oalvelut ja yritykset
Eastern European Markets
business news
Trade StationFinland
Business Finland
Trade Service Companies
Olga Mashkina and Simo Leppänen

June 2006 Biannual monitoring review

The Centre for Markets in Transition and the Department of Economics
at the Helsinki School of Economics.
Focus on 2005

All reports are available at www.economicmonitoring.com

Biannual economic review
Review focuses on recent economic development in six regions of Northwest Russia. The review is produced by the following team of Finnish and Russian research institutes and researchers under the coordination of the Centre for Markets in Transition at the Helsinki School of Economics: Murmansk province: The Institute for the Economy of the Kola Science Centre of the Russian Academy of Sciences in Apatity, Murmansk province, Republic of Karelia: The Institute of Economics of the Karelian Research Centre of the Russian Academy of Sciences in Petrozavodsk, Karelia, and the Karelian Institute of the University of Joensuu, Leningrad province: The Solid Invest Group from St Petersburg, City of St Petersburg: The Solid Invest Group from St Petersburg, Novgorod province: The Novgorod Economic Council and the Karelian Institute of the University of Joensuu, Kaliningrad province: A. Usanov and A Kharin

This summary review is based on the individual regional reports and Rosstat statistics. The authors assume no responsibility for the completeness or accuracy of the information. Authors: Olga Mashkina and Simo Leppänen, Center for Markets in Transition at the Helsinki School of Economics (HSE).

NWFD development in 2005
A decent year for Northwest Russia

The NWFD continued to perform better than the Russian average but a bit more moderately than in 2004. Within the NWFD, the Kaliningrad province experienced the highest industrial growth in comparison with 2004. Kaliningrad is currently facing an interesting situation as its special economic zone (SEZ) regime will change. The effects of the change from custom benefits on processed goods to tax breaks for large investors are still somewhat ambiguous. A positive surprise in 2005 was the good development of the Republic of Karelia. Investment development was fragmented but a noteworthy point was the major increase in St Petersburg’s inward foreign investments. Most regions are experiencing a trend whereby the share of non-food products is increasing in the retail trade structure. Favourable prices for oil and metals provided an increase in foreign trade turnover.

Mainly slowing but decent growth in NWFD

The industrial growth slowed down both in Russia as a whole and in the NWFD. In 2005 the industrial production of the NWFD was still quite clearly above the Russian average although the difference between growth in the NWFD and in Russia is not as significant as in previous years.

All the regions under review experienced positive growth of industrial production; the growth rate was slower for all regions except Karelia, where the industrial growth rate in 2005 doubled.

2005 St. Petersburg’s economy followed the cyclical pattern evident since the 1998 crisis, as its industrial production growth was clearly slower than in 2004. The structure of the economy is becoming progressively post-industrial in nature – the share of the service sector is increasing stably. The mining sector had an incredible growth rate of 240% due to the opening up of new plants for mining sand used for construction. The manufacturing sector grew at quite a low rate of only 3.9% due to the production cycle and the strengthening ruble complicating the position of exporters. In 2005 the first stage of the construction of the Elcoteq plant was completed; construction of the Toyota, Bosch&Siemens and Knauf plants was undertaken.

In the Leningrad province industrial production grew by 5.9% which was the lowest rate for the last 6 years. There are clear signs that growth is evening out after a period of very rapid growth. The production and supply of electrical power, the gas and water sector and the mining sector hampered industrial growth as these sectors declined by 2.5% and 15% respectively. The manufacturing sector grew by 7.5%.

Kaliningrad’s economy grew the fastest among the economies of the regions under review, although the growth rate slowed clearly in comparison with 2004. The highest growth rate was in the oil sector – oil extraction in the region increased by 47.5%. This growth was expected as a result of full-scale oil production at the Kravtsovskoe (D-6) field on the Baltic Sea shelf by Lukoil. The oil sector is becoming increasingly important to the region’s economy and in 2005 its growth helped to offset the significant deceleration in growth in the manufacturing sector (only 4.6%). The machine building industry, which has been the leader of recent years, fell from the top spot, given that its growth was markedly down on the record figures. The pulp-and-paper industry experienced a marked drop in production (by 20.5%). Wood processing production increased by more than 100% due to the opening of a large new wood processing plant by the Lesobalt Company. The new law on the Special Economic Zone (SEZ) in the Kaliningrad province was approved in December, which will be a major test for assembly plants in the region, and some natural selection can be expected.

