Russia – What is changing?Russia – What is changing?

Erik BerglofChief Economist

European Bank for Reconstruction and DevelopmentThe Portoroz Business Forum

November 16, 2006

Russia is changingRussia is changing

Economy growing, fueled by consumption Middle class emerging Foreign direct investment expanding rapidly Russian private business changing dramatically Sound macro management, but little reform of state

sector and increasing interference Now shifting from savings to spending mode Facing increasing capacity constraints

Russia’s Difficult TransitionRussia’s Difficult Transition

Deeper and more drawn-out transition recession than CEE

1998 financial crisis marked a turning point

Remarkable and unexpected growth spurt post-1998

Line shows all transition countries

Russia is growingRussia is growing- dollar GDP quadrupled since 2000; to surpass $2 trln in 2010- dollar GDP quadrupled since 2000; to surpass $2 trln in 2010

314

392

405

271

196

260

345

432

589

764

2,09

1

1,79

4

1,50

3

1,22

8

954

307

0

500

1,000

1,500

2,000

2,500

95 96 97 98 99 00 01 02 03 04 05 06F 07F 08F 09F 10F

$ bn

Source: Russian authorities, DB Research estimates

Real wages rising and consumption Real wages rising and consumption booming…booming…

– Real wage increases drive consumption

– Further wage hikes to be expected…

– …as public sector wages planned to double in 2005-8

Growth in retail trade and real average wage growth, YoY, 3mma

4%

6%

8%

10%

12%

14%

16%

18%

Jan-

03

Apr-0

3

Jul-0

3

Oct-0

3

Jan-

04

Apr-0

4

Jul-0

4

Oct-0

4

Jan-

05

Apr-0

5

Jul-0

5

Oct-0

5

Jan-

06

Apr-0

6

Jul-0

6

Retail trade, YoY, 3mma Real average wage, YoY, 3 mma

Source: Rosstat

……consumer credit exploding…consumer credit exploding…

– Growth in consumer credit nearly 100% year-on-year…

– …with ratio of retail consumer loans to GDP approaching 6%

– Deposits also up, but not growing as fast

Consumer credit growth, YoY, 2003-5

0%

20%

40%

60%

80%

100%

120%

140%

Dec

-02

Mar

-03

Jun-

03

Sep-

03

Dec

-03

Mar

-04

Jun-

04

Sep-

04

Dec

-04

Mar

-05

Jun-

05

Sep-

05

Dec

-05

Mar

-06

%

Consumer credit growth, YoY Retail deposits growth, YoY

Source: CBR

……falling unemployment despite falling unemployment despite restructuring…restructuring…

– Surging services sector and turnaround in manufacturing employment

– Fall in unemployment also feeds consumption

Unemployment rate, %

0

2

4

6

8

10

Jan-03 May-03 Sep-03 Jan-04 May-04 Sep-04 Jan-05 May-05 Sep-05 Jan-06 May-06

%

Unemployment rate Officially registered unemployed, % of labour force

Source: Rosstat

……small business growth creating jobssmall business growth creating jobs

01,0002,0003,0004,0005,0006,0007,0008,0009,000

1998 1999 2000 2001 2002 2003 2004 9mo2005-10%

-5%

0%

5%

10%

15%

20%

Employment in small businesses, thousands (lhs)

Employment growth in small businesses cumulative relative to the base year (1998),%, (rhs)

Small business employment (employment and employment growth post-1998)

Inflation still a concern…Inflation still a concern…

0%

10%

20%

30%

40%

50%

60%

70%

2000 2001 2002 2003 2004 2005 2006 2007

CPI, YoY, % PPI, YoY, %

……but short-term dynamics under controlbut short-term dynamics under control

(in % to December 2005)

100

102

104

106

108

110

Consumer prices

Producers prices for manufactured goods

Prices on sold agricultural productsGeneral cargo rates

excluding pipelines

Consolidated price index

for construction products

January-May 2006.

