Russia – What is changing?

1. Russia – What is changing? Erik Berglof Chief Economist European Bank for Reconstruction and Development The Portoroz Business Forum November 16, 2006

2. Russia 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

3. Russia’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

4. Russia is growing- dollar GDP quadrupled since 2000; to surpass $2 trln in 2010 Source: Russian authorities, DB Research estimates

5. Real wages rising and consumption booming… • Real wage increases drive consumption • Further wage hikes to be expected… • …as public sector wages planned to double in 2005-8

6. …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

7. …falling unemployment despite restructuring… • Surging services sector and turnaround in manufacturing employment • Fall in unemployment also feeds consumption

8. …small business growth creating jobs Small business employment (employment and employment growth post-1998)

9. Inflation still a concern…

10. (in % to December 2005) Consumer prices 105.9 110 107.3 103.6 108 108.5 104.8 109.7 106 Consolidated price index Producers prices for manufactured goods 104 for construction products 102 100 January-May 2006. 108.6 January-May 2005 103.8 108.8 104.5 General cargo rates Prices on sold agricultural products excluding pipelines …but short-term dynamics under control

11. Remarkable 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)

12. 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 From “savings mode” to “spending mode”

13. 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

14. Hitting capacity constraints • High energy prices associated with strong growth… • …but capacity constraints are now imposing limits

15. Investment critical to sustain growth • Higher investment needed to sustain growth in consumption… • …with latest figures showing improvement

16. Huge 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

17. Corporate Sector Transforming • Consolidation of ownership and control • Better governance standards and transparency • More professional management • Restructuring... • ...and investing

18. Productivity 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

19. Internationalization 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...

20. FDI: 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

21. More FDI flows to banking and manufacturing - and the regions

22. Russia: 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

23. 20% 18% 16% 14% 12% 10% 8% 8% 6% 5% 4% 2% 0% 2001 2002 2003 2004 2005 2006 2007 Implied equity risk premium Russia 2030 Eurobond YTM Falling cost of capital… …attracts large companies to capital markets Cost of capital since 2001 Capital market financing Debt (gross) Equity (IPOs) M&A Eurobonds ($bn) Rb bonds (Rb bn) $bn $bn 7.6 144 0.88 23.1 2004 261 5.1 39.4 14 2005 20 350 18.4 44.6 2006F Source: Deutsche UFG Research estimates Source: Bloomberg, Deutsche UFG Research estimates

24. Russia’s De-Dollarisation

25. Russia: 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

26. Investment 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

27. Power giant UES investment program Source: UES

28. Failure 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

29. Emerging economic model: 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”

30. ...but earlier reforms are paying off... • Deregulation for small businesses • Strengthened banking regulation • Pockets of rejuvenation in state administration • New generation of managers...

31. …progress 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

32. Russia 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