Industrial production in the Novgorod province grew by 6.1%, and attained a good rate of growth in almost all sectors. Particularly strong growth was achieved in the metal industry where output almost tripled on account of the expansion of the Novgorod Metal Plant producing copper wire. In the paper industry the Amcor Rentsch Company increased its production of paper packaging materials by 55.6%, which resulted in a rise in the total output of Novgorod’s paper industry by 29.3%. The machine-building industry continued to decline (by 13.0%) due to disinvestment and low competitiveness. The food industry grew by 11.6%.

The slight acceleration of industrial production for 2003-2004 in the Murmansk province slowed again in 2005 to almost zero growth. It seems that the region has still not found the means to achieve momentum for steady growth. A positive point in 2005 was the fact that the slump in fisheries, observed during the two previous years, was overcome. Catches of fish and other sea products increased by 10%.

In Karelia industrial growth was, somewhat surprisingly, one of the highest of all the regions of the NWFD and was double that of the previous year. All major industrial braches achieved very high rates of growth. The production of metals grew by 56.8%; machinery, by 25.2%; plywood, by 23.0%; cardboard, by 28.9% and paper, by 8.6%. This was a result of large-scale investments, which were made in the metals (Kostomuksha, Värtsilä and Nadvoitsy), mining (Vepsskya volost, Medgora and Pryazha) and pulp-and-paper industries (Kondopoga and Segezha) from 2003-2005. In the timber-logging industry output dropped by 8.4%. This was caused by a number of regulatory restrictions, as well as by the lockout in the Finnish paper and woodworking industry which lasted from May until July 2005 and led to a considerable drop in demand for Russian timber.

Investments in fixed capital mainly on the rise

In 2005 the volume of investments in fixed capital grew in all monitored regions except Karelia and the Leningrad province. The growth rate of the NWFD more than doubled and was virtually the same for Russia as a whole.
In 2005 investments in fixed capital in St Petersburg grew significantly (by 48% compared to 2004). 53.7% of investments in fixed capital were allocated for the construction and modernization of non-residential premises and buildings, and 36.7% for machinery, equipment and vehicles. The construction of several plants started in 2005 (including the Toyota automobile assembly plant and the Bosch&Siemens plant).

2005 was the second consecutive year of decelerating investment growth for the Leningrad province. It will be interesting to see whether this development is temporary or is related to the normalization process in the region’s economic development. 40% of the total investment was spent on the acquisition of machines, equipment and means of transport, whereas 48% was spent on buildings. The highest concentration of newly constructed facilities was located in Vsevolozhsk (Nokian Tyres, an assembly plant for water heaters, a printing enterprise, and various others).

The total amount of investments in Karelia showed a modest decline in real terms, which was largely caused by a steep drop in investments in the machine-building industry, finance, trade and fishing. However, there were several domestic and foreign investments in fixed capital: the extensive modernisation of the Segezha and Pitkäranta pulp-and-paper mills, the construction of railroad facilities, new saw-mills in Muezerka and Lahdenpohja, and the modernisation of agricultural enterprises in the Olonets municipality.

The Murmansk province achieved investment growth higher than the average in the NWFD or the Russian Federation following the decline in 2004. Among the most important investment projects completed in 2005 was the dry gas purification complex at the Kandalaksha aluminum plant. This USD 20 million project was funded by the SUAL holding enterprise and the regional budget. The share of budget funding of investments (16%) was higher than the average in the NWFD (15.6%) but was still lower than the Russian average (20.1%).

In the Kaliningrad province investments in fixed capital grew by only 5.6% in 2005. At the same time, budgetary investments increased by 87%. This remarkable growth is linked to the preparations for the celebration of the 750-year anniversary of the city of Kaliningrad and final work on the first section of the power plant TEC-2. Private investment declined in 2005 by 3%, which was most likely a result of the increased uncertainty relating to the appointment of a new governor and the adoption of the new SEZ law.

Investments in fixed capital in the Novgorod province seem to be following cyclical dynamics, linked to the cyclical annual fluctuations in the volume of foreign investments. The share of transport and communications in total investments was the largest, at 26%. This was a result of large-scale public investments in gasification, road repair works, water supply and sewage systems, and the railway network.

