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INSTITUTE FOR THE ECONOMY IN TRANSITION RUSSIAN ECONOMY: TRENDS AND PERSPECTIVES March 2005 MONTHLY BULLETIN Moscow 2005 Institute for the Economy in Transition, 1996. Licence, 02079 19 2000 .

5 Gazetny pereulok, Moscow 103918, Russian Federation Phone: (095) 203-88-16 Fax: (095) 202-42-24 E- Mail: todorov@iet.ru 1 Budgetary and tax policy......................................................................................................................... 3 Monetary Policy...................................................................................................................................... 4 Demand for real cash balances in 2004................................................................................................... 7 Financial markets.................................................................................................................................... 9 Investment in the real sector of the economy........................................................................................ 18 Foreign investment in the Russian economy......................................................................................... 20 Regions: attraction of investment in 2004............................................................................................. 25 The Real Sector of the Economy: Factors and Trends.......................................................................... 27 IET Business Survey: Industry in March of 2005................................................................................. 30 Factors of Economic Growth in 1996 Through 2004............................................................................ 31 Foreign trade......................................................................................................................................... 34 Higher school: the trends towards the tightening of control of the quality of education..................... Issues Considered at the Sessions of the Russian Federation Government on March 3 and 10............ Review of legal documents concerning the issues of taxation for February - March 2005................. A review of economic legislation: March of 2005................................................................................ Budgetary and tax policy According to the results of preliminary execution for January-February 2005, the revenue level of the RF Federal budget reached 28,3% GDP1, the expenditure level of the Federal budget 19,8% GDP, while the budget surplus 8,5% GDP. As of March 1, 2005, the volume of funds of the RF Stabilization fund reached Rb 707.5 bn.

Position of the government budgetAccording to preliminary estimate of the Ministry of Finance of the RF for January-February 2005, the federal budget was executed by revenues to the amount Rb 744.96 bn (28,3% GDP), by expenditures - Rb 520.4 bn (19,8% GDP). The federal budget surplus made up Rb 224.5 bn (8,5% GDP). It is to be noted that, in 2005, the volume of federal budget revenues markedly exceeds the same indicator for the relevant period of 2004 amounted to Rb 434.6 bn (19,6% GDP). The federal budget revenues for January-February 2005 also increased in relation to relevant indicator for 2004 (Rb 319.2 bn or 14,4% GDP). The budget surplus for the period in question also considerably surpasses the indicator of 2004 (Rb 115.46 bn or 5,2% GDP).

The volume of the federal budget revenues in January and February 2005 made Rb 456.88 bn and Rb 288.08 bn accordingly, which amounts 35,3% and 21,5% of the monthly GDP. The federal budget expenditures in January and February 2005 made Rb 264.6 bn (20,4% ) and Rb 255.8 bn (19,09% ) accordingly, the federal budget surplus Rb 192.3 bn and Rb 32.2 bn, which amounts, in relation to GDP, 14,8% and 2,4% correspondingly. Therefore, it is important to note noticeable reduction of revenues in February, as compared to January, in both - absolute values and percentage ratio to GDP.

Table Volumes of revenues of the RF federal budget in January-February (in % GDP, by cash execution) Cash execution January February Taxes and other payments adminis24,97% 17,90% trated by the Federal tax service Taxes and other payments adminis8,93% 9,14% trated by the Federal tax service Collections administrated by the Federal Agency for Federal Property 0,33% 0,21% Management Federal budget revenues adminis1,06% 1,02% trated by other federal bodies Total revenues 35,28% 28,27% For January-February 2005 the federal budget revenues in cash execution reached 28,27% GDP (see Table 1). Major part of revenues fell on taxes and other payments administrated by the Federal tax service (17,9% GDP), and also the payments, administrated by the Federal customs service (9,14% GDP). A total of collections, administrated by the Federal Agency for Federal Property Management and other federal bodies, relative to GDP, made about 1,23%.

As of March 1, 2005, the volume of funds of the RF Stabilization fund amounted to Rb 707.5 bn.

Thus, as much as Rb 60.3 had been transferred in February to the RF Stabilization fund.

