Russia’s short-term economic growth has accelerated above its long term trend, defying weak global conditions. In 2007, the economy grew by 8.1 percent on the heels of high oil prices, robust domestic demand and strong macroeconomic fundamentals. Preliminary data indicate an even faster real growth in GDP and industrial production of 8.7 and 6.2 percent in the first quarter of 2008.

Rising inflation and capacity and labor utilization, tightening infrastructure constraints, and real wage increases outpacing productivity gains, however, suggest that the economy is overheating, i.e., aggregate demand is outpacing long-term productive capacity of the economy. Reducing inflation and reinvigorating the remaining structural reforms will be key policy challenges for the new Russian government going forward.

Russian economic performance remains robust. Having grown by 7.9 percent (year on year) in the first half of the year, Russia is likely to post full-year GDP growth of over 7 percent in 2007. Output growth was driven by rising domestic demand, in particular, buoyant household consumption and business investment. On the supply side, sectors servicing the domestic demand (construction and retail trade) continued to boom. Manufacturing growth remains solid but is tapering off. The negative contribution of net exports to GDP growth is explained by the real appreciation of the ruble, which is making Russia's exports more expensive abroad and imports less expensive to domestic consumers.

In a context of an economy growing close to potential, with high energy prices and large capital inflows, Russia faces two main challenges: inflationary pressures and rapid appreciation of the exchange rate. The most notable monetary development in 2007 is the surge in inflation. While it remained under control in the first quarter, inflation kept gaining momentum in the remainder of the year. Inflation reached 9.3 percent over the first ten months of 2007.

Most likely, end-of-year inflation will reach 11 percent (Dec/Dec) compared to 9 percent in 2006 over the same period. The surge in inflation is explained by rising world food prices and by monetary factors. Large capital inflows pushed the balance of payment surplus to record highs and are becoming an important source of reserve accumulation ($450 bn).

However, unlike oil revenues, capital inflows are not absorbed by the Stabilization Fund, driving money expansion and exerting upward pressures on the ruble. Given limited monetary instruments for sterilization and the current stance of monetary policy (that limits the pace of nominal exchange appreciation), reducing inflationary pressures is becoming exceedingly a difficult task.

Russian economic growth and investment accelerated notably in early 2007. For the first time in years, manufacturing posted very impressive growth relative to the same period in 2006, although at least some of the factors supporting manufacturing were temporary in nature. The investment boomhas continued into the second quarter of the year, and 2007 looks to be a year of relatively rapid economic growth for Russia.

Contrary to some expectations, Russia’s balance of payments has strengthened still further due to high capital inflows in the first half of the year. This has created challenges for macroeconomic policy. Money supply growth is reaching record levels, and less of the monetary expansion is being sterilized by accumulation in the Stabilization Fund than in the past. Inflation has remained under control in early 2007, but could very well become problematic in the second half of the year.

The Russian government has approved and submitted to the Duma its first three-year budget, which represents important progress in increasing the horizon of budgetary planning. It has also changed the rules for the management of surplus oil revenues, and will divide the Stabilization Fund into a Reserve Fund for insuring the budget against fluctuations in oil prices and a Fund for Future Generations, which will be invested in longer-term assets. But questions and controversies persist over the investment strategy and potential uses for the Fund for Future Generations.

A booming domestic market continues to drive strong economic growth in Russia. 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 theyear. 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.

A strong expansion in internal demand continues to drive economic growth in Russia,although a slowdown in most manufacturing and tradable sectors is becoming increasinglyvisible. Preliminary estimates place growth in GDP and industrial production for 2005 at6.4 and 4.0 percent, respectively, relative to 7.2 and 8.3 percent in 2004. Preliminary datafor the first two months of 2006 suggest that the industrial slowdown may be continuing.GDP growth is deriving increasingly from non-tradable sectors, and investment remainsconcentrated in oil and gas. Recent productivity growth has still been strong in some parts ofmanufacturing, although this appears in large part due to labor shedding.

