October 2010 Evgeny Gavrilenkov, Chief Economist

1. Russia: Poised for Growth, but Constrained by Policy October 2010 Evgeny Gavrilenkov, Chief Economist

2. Russia’s growth model should undergo uneasy transformation amid institutional constraints • In the aftermath of last year’s correction, Russia’s growth is moderating after a period of overheating and excessive borrowing. Nonetheless, growth is expected to be rather strong this year – Russia’s GDP can expand around 4-5% and our outlook has not changed since mid-2009, however recent changes in budgetary policy reduce optimism. • The State Statistics Service is now transitioning to a new base year (2008 instead of 2003). This means that data for 2010 and preceding years are often incompatible and thus should be treated cautiously. Statistical errors were already too high last year, which means that even last year’s numbers are suspicious. • Last year’s economic performance may have been better than the State Statistics Service reported. This is because monetary and financial indicators, which indirectly point to where the economy is heading, look very encouraging since 2Q09 (including 1H10). • Russia did not face any serious budgetary constraints, but rather institutional constraints.

3. GDP 4.2% Agriculture 1.8% Fishing 8.0% Raw materials extraction 8.4% Manufacturing 14.4% Supply and redistribution of electricity, gas and water 6.8% Construction -3.9% Retail 1.7% Hotels and restaurants -1.4% Transport and communication 9.5% Finance -4.3% Real estate -1.0% State administration, military, social services 1.9% Education 0.4% Health care -0.3% Housing and social services -19.0% Net taxes on products 7.7% Statistical revisions were significant in the case of industrial output and are yet to come for GDP Revised industrial output figures, y-o-y GDP growth breakdown, 1H10, y-o-y Source: State Statistics Service Source: State Statistics Service

4. Russia’s economy will expand around 4-5% in 2010 2008 2009* 2009*** 2010 2009** GDP 5.6% - 7.9% -7.0% 5.0% -7.9% Consumption 8.6% - 5.4% -3.2% 3.1% -5.1% 5.0% Household consumption 10.8% -8.1% -5.0% -7.7% Public sector consumption 2.9% 1.9% 2.0% 1.0% 2.0% -1.0% Consumption of other sectors -1.4% -1.8% 0.0% -1.4% Gross investments 10.5% -37.6% -30.0% 18.0% -37.4% Fixed capital investments 10.4% -18.2% -17.0% -15.7% 3.0% Changes in stocks 11.5% – – – – Net export of goods and services -35.5% 58.0% 34.0% -2.0% 56.6% * State Statistics Service (first estimate) ** State Statistics Service (second estimate) *** Troika estimates Source: State Statistics Service; Troika estimates

5. Retail Services Household Real disposable Real consumption incomes wages 1Q08 17.2% 7.4% 14.6% 7.5% 13.4% 2Q08 14.9% 5.4% 12.1% 5.7% 12.5% 3Q09 15.0% 5.1% 11.2% 4.5% 12.2% 4Q08 8.7% 1.8% 6.2% -6.9% 5.0% 2008 13.5% 4.8% 10.7% 1.9% 11.5% 1Q09 -0.1% -0.9% -2.6% 0.7% -0.8% 2Q09 -5.6% -4.7% -7.5% 3.4% -3.9% 3Q09 -9.2% -6.4% -10.8% -3.4% -5.2% 4Q09 -6.1% -4.4% -9.4% 8.2% -0.7% 2009 -5.5% -4.3% -7.7% 2.3% -2.8% “But actually, he thought as he re-adjusted the Ministry of Plenty’s figures, it was not even forgery. It was merely the substitution of one piece of nonsense for another.” (George Orwell, Nineteen Eighty-Four) Source: State Statistics Service

6. Following the crisis, the Russian economy looks healthier, but risks of derailment cannot be ruled out • Last year, Russia was able to deflate not only the financial bubble, but the consumption bubble as well. Monthly growth, which resumed from 2Q09, moderated but looked healthier and more balanced. • Since April-May 2010, almost all y-o-y indicators have turned positive. Even though y-o-y and m-o-m growth numbers are still incompatible for some economic indicators, the growth this year looks robust. According to official statistics, investment was up 10.9% in August (2.8% in 8m10 and 1.3% in 7m10) and retail up 6.5% (4.3% in 8m10 and 3.9% in 7m10). According to revised figures, industry grew 9.2% y-o-y in 8m10. There is an acceleration of growth on the demand side and a deceleration of supply, implying more imports. • Annual nominal wage growth fluctuated around 10% in 1H10 and also moderated relative to the pre-crisis overheated years, which resulted in disinflation in 1H10 and July (5.5% y-o-y). Wage growth accelerated in recent months, which, combined with drought and some negative shifts in monetary and fiscal policy, triggered acceleration of inflation in August-September. Nonetheless, y-o-y inflation will be a bit lower in 2010 compared with 2009.