In this section the estimated data on GDP are used, for this reason, summarizing the results of the year, the indicators provided may be slightly reconsidered.

Because of changes in classification of the budgetary revenue and expenditure items, and also the absence of official information on execution of the consolidated RF budget for January 2005, no analysis will be given in the review for March 2004 of the revenue and expenditure items of the consolidated budget.

Major events in the budgetary sphere.

In March, the Ministry of Finance of the RF voiced against abolishing VAT and its substitution for sales tax, responding to VAT abolishing suggestions. According to the Ministry of Finance estimates, the sales tax revenues before its abolishment made up around Rb 60-63 bn, whereas collections from VAT Rb 870-900 bn. In this connection, abolishing VAT would require considerable raising of sales tax to 70-75%. In view of the above, they believe in the Finance Ministry that it is necessary to improve the corporate profit tax, not to reduce the single social tax, and to introduce VAT single rate not earlier than 2008.

Later on the decision had been taken at the session of the government budget committee to reduce VAT rate from the current level. According to Finance Ministry, it is advisable that the question of VAT reduction be considered not earlier than three years later. Besides, it had been stated that in forming the RF budget forecast for three years the RF Ministry of Finance will be basing on the price of oil Urals in 2006 at the rate of $32-34/barrel.

In March, the Finance Ministry again remarked on the impossibility of use of funds of the RF Stabilization fund domestically. According to Finance Ministry estimates, in the current world oil prices, using domestically of additional Rb 100-150 bn from the Stabilization fund may additionally give to 1% of inflation. Consequences of such kind contradict the current policy of the RF Government and the Central Bank on reducing the inflation rates in Russia. The Finance Ministry considers that it is more practical to use the means of the Stabilization fund for early repayment of the foreign debt.

D. Polevoi Monetary Policy In February, there was observed a decline in the rates of inflation to 1.2 per cent, however, the value of CPI was still above the level registered in the respective period of the preceding year. In the RF, the money supply resumed: the monetary base increased by 5.4 per cent after the January fall by 9.9 per cent. At the same time, the rates of growth in gold and foreign exchange reserves accelerated; by the beginning of March these reserves made US $ 134.2 billion. The Bank of Russia has set forth the following weights of currencies to be used for implementation of the exchange rate policy: 20 per cent of Euro and 80 per cent of US $.

In February of 2005, the value of the consumer price index made 1.2 per cent (1 per cent in February of 2004, see Fig. 1). As concerns the group of food products, the respective prices grew by 1.4 per cent (as compared with 1.1 per cent registered in February of 2004). In January through February of this year, the prices of food products increased by 2.8 per cent (in January through February of the increase also made 2.8 per cent) By the end of February, the most perceptible growth in prices was observed with respect to fruits and vegetables (+ 6.1 per cent), meat and poultry (+ 2.3 per cent), as well as fish and sea products (+ 2.1 per cent). A decline in prices was observed only with respect to the following commodity groups: sugar (-0.5 per cent) and beans (-0.4 per cent). Therefore, over the first two months of the year fruits and vegetables accounted for the most significant contribution to the rise in prices of food products (over this period, the respective prices grew by 11.5 per cent, while in January through February of 2004 the rise in prices made 7.1 per cent). In comparison with the figures registered in the preceding year, in January through February of 2005 the prices of baked goods increased at a slower rate (+ 0.9 per cent as compared with + 7.6 per cent), on the other hand, the prices of meat and poultry, as well as fish and sea products, increased at higher rates (+ 4.4 per cent as compared with + 1.7 per cent and + 3.9 per cent as compared with + 0.9 per cent, respectively).

The increase in the prices of paid consumer services continued to make the most significant contribution to the CPI increment 2.2 per cent (1.6 per cent in February of 2004). At the same time, the growth in prices of paid services slowed down 4 times in comparison with the figures observed in January of this year. It should be noted that in January of 2005 HPU services demonstrated the most intensive growth (+ 19.4 per cent), in February the rates of growth in the prices of HPU services declined to + 4 per cent, while the services related to preschool education grew by 4.5 per cent. Over the first two months of the year, the prices of paid consumer services increased by 11.2 per cent, while in the respective period of the preceding year the growth in prices of these services made only 5.8 per cent.

