Domestic Market Boom Helps
Boost Russian Economic Growth

The Russian economy is on the upswing, thanks to a revival of domestic demand. Two different studies, one conducted by the World Bank and the other by the organization of Economic Cooperation and Development (OECD) have identified exports and favourable terms of trade as the main features which have been fuelling and supporting domestic consumption. This in turn, accelerated the pace of Russian economic growth, especially during the second half of 2006. Industrial production, which witnessed a slowdown during the early part of the year, picked up during the second and third quarters of the year. Overall, the annual GDP growth has been estimated at 7.4 percent for the year. More importantly, Russia's transition to market economy has helped stabilize the GDP growth.

A booming domestic market continues to drive strong economic growth in Russia, according to a report of the World Bank, released in December 2006. 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, Russia's 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 Russia's 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 the above 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 Russia's future development. In this regard, Russia's 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 Russia's 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 lion's 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...

Rising trade & domestic consumption
The World Bank's assessment is amply supported by a survey made by the Organization of Economic Cooperation and Development (OECD). It says Russian economy continues to grow strongly, buoyed by strong terms of trade, which, in turn, are supporting a boom in domestic consumption.
This survey analyses the main challenges involved in sustaining strong growth over the long term. It argues that growth since 1999 has been largely dependent on transitory factors and that the transition to self-sustaining, investment- and innovation-led growth will require both continued sound macroeconomic management and a range of structural reforms aimed at improving framework conditions for business. The survey assesses recent macroeconomic and structural policy, and introduces the chapters that address the main challenges Russia faces with respect to macroeconomic management, public administration reform, innovation policy and healthcare reform.

Sustaining sound macro-economic management
Macroeconomic management first examines the impact of rising terms of trade on the domestic economy, particularly with respect to exchange-rate appreciation, competitiveness and inflation. It then considers the role of monetary and fiscal policies in ensuring a smooth adjustment to the higher terms of trade. Fiscal policy should be the primary instrument for tackling this challenge. It therefore focuses on the potential role of a fiscal rule in insulating the economy and the budget from commodity-price fluctuations, and on the management of windfall oil and gas revenues accumulated in the fiscal Stabilization Fund.

Improving the quality of public administration
The inefficiency, corruption and lack of accountability that afflict public administration in Russia impose substantial direct costs on both entrepreneurs and ordinary citizens. This Survey examines the major weaknesses of Russia's public administration and assesses the government's recently revised programme of administrative reform. It lays particular stress on the relationship between public bureaucracies and the larger institutional environment within which they operate, as well as on the need for far greater transparency of public bodies and stronger non-judicial means of redress for citizens wishing to challenge bureaucratic decisions. Many of the problems of Russia's public administration are aggravated by the fact that the Russian state often tries to do too much: the chapter therefore explores the link between administrative reform and the scope of state ownership and regulation.

Enhancing the efficiency of innovation policy
The potential role of innovation policy in enhancing long-term productivity growth in Russia. It begins by exploring the role of framework conditions for business in encouraging innovative activities, particularly with respect to intellectual property rights and competition. Realizing Russia's innovation potential will also require reform of the large public science sector. This raises issues pertaining to the organization and financing of public research bodies and, in particular, to the incentives and opportunities they face in commercializing the results of their research. Apart from this, the role of direct interventions, such as special economic zones and technoparks, as well as the scope for improving the tax regime for private-sector R&D is also important.
Real GDP growth will remain fairly robust, though moderating gradually over the projection period as the impulse from recent terms-of-trade gains diminishes. Growth will continue to be driven mainly by consumption, but investment growth is also expected to be relatively strong. Inflation is likely to decline despite continued rapid money-supply growth, as rising confidence in the rouble contributes to the rapid growth of money demand. However, inflationary pressures are likely to abate only gradually, given the government's plans for further spending increases in 2007.