7. Industrial output has been recovering m-o-m since February 2009, Jan ’06 = 100% Source: State Statistics Service

8. 2,000 2,000 2008 1,500 1,500 2007 1,000 1,000 GDP, $ bln 2006 2004 2005 500 500 2003 1999 0 0 0 20 40 60 80 100 Urals, $/bbl Russia’s nominal GDP (in dollar terms) correlates with the oil price 2010 2009 Source: State Statistics Service, Troika estimates

9. Rising oil price and expanding foreign borrowing failed to accelerate Russia’s growth: in principle Russia can grow at any oil price Source: State Statistics Service, Troika estimates Source: State Statistics Service, Troika estimates

10. Retail was booming due to foreign borrowing, which stimulated imports Acceleration due to borrowing Source: State Statistics Service, Central Bank, Troika estimates

11. After a short correction a year ago, consumption is rising steadily, while household debt shrank Growth accelerated amid excessively rapid expansion of credit Source: State Statistics Service, Central Bank, Troika estimates

12. Bonds were replacing loans in banks’ portfolios Bonds and loans in banks’ portfolios Source: Central Bank

13. Russia is returning to a more balanced model of economic development after several years of overheating Source: State Statistics Service, Troika estimates

14. New equilibrium: Since 1999, South Korea’s growth has moderated after decades of unbalanced investment-led growth Source: National statistics, Troika estimates

15. China: a balance is yet to be found… 20% 1984 15% 1992 1993 1987 2006 1978 1996 10% 2003 1986 2008 2009est GDP, y-o-y 1980 1999 1981 5% 1990 ? 0% -5% 25% 30% 35% 40% 45% 50% 55% Investments/GDP Source: National statistics, Troika estimates

16. GDP per capita in the former Soviet republicsin 1991 and 2009, $ Source: IMF

17. GDP per capita in the former Soviet republicsin 2009 and external borrowing Source: IMF, CIA, national banks

18. In uncertain times, economic performance is affected by government policy more than before • In addition to monetary policy, which has improved since the Central Bank abandoned exchange rate targeting in February 2009, fiscal policy looked less generous in 1H10, which was extremely positive. For the first time ever, expenditures were not expected to rise in 2010 and beyond – a major disinflationary factor. Recent decisions to inflate budgetary expenditures accompanied by sporadic intervention by the Central Bank on the forex market are dangerous. • On the back of rapidly rising budget expenditures, inflation remained high in preceding years, while the former did not encourage economic growth. Russia needs to balance the budget in the years to come in order to secure growth. As the breakeven oil price reached $95/bbl last year, the budget’s dependence on the oil price should be reduced, but the government has no plans to do so. • Apart from external risks, Russia’s major internal risk is excessive dependence of the budget on the oil price. Budgetary spending was raised this year amid an improved external environment and better performance of the domestic economy. The risk of further increases in 2011 and beyond still exists. The proposed budgets for 2011-12 look excessively generous while borrowing plans seem unrealistic.

19. Budget revenues fell in 2009, but not as much as the government expected, R bln... 2005 2006 2007 2008 2009 2010E 7,784 7,338 Total revenues 5,127 6,276 7,779 9,274 – 195 Profit tax 378 510 641 761 – 510 Social tax 268 316 405 507 – VAT 1,472 1,511 2,262 2,132 2,050 – 982 Raw materials extraction tax 855 1,094 1,123 1,605 – Export duties 1,352 1,896 1,835 2,859 2,042 – Import duties 271 342 488 626 467 Other 533 608 1,026 784 1,092 – Note: The government initially forecast revenues in 2009 at R6,713.8 bln. In 7m10, revenues reached R4,659.2 bln, while the deficit was R538.8 bln. Source: Finance Ministry

20. … but expenditures increased massively, R bln 2005 2006 2007 2008 2009 2010E 10,212 Total expenditures 3,514 4,281 5,983 7,567 9,660 839 State administration 501 530 812 835 829 1,264 National defense 581 682 832 1,041 1,188 1,096 National security 450 550 667 836 1,005 1,583 National economy 249 345 693 1,025 1,651 198 Housing sector 7 53 295 130 152 433 Education 162 212 295 355 418 341 Medical care, sport 88 148 197 278 352 329 Social policy 178 201 214 294 324 3,633 Transfers 1,246 1,499 1,900 2,675 3,594 Other 52 62 79 99 147 496 Note: The government initially planned expenditures in 2009 at R9,845.2 bln. Source: Finance Ministry