As concerns the nonfood goods, in February of this year the prices of these products grew by 0.per cent on the average (similarly to the situation observed in January of 2005). Therefore, in January through February of this year, the increase in the prices of nonfood items made + 0.7 per cent (+ 0.per cent in January through February of 2004). In February of 2004, the prices of this group of products grew at the same rate. In February, the trend towards a more rapid rate of rise in prices of jersey persisted (+ 0.6 per cent). It should be also noted that the prices of gasoline continued to decline (by 0.2 per cent).

In February of 2005, the growth in the Base Consumer Price Index (BCPI) 3 made 0.7 per cent (the rate registered in February of 2004 made 0.8 per cent). In the first two months of the year, the base inflation was at 1.6 per cent (at 1.7 per cent in the respective period of the preceding year). Therefore, there is observed a certain slowdown of the rates of base inflation, what is a positive factor for a decline in CPI. So, the major factor behind the surge in prices in the beginning of the year was the sharp increase in the tariffs on paid household services. At the same time, in January through February there was observed a rather significant rise in prices of fruits and vegetables.

According to our estimates, in March of 2005 the CPI value in the RF will make Figure The Growth Rate of the CPI in 2002 - 2004 (% per month).

3,5% 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0% -0,5% In February of this year, the monetary base of the Russian Federation (in the broad definition4) increased by RUR 115.9 billion and made RUR 2.27 trillion (+ 5.4 per cent). As on January 1, 2005, the amount of the monetary base of the Russian Federation (in the broad definition) was at RUR 2.39 trillion. Therefore, in January through February of this year the decline in the monetary base made 5 per cent. In the respective period of the preceding year, the monetary base increased by 4.9 per cent. Below, the dynamics of the monetary base (in the broad definition) will be analyzed across its components.

The Base Consumer Price Index (BCPI) is an indicator reflecting the inflation rate on the consumer market. It leaves out of account the seasonal (prices of fruits and vegetables) and administrative (tariffs on regulated types of services etc.) factors, calculated by the Statistics Service of the RF.

The RF Monetary Base in broad definition includes cash in circulation, the Ruble denominated funds in mandatory reserves relating to the borrowings of credit organizations, and funds in credit organizations correspondent accounts and commercial banks' deposits with the Bank of Russia.

Jul Jul Jul Jan Jan Jan Jan Sep Sep Sep Mar Mar Mar Nov Nov Nov May May May The amount of cash in circulation (as adjusted for cash balances of crediting organizations) made RUR 1.55 trillion as on March 1 (+ 1.5 per cent as compared with the level registered on February 1 of this year). On the same date, the amount of accounts of crediting organizations with the Central Bank of Russia made RUR 343 billion (+ 12.8 per cent), the amount of mandatory reserves was at RUR 129.6 billion (+ 2.9 per cent), the amount of banks deposits in the Bank of Russia made RUR 218.billion (+ 30 per cent), the amount of the Bank of Russia bonds held by crediting organizations made RUR 16.5 billion (+ 30 per cent), the amount of the Central Banks liabilities related to the reverse repurchase of securities was at RUR 2.5 billion (did not change), and the funds transferred to the Bank of Russia as the reserves related to foreign exchange operations made RUR 5.9 billion (- 36.6 per cent).

An increase in the amount of cash in circulation observed this February (+ 1.5 per cent), as well as the growth in the amount of mandatory reserves (+ 2.9 per cent), resulted in the expansion of the monetary base in the narrow definition (cash plus mandatory reserves) 5 by 4.6 per cent (see Fig. 2).

Simultaneously, in February there was observed a growth in the amount of gold and foreign exchange reserves of the RF Central Bank (+ 7.4 per cent); as a result, the amount of these reserves made US $ 134.2 billion as on March 1, 2005. In the first two weeks of March, the amount of gold and foreign exchange reserves increased to the level of US $ 136.4 billion (+ 1.5 per cent).

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