Russian Economic Report No. 25 Zeljko Bogetic Lead Economist and Coordinator for Economic Policy for Russia, The World Bank Segei Ulatov Resident macroeconomist, Moscow office June 8, 2011 Moscow Securing Stability and Growth

OUTLINE I.Recent Economic Developments and Policies II.Russias Outlook for III.Export Diversification: Binding Constraints and Policy Options

I. DEVELOPMENTS AND POLICIES: G LOBAL TRENDS The world economy has entered a post-crisis phase of moderate growth driven in large part by developing countries slowing of growth in low and middle-income countries from over 7 percent in 2010 to 6.3 percent in 2011 GDP growth in high-income countries is expected to slow to 2.2 percent in 2011 (from 2.7 percent in 2010) reflecting weak domestic demand Activity in developing countries of Europe and Central Asia is projected to continue growing moderately

Despite some deceleration, growth in developing countries remains robust Global Industrial production Source: Global prospects, World Bank.

Capital flows to developing countries-reflecting global and regional risks Source: Global prospects, World Bank. * Including Poland & Croatia

Debt crisis in euro zone, political instability in North Africa: CDS spreads in selected countries in Euro zone and in Egypt are considerably higher than in Russia

RUSSIAS RECENT ECONOMIC DEVELOPMENTS AND MACRO POLICIES IN 2011 Economic growth slowed to 4.1 percent in the first quarter of 2011 Balance of payments––stronger because of high oil prices, but net capital outflows External debt - increased exposure of the corporate sector Labor markets –– recovery continues Monetary policy–– inflation concerns remain Fiscal policy––return to surpluses, but non-oil deficit remains high

Economic growth slowed to 4.1 percent in the first quarter of 2011, driven by a continuing industrial recovery Source: World Bank staff calculations based on Rosstat data. GDP growth by main sectors (value added): 2006– GDP growth Tradable sector Agriculture, forestry Extraction industries Manufacturing Nontradable sector Electricity, gas, and water production and distribution Construction Wholesale and retail trade Transport and communication Financial services

Balance of payments––stronger in the first quarter because of high oil prices, but net capital outflows continue Source: CBR. a Preliminary estimates a Q4-2010Q a Current account balance Trade balance Capital and financial account Errors and omissions Change in reserves (+ = increase) USD billions

Net capital outflows has been a long term phenomena in Russia Source: CBR, Global prospects.

Labor markets – improving but not everywhere Regional unemployment in Russia, (average) Source: Rosstat Q Russian Federation Central Federal Okrug North-west Federal Okrug South Federal Okrug North Caucuses Federal Okrug Volga Federal Okrug Ural Federal Okrug Siberian Federal Okrug Far-East Federal Okrug

Real income and wage growth unexpectedly fell as inflation picked up in January-April 2011, but dollar wages reached a record high, reflecting the rubles appreciation Jan– Dec Jan- April GDP growth (%, y-o-y) * Total employment (million people) Employment growth (%, y-o-y) * Labor productivity growth (%, y-o-y) * Real disposable income growth (%, y-o-y) Real wage growth (%, y-o-y) Average monthly wage (US$) Unemployment a (%, end of period) */ Estimate for Q a. International Labor Organization definition.

Russias national poverty rate at end-2010 was essentially flat and the government managed to cushion the previous social impact by a large fiscal stimulus Sources: Rosstat, actual data for 2006–10; RER team calculations based on Household Budget Survey data and projections for 2011–12.

Rising Food and Oil Prices: the Europe and Central Asia Region

Monetary and exchange rate policy Source: CBR; World Bank staff estimates. Money Supply Growth, % (M2, y-o-y) Inflation pressures remain despite active monetary tightening in February – April 2011 Monetization of the economy has slowed the CBR has returned to a more active posture in the exchange rate market

Credit recovery continues Sources: CBR; World Bank staff estimates.

The federal fiscal outcome much better than planned mainly because of higher oil and gas revenues; but non-oil deficit remains large 2011 (federal budget) 2011 (amendment)change Revenues Oil revenues Non-oil revenues9.5 0 Expenditures Deficit Non-oil deficit Source: Ministry of Finance, Economic Expert Group.

A more ambitious adjustment than envisaged by the government, but is fully achievable and necessary for Russia to achieve long-term fiscal sustainability Russia should prudently aim for non-oil fiscal deficit of about 4.3 percent of GDP, implying an adjustment of about 6.5 percentage points of GDP over the medium term A combination of revenue and expenditure measures including cutting unproductive expenditures and improving expenditure efficiency while investing in productive infrastructure To insulate public expenditure from possible political pressures, fiscal should be based on an explicit fiscal rule (such as the permanent income rule) towards macroeconomic stability and long-term sustainability It would be easier to achieve this now in the context of a large, temporary oil windfall compared with the prospects of several months ago Such an adjustment would also be conducive to dynamic, long-term growth

The experience of Chile--also rich in resources--shows that saving of windfall revenues (for future use in crisis periods) could bring economic and political dividends Many stabilization funds failed to fulfill their objectives because it was difficult to resist political pressure for excessive expenditure during booms

II. Global Outlook, real GDP growth, % Source: Global Prospects for world growth; Russian Economic Report for Russia, The World Bank (projected) 2012 (projected) World High-income countries Developing countries Russian Federation

The oil price outlook has been revised upwards World Bank oil price forecast. Average crude (Brent, Dubai and WTI), simple average, $/bbl

Outlook for Russia: Source: Russian Economic Report, The World Bank GDP growth (%) Consolidated government balance (%) Current account (US$ billions) Percentage of GDP Capital account (US$ billions) Percentage of GDP 0.9

Demand Sources of Russias Growth Demand sources of Russias real growth, by quarter, 2008–10 (percent change year to year) Source: Rosstat; World Bank staff estimates.

III. Export Diversification in Russia: current situation Russias narrowing product base Russian exporters face difficulties not only entering but also sustaining their presence in foreign markets Russia currently exhibits comparative advantages in trade in very few sectors, clear only in two sectors extractive industries and iron and steel Russia seems to be underperforming even compared with its existing trade potential

Productivity is key to exports and that lack of competition and entrepreneurial innovation are relevant obstacles to the emergence of new, potentially exportable products

Policy Implications for export diversification Improving investment climate to facilitate productivity growth, innovation and R&D, and competition the outcomes of traditional industrial policy decreasing state capture in the economy facilitating entrepreneurial and innovation activity implementing comprehensive competition policy

Resume: Securing Stability, Growth and Equality Macroeconomic stability Growth outlook for Russia - 4.4% in 2011, 4.0% in 2012 Strengthening economic policy in the area of long-term fiscal sustainability, improving efficiency of government spending and lowering inflation Economic growth and diversification Productivity growth, innovation and competition are key for export diversification. Improving investment climate and eliminating infrastructure bottlenecks is also important Poverty and Equality 18 million people in Russia still live in poverty Growth will help to reduce poverty, but further reductions in poverty will require greater policy focus and persistence in implementing more effective and targeted programs, especially in the poorest regions. The government should not miss the opportunity of a large oil windfall to substantially improve its long-term fiscal position, further reduce inflation and, therefore, ensure a strong basis for durable stability and healthy growth in the future.

Thank you!