and instruments
  (Chinese experience).
• Reform of the education system, and of the system
  of state research and development finance.
• Best world experience in specific programs to
  stimulate innovation and training