The continued widening of Russia’s balance of payments strengthens the country’s financialposition, but also creates new challenges. In addition to record current account surpluses,Russia is beginning to attract substantial capital inflows, including foreign direct investment.While this should give a needed boost to investment and modernization, additional inflowsare also increasing pressure on inflation and the real exchange rate. An associated monetaryexpansion in Q4 2005 contributed to higher base inflation in early 2006.

Economic policy has become increasingly focused on the implementation of four priorityNational Projects in health, education, housing, and agriculture. The government has anopportunity to combine higher spending in these areas with structural reforms that couldensure sustainable improvements. Higher-than-expected inflation in early 2006 hasmotivated discussions of a new package of anti-inflationary measures by the government andCentral Bank.

Russian economic growth in 2005 has been influenced by three primary factors: a continuing rapid expansion of domestic incomes and demand, improvements in the expectations of investors, and growing competitive pressures from the real appreciation of the ruble. In this context, Russian economic growth remains strong, although the slowdown in many sectors since the second half of 2004 continues. Recent data provides more evidence of growing competitive pressures from a stronger ruble.

Higher oil prices have brought even greater windfall revenues to the federal budget. Core consumer price inflation remains roughly at the same level as in 2003 and 2004. Debates surrounding the management of mounting surplus state revenues have intensified, and these debates find reflection in the 2006 federal budget.

This issue of the RER combines an analysis of recent developments in the Russian economy with discussions of two critical issues for economic policy: achieving diversified growth and accession to the World Trade Organization. The conclusions are rather optimistic. There ismuch that the Russian government can do to ensure sustainable and diversified growth, and this would not require a substantial change in course from the basic reform and policy strategy that has been pursued by the government since 2000.

The draft Medium Term Social and Economic Program of the Government appears to be a promising document in this regard. An analysis based on a computable general equilibrium model of the Russian economy confirms that WTO accession should benefit the vast majority of households in the country, including the poor.

Economic growth in Russia continued through the first half of 2004 at roughly the same pace as in 2003. Compared with last year, this growth was also more diversified, with many nonresource sectors of the economy growing at a faster pace than the oil sector. The average standard of living of Russian citizens has been increasing and rates of poverty continue to decline.

A new Russian government assumed power under these rather favorable conditions, and is preparing a new Medium-Term Strategy for Social and Economic Development. A strategic vision will be important. Russia now finds itself in the midst of a number of complicated structural reforms, including government administration, state budgeting, interbudgetary relations, the banking sector, and the re-organization of the electricity industry. The successful implementation of all of these very ambitious measures, as well as other key structural reforms, will require significant efforts and perseverance over a number of years.

Russia is continuing on a path of brisk economic growth, and the best news is that this is not news anymore, as growth rates in excess of 7 percent acquire an air of normality. Estimated first quarter growth in 2004 was 7.4 percent, close to the 7.5 percent observed last year.

However, seven out of eleven of Russia’s CIS neighbors are growing at an even brisker pace, and it should also be noted that the price for Russian oil, the country’s mainstay export, increased by 20 percent from January through May over the same period last year, averagingUSD 28 per barrel. As a simple rule of thumb, growth above 5 percent in Russia has always come with an increase in oil prices; and this association seems to have held in the first quarter this year.

Looking back, 2003 was a year of rapid economic growth. Russia’s macroeconomic accounts all remained in surplus; domestic real capital formation rose substantially, and there was growth in almost all regions and sectors. However, the reform agenda slowed and the economy remains highly dependent on hydrocarbons. The outstanding reforms are technically difficult and may encounter resistance from powerful vested interests. With the seemingly relentless increase in commodity prices, there is the ever present risk of reform fatigue and complacency and it will require a powerful and purposeful effort to put reforms back on track.

Failure to implement the reform agenda, in the natural monopolies, banking, housing, education, health to name but a few, will place at risk the sustainability of high growth rates and increase the chances of ever greater dependency on hydrocarbon prices.