January-May 2005

108.5

109.7

105.9

107.3103.6

104.8

108.6

108.8103.8

104.5

Remarkable macro managementRemarkable macro management

Huge current account surpluses

Large budget surpluses 2004-2006

Built substantial reserves – Stabilisation Fund over $70 bn in November 2006...

...but mode is changing Fiscal balance (% of GDP)

Current account balance (% of GDP)

From “savings mode” to “spending mode”From “savings mode” to “spending mode”

In 2007 budget outlays are set to increase by around shift 4% of GDP

More than 50% capital spending into the key sectors of the economy

The “winners” include electricity, IT-sector, transportation and housing

Uneven Progress on Transition Uneven Progress on Transition

Advanced far on first-stage reforms: trade and price liberalisation, and privatization

More modest progress on more complex institutional reforms

Two upgrades in 2006: banking and non-bank financial sector

Russia 2006 (EBRD Indicators)

Highest score

Lowest score

Hitting capacity constraintsHitting capacity constraints

High energy prices associated with strong growth…

…but capacity constraints are now imposing limits

-5

0

5

10

15

20

In p

er ce

nt (a

nnua

l weig

hted

avg.

)

0

10

20

30

40

50

60

70

US$ p

er b

arre

l (ann

ual a

vera

ge)

Russia (left axis) Oil price - Brent (right axis)

Investment critical to sustain growthInvestment critical to sustain growth

– Higher investment needed to sustain growth in consumption…

– …with latest figures showing improvement

Investment vs industrial production growth , YoY, %

0%

4%

8%

12%

16%

Jan-

03

Apr-0

3

Jul-0

3

Oct

-03

Jan-

04

Apr-0

4

Jul-0

4

Oct

-04

Jan-

05

Apr-0

5

Jul-0

5

Oct

-05

Jan-

06

Apr-0

6

Jul-0

6

%

Industrial production growth, YoY, 3mma Investment growth, YoY, 3 mma

Source: Rosstat

Huge investments needsHuge investments needs

New extraction and refining capacity in resource industries, particularly in oil and gas

Machinery and equipment in manufacturing industry old – average more than 20 years

Extreme underinvestment in hard infrastructure: power, transportation, municipal infrastructure (water etc.)...

...not to speak of education and health care

Corporate Sector TransformingCorporate Sector Transforming

Consolidation of ownership and control Better governance standards and

transparency More professional management Restructuring... ...and investing

Productivity growing under pressureProductivity growing under pressure

– Productivity improving in sectors competing with imports (consumer goods…)

– …pressured by stronger rouble and trade liberalization

– labour-shedding, but..– …growth in services

sector compensates

Productivity growth vs real wages growth by sector, 2005

Productiopn and distribution of electricity, gas

and water Vehicles production

Equipment production

Metals

Chemical production

Light industry

Food industry

Extraction of fuel raw materials

Total industry

0

4

8

12

0 4 8 12

Productivity growth, %

Real

avera

ge w

age g

rowth,

%

45o

Source: MEDT

Internationalization of industryInternationalization of industry

Increasing productivity at least partially offset rouble appreciation

Increasing exports, but still dominated by resource-based industries

Outward direct investment increasing, with resource industries leading, but facing constraints

Listings on foreign exchanges booming...

FDI: new records, from low levelsFDI: new records, from low levels

– FDI expected to more than double to more than $30 bn this year

– Further growth expected with continued macro stability

– Now twice those of Brazil and five times those of India; but less than half of China’s

FDI forecast

0

5

10

15

20

25

30

35

40

45

50

2004 2005 2006F 2007F 2008F

$ bn

Source: CBR, Deutsche UFG Research

More FDI flows to banking and More FDI flows to banking and manufacturing - and the regionsmanufacturing - and the regions

FDI, regional breakdown, 2005

Other14%

Sakhalin Oblast28%

Omsk Oblast24%

St. Petersburg & Leningrad Oblast

4%

Tyumenn Oblast6%

Moscow region8%

Moscow16%

Source: Rosstat

FDI by sector, 2005

Extraction of raw materials, fuel

30%

Manufacturing46%

Real Estate7%

Trade & Services6%

Financial services5%

Other6%

Source: Rosstat

Russia: Financial sector developmentRussia: Financial sector development

Banking sector expanding rapidly (>40 %) in all products and most regions; products in roubles

