Russia: Uneasy Growth Amid Budgetary and Institutional Constraints

1. Russia: Uneasy Growth Amid Budgetary and Institutional Constraints April 2010 Evgeny Gavrilenkov, Chief Economist

2. Russia’s growth model should undergo uneasy transformation amid institutional constraints • Russia’s growth is moderating after a period of overheating and excessive borrowing. Nonetheless, growth is expected to be strong this year – we expect Russia’s GDP to expand around 5% and our outlook hasn’t changed since mid 2009. • The Statistics Service is now transitioning to a new base year, which 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 under suspicion”. • Last year’s economic performance may have been better than the Statistics Service reported, as monetary and financial indicators, which indirectly point to where the economy is going, look very encouraging since 2Q09 (including January-February 2010). • Russia didn’t face any serious budgetary constraints, but rather institutional constraints – a challenge that hasbroader recognition within the ruling elite. Hopes for slow institutional transformation rose as inflating growth via easy money becomes increasingly difficult.

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

4. Retail was booming due to foreign borrowing Acceleration due to borrowing Source: State Statistics Service, Central Bank, Troika estimates

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

6. 15% 10% 1961 1999 5% 1989 GDP, y-o-y 0% -5% 2009 -10% -15% 1992 10% 15% 20% 25% 30% 35% 40% Investments/GDP Russia is returning to more a balanced model of economic development after several years of overheating Source: State Statistics Service, Troika estimates

7. Industrial output has been recovering m-o-m since February 2009, however statistical errors (transition to a new base year) are too significant to be ignored Source: State Statistics Service, Troika estimates Source: State Statistics Service, Troika estimates

8. 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% 0.4% -0.8% 2Q09 -5.6% -4.7% -7.5% 3.1% -3.9% 3Q09 -9.2% -6.4% -10.8% -2.9% -5.2% 4Q09 -6.1% -4.4% -9.4% 7.0% -1.0% 2009 -5.5% -4.3% -7.7% 1.9% -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, Troika estimates

9. Russia is returning to growth in 2010 amid falling inflation, which creates a new platform for economic performance in the years to come • Inflation fell to 6.5% y-o-y in February 2010 with good chances to stay around 6.0% for the year as a whole. More rate cuts are expected. A lower cost of borrowing is supposed to be a new platform for more diversified growth (as opposed to continuous attempts to modernize the economy based on a “hands-on” approach, which produces inefficiencies economy wide and ousts potentially more efficient businesses). • On the back of rapidly growing budget expenditures, inflation remained high in preceding years, while the former did not encourage economic growth. Russia needs to avoid sovereign borrowing to secure growth. In the current environment, Russia’s least important need is to set up a proper benchmark for the bond market. Sovereign borrowing, if it occurs (amid a $75-80/bbl oil price environment!), will also establish a new “benchmark” for public spending and increase the budget’s dependence on the oil price even more, which will elude a market benchmark.

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

11. The government expects budget revenues to fall, R bln... Note: The government initially forecasted revenues in 2009 at R6,713.8 bln. Source: Finance Ministry

12. … but has not cut expenditures, R bln Note: The government initially planned expenditures in 2009 at R9,845.2 bln. Source: Finance Ministry

13. Budget revenues will exceed target in 2010 Oil and gas revenues/oil price ratio Official forecasts Source: Economics Ministry Source: Finance Ministry, Troika estimates

14. Historical exchange rate and oil price

15. In uncertain times, economic performance depends on government policy more than ever before – both in Russia and worldwide • As the global economy is no longer “overheating”, Russia is forced to adjust to the new environment. Disinflation helps to restore confidence in the ruble and get rid of the sort of currency board regime it has implicitly implemented since 1999. Money is gradually becoming more “endogenous” amid declining borrowing costs and more regular Central Bank refinancing of commercial banks. The ruble will keep appreciating, albeit with volatility. • In contrast with monetary policy, which has improved significantly since the Central Bank abandoned exchange rate targeting in February 2009, fiscal policy is expected to become less generous in 2010. For the first time ever, expenditures are not expected to rise in 2010 and beyond – a major disinflationary factor. Fiscal performance this year is expected to be better than was planned by the government due to higher oil prices and better economic performance. The federal budget deficit in 2010 won’t exceed the size of the Reserve Fund (unless expenditures are amended).

16. M2 declined in nominal terms, but started to rise since 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

17. The ruble has appreciated since February 09 after the CBR 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 Source: Central Bank

18. 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

19. 800,000 4,000,000 600,000 3,000,000 400,000 2,000,000 200,000 1,000,000 0 0 Nov ’08 Nov ’09 Jan ’08 Jun ’08 Jul ’08 Jan ’09 Jun ’09 Jul ’09 Apr ’08 Apr ’09 Jan’ 10 Feb ’08 Mar ’08 Feb ’09 Mar ’09 Aug ’08 Sep ’08 Dec ’08 Aug’ 09 Sep ’09 Oct ’08 Oct’ 09 Dec ’09 Feb’ 10 May ’08 May ’09 Total credits to banks, R mln REPO (rhs) Central Bank absorbed previously extended loans, R mln Source: Central Bank

20. Inflation is falling in any case Source: State Statistics Service, Troika estimate

21. Nominal interest rates have started to decline… Source: Central Bank, State Statistics Service

22. … but real rates grew due to deceleration of inflation Based on 6m moving average inflation Based on y-o-y inflation Source: Central Bank, State Statistics Service Source: Central Bank, State Statistics Service