With an estimated 7.2 percent growth in the first half of 2003, Russia’s economic performance once again exceeded even the most optimistic expectations. High growth was accompanied by impressive advances in household incomes, industrial production and investment. Yet, this performance once again followed an equally impressive increase in the price of hydrocarbons, Russia’s main export commodity. In the wake of the political events surrounding Iraq, the average price of Russian oil for the first half of the year increased from 18.5 US Dollar per barrel to 23.7, or by 28 percent compared to the same period last year.

This raises the question of how much of Russia’s progress is the result of this increase in the prices of oil and gas and, whether this rapidly growing economy is becoming less dependent on oil?

By most measures, Russia is now well positioned for further growth. However, according to official figures, growth is slowing and this trend may continue. Part I of this report takes a look at the structural changes that underlie current economic trends and argues that the economy in 2002 has continued to adjust in favor of sectors which have shown themselves reasonably immune to the cost increases observed over the previous three years (in particular resource exports and non-tradable services). On the other hand, the competitiveness of sectors whichwere able to rely on underutilized capacity after the crisis, and in particular of capital intensive sectors competing against imports, has diminished.

Parts II and III take a closer look at prospects in two complex reform areas, namely the need to prioritize budgetary expenditures in line with the Government’s Medium Term Program for Economic Reform (part II), and the design and implementation of pension reform in Russia (part III).

This report looks at structural change from several angles. In the general review of recent economic developments (part I), we use sectoral disaggregation to determine whether Russia’s positive growth performance has led to greater diversification of the economy. Oil extractionand the public sector not only continue to attract the largest share of domestic investment, but these are also the two sectors where wage increases have by far outperformed the rest of the economy.

Not surprisingly, labor and capital both go “where the money is”. However, the outcome of this re-allocation is that Russia’s economy is even more dependent on natural resources. Part II of the report contains a brief overview of the increasing per capita income differentials across regions, which are driven mainly by domestic fixed capital investment. The published data suggest strongly that these flows are again primarily attracted by the availability of natural resources. Finally, Section III introduces the first of a series of bi-annual surveys designed to capture the effects of the Government’s recently introduced deregulation laws to encourage small firm growth.

For the past three years, the economy has grown rapidly, although growth rates have declined year after year. This trend continued over the first months of this year, when the rate of growth of industrial output slowed to three percent in the first four months and investment growth slowed to 1.2 percent in the first quarter.

The possibility of increasing the utilization rates of capital and labor, after the long period of decline and the crash 1998, guaranteed high growth and considerable productivity advancements. However, the aggregate data suggest that the ceiling on improvements of capacity utilization and hoarded labor is being approached. Consequently, future growth is likely to rely more on investment and the productivity advancement embodied in it than it has in recent years.

The year 2001 was a good year for Russia’s economy. Neither Russia’s economic performance nor the continued implementation of economic reforms were visibly affected by the international economic slowdown. The main macro-accounts again show sizeable surpluses, growth is highenough to continue catching up with OECD countries, and legislation on economic reforms passes the Duma at a record rate. Structural reforms are being implemented, but by their nature, take time.

There is, as everyone agrees, a long way ahead. A fast road to recovery and sustainable growth requires diversification away from the current concentration of largely mineral based industrial and financial conglomerates. Economic policy should continue to encourage the growth of new and viable enterprises, and the restructuring of those inherited enterprises which find a market to survive.Knowledge of the relative weight and performance of these two segments of companies, however, is still limited. In part II, this report introduces briefly two publications, of which one is looking at the barriers for new firm growth, and the other at the question of how to protect those working in the old industries from the social consequences of industrial restructuring.

This is the first of a new series of periodic economic reports form the Moscow office of theWorld Bank. Each report will contain a concise description of the major economic trends andissues facing the Russian economy. In addition, the reports will often include a special focus,based on work carried out by the World Bank as part of its assistance program to the RussianFederation. In this edition, we examine the efficiency of public investment in Russia.