Securities markets also expanding: greater liquidity, longer maturities in bond markets, London IPOs

Banking sector reform weak in application of minimum capital requirements and transparency

July 2006 capital account convertibility – supports bond market liquidity, and result in net inflow, but…

…banking sector more vulnerable to outflows; underlines need for consistent macro management

Falling cost of capital… Falling cost of capital… …attracts large companies to capital markets…attracts large companies to capital markets

Source: Bloomberg, Deutsche UFG Research estimates

Equity (IPOs)

Eurobonds($bn)

Rb bonds (Rb bn) $bn

2004 7.6 144 0.88

2005 14 261 5.1

2006F 18.4

Debt (gross)

Source: Deutsche UFG Research estimates

20 350

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2001 2002 2003 2004 2005 2006 2007

Implied equity risk premium Russia 2030 Eurobond YTM

8%

5%

Cost of capital since 2001 Capital market financing

M&A

$bn

23.1

39.4

44.6

Russia’s De-DollarisationRussia’s De-Dollarisation

Growth in bank loans to the non-financial private sector

0

10

20

30

40

50

60

70

per

cent

total deposits in RUB in foreign exchange

Growth in bank deposits

-30

-20

-10

0

10

20

30

40

50

60

per

cent

total deposits in RUB in foreign exchange

Russia: key challengesRussia: key challenges

Consolidation of industrial groups will need to be checked by credible enforcement of competition policy.

Return to private sector initiative and reduce state interference in the economy to restore business confidence

Contain inflationary pressures by limiting fiscal relaxation in the 2007 budget, while transitioning to an inflation targeting regime

Investment FundInvestment Fund

– Vehicle for financing private-public partnerships– Allocations to Investment Fund

2006FY: ~$3 bn 2007FY: ~$6-7 bn

– Government commission already approved 7 projects Total investment consideration $23 bn Majority of the approved projects have to do with

transport infrastructure Private-to-public financing ratio is 3:1 to 4:1

Power giant UES investment programPower giant UES investment program

1.4 2.1 2.9 3.7 21.118.618.315.46.90

5

10

15

20

25

02 03 04 05 06F 07F 08F 09F 10F

Cape

x fo

r Rus

sian

powe

r gen

erat

ion,

$ b

n

Source: UES

Failure to reform state sectorFailure to reform state sector

State sector still largely unreformed; civil service reform failed

Number of Russian bureaucrats doubled in the 1990s…

…with the bulk of the increase taking place in the regions

Number of employees in state administration, in thousands

0

200

400

600

800

1,000

1,200

1,400

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

'000

Source: Rosstat

Emerging economic model: Emerging economic model: Strong state interference and nationalism...Strong state interference and nationalism...

Resource sector understandable...– Difficult choices – Russian choices– Time pressures (energy sector)

...but spreading to other strategic sectors– Uncertainty undermines investment climate

Industrial policy increasingly vertical... ...”National champions” and ”priority projects”

...but earlier reforms are paying off......but earlier reforms are paying off...

Deregulation for small businesses Strengthened banking regulation Pockets of rejuvenation in state administration New generation of managers...

……progress towards WTO accessionprogress towards WTO accession

Trade in goods: main impact through stricter standards on certain trade instruments, e.g. anti-dumping; less uncertainty about market access conditions for Russian export

Services sectors: greater foreign competition through direct investment may raise productivity

Enforcement of domestic law now potentially subject of international dispute settlement

Russia is changingRussia is changing

Phase 1 (1991-1999):

Drawn out transition recession

Phase 2 (2000-2005):

Strong macro management and rapid growth, driven by private consumption

Phase 3 (2006-):

Investment (and public consumption + transfers)– Huge needs throughout economy– Substantial resources + foreign direct investment– Severe implementation constraints (need private sector)– Reform of state critical for Russia’s economic model