21. A larger government and a budget deficit in Russia usually mean worse economic performance Source: State Statistics Service, Finance Ministry, Troika estimates Source: State Statistics Service, Finance Ministry, Troika estimates

22. Government interventions were inflationary: public consumption shrank in real terms Deflator for public consumption remainedhigher than for other elements of GDP Public consumption to GDP ratio shrank in real terms, its contribution to economic growth diminished Source: State Statistics Service Source: State Statistics Service

23. Due to increased expenditures, the breakeven oil price climbed close to $100/bbl Urals Breakeven oil price, $/bbl Urals Federal budget expenditures exceedpre-crisis level Source: Finance Ministry, Troika estimates Source: Finance Ministry, Troika estimates

24. Finance Ministry has become too generous: planned expenditures tend to grow November 2009, R bln 2009 2010E 2011E 2012E 2013E 7,336.0 6,950.0 8,077.0 8,549.0 9,147.6 Revenues 9,662.2 9,886.9 9,857.4 9,895.6 10,078.7 Expenditures -2,326.2 -2,936.9 -1,780.4 -1,346.6 -931.1 Deficit of the federal budget % of GDP -5.9% -6.8% -3.6% -2.4% -1.5% August 2010, R bln 2009 2010E 2011E 2012E 2013E 7,336.0 7,783.8 8,617.8 9,131.7 9,983.9 Revenues 9,662.2 10,212.4 10,385.1 10,844.6 11,749.1 Expenditures -2,326.2 -2,428.6 -1,767.3 -1,712.9 -1,765.2 Deficit of the federal budget % of GDP -5.9% -5.4% -3.6% -3.1% -2.9% September 2010, R bln 2009 2010E 2011E 2012E 2013E 7,336.0 7,783.8 8,843.8 9,502.7 10,378.9 Revenues 9,662.2 10,212.4 10,658.0 11,237.3 12,174.9 Expenditures -2,326.2 -2,428.6 -1,814.2 -1,734.6 -1,796.0 Deficit of the federal budget % of GDP -5.9% -5.4% -3.6% -3.1% -2.9% Source: Finance Ministry

25. Sources of deficit financing, R bln

26. Voluntary reserves increased as the Central Bank offered an attractive risk-free rate Voluntary reserves have increasedsharply in 1H10 Central Bank deposit and bond rates Source: Central Bank Source: Central Bank, Troika estimates

27. Banks’ voluntary reserves are not inflationary if real rate on household deposits is positive Growth in real deposit rate stimulatesincrease in deposits Money supply and bank reserves,R bln Source: Central Bank, Troika estimates Source: Central Bank

28. Central Bank absorbed previously extended loans, R mln Source: Central Bank

29. M2 declined in nominal terms, but started to rise in February 2009, a sign that the economy is recovering (R bln); a sort of “currency board” regime is seemingly over: money is becoming endogenous ($ bln) Source: Central Bank, Troika estimates Source: Central Bank, Troika estimates

30. The ruble has appreciated since February 2009 after the Central Bank stopped targeting the exchange rate, which became more volatile; the Central Bank’s role as lender of last resort grew in importance Source: Central Bank, Troika estimates Source: Central Bank

31. Historical exchange rate and oil price: new regime emerges as the Central Bank reduces interventions 38 35 32 Exchange rate regime since February 2009 R/$ 29 26 23 20 20 40 60 80 100 120 140 $/bbl Urals Source: Central Bank, Bloomberg, Troika estimates

32. Two regimes of targeting: currency first, money market second Volatility high on the money market, low on the forex market Volatility high on the forex market, low on the money market Source: Central Bank

33. Nominal interest rates declined, but may go up again Source: Central Bank, State Statistics Service

34. Real rates have grown due to decelerating inflation, but will go down as inflation accelerates Based on y-o-y inflation Source: Central Bank, State Statistics Service

35. Annual inflation has been slowing more rapidly, but started to accelerate in August Annual inflation versus refinancing rate Monthly inflation Source: State Statistics Service, Central Bank Source: State Statistics Service, Central Bank, Troika

36. The direct impact of monetary factors on inflation is not obvious, irrespective to whatever lags are used No obvious correlation between inflation and money supply No stable correlation between inflation and the exchange rate Source: Central Bank, State Statistics Service

37. There has been a sort of inverse correlation between money supply growth and inflation Source: Central Bank, State Statistics Service

38. Money supply dynamics affect changes in inflation (acceleration or deceleration) The correlation existed before 2009… …but increased in 2009-10, when real interest rates became positive Source: Central Bank, State Statistics Service

39. Mcap and the money supply drift together Source: Central Bank, State Statistics Service, Bloomberg

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