Foreign investment activity accelerated in all regions

Foreign investment activity grew significantly in all the regions in 2005. The inflow of foreign direct investment (FDI) declined in Karelia and in the Murmansk province.
In St. Petersburg foreign investment grew by 44% against 2004 and now represents a record. During 2005 rating agencies raised the finance and credit rating of St Petersburg four times. Currently St Petersburg has the lowest investment risk among all the 88 Russian regions. The share of FDI was 17.6% and the share of other investment was 81%. Major investment projects launched or carried out by foreign investors in 2005 included the Elcoteq plant, a techno-park in Neudorf-Strelna and a Toyota assembly plant in Shushary. Additionally, in 2005, Chinese investors began preparatory work on the “The Baltic Pearl” project to create a Chinese business district in the south-western part of St Petersburg.

In the Leningrad province the total volume of foreign investments grew more than twofold in 2005 compared to 2004. The majority of foreign investment was directed to manufacturing industries (82.6%). 7.7% was directed to agriculture, and 6.5% to the real estate sector. The share of Finnish investment in total foreign investment, as compared to 2004, fell to 11%. In 2005, the company Metsä Botnia continued the construction of the wood-processing plant “Svir Timber”, and the first stage of the Nokian Tyres plant was taken into operation in Vsevolozhsk.

In 2005 foreign investments grew by 83% in Karelia. However, this growth occurred only on account of trade loans (included in “other” foreign investments). At the same time, foreign direct investments (FDI) dropped by 52%, which underlines a number of serious problems impeding FDI in Karelia. Two thirds of the total foreign investments were made into the ore extraction industry, mostly in Kostomuksha. In 2005 this municipality accounted for 69% of the share of total foreign investments. Amongst the main projects with foreign investments were the start-up of iron ore extraction (in Kostomuksha), the construction of Swedwood (Kostomuksha), the second stage of the Stora Enso saw-mill in Pitkäranta, two wood-processing plants by the Finnish JMC Finance Oy, and the third stage of the Finnish AEK-Karkhakos factory in Kostomuksha. Finnish investors are still playing a major role in Karelia’s inward foreign investments.

The total foreign investment in the Kaliningrad province grew by 21.6% in 2005 mostly because of significant growth of trade and other credits, while FDI declined by 16%. This fall was related to an increase in uncertainty in the regional investment climate caused by the new SEZ. Assessment of per capita figures clearly shows that the Kaliningrad province is regarded as a fairly unattractive investment target for foreign investors. As in previous years, the main destinations for foreign investments were the financial sector (37%) and wholesale and retail trade (17%). The manufacturing sector was the recipient of 23% of all foreign investments including 13% which went into food manufacturing.

In 2005 the total amount of foreign investment in the Novgorod province was almost two times higher than in 2004. FDI also grew by 2.5 times, while other foreign investments grew by 34%. Thus there is a clear cyclical tendency of unknown origin: a year with a high volume of investments seems to be followed by a year with a low volume of investment. 51% of foreign investments went to the food industry, 31% went to wood–working and 17.4% went to the paper industry.

In 2005 the Murmansk province recovered from the declining trend in foreign investment. The total amount of foreign investments was almost two times more than in 2004 although their absolute size was still lower than in 2002 and 2000. FDI grew almost five times although this was largely due to their low absolute volume. Most foreign investment (63%) was received as loans. The largest recipients of foreign investment were the wholesale trade (34%), fishing and fish farming (24%) and transport and communications (21.4%).

Growth of retail trade and services continues in all regions

In 2005 the growth rate of retail trade remained at the good level of 2004 and was reasonable for all the monitored regions. As in 2004, growth in the NWFD was virtually in line with growth in Russia as a whole. In the Leningrad, Murmansk and Novgorod provinces the retail growth rate in 2005 exceeded that of 2004. In the other regions it was slower than in 2004 but still remained at a significant level. In 2005 the structure of retail trade was changing. In most of the regions sales of non-food products grew much more rapidly than sales of foodstuffs. This is a positive sign as it is evidence of growing standards of living for the population.

The growth in purchased services in the NWFD also continued in 2005 (4%), although at a considerably slower pace than in 2004 (12.9%). This was not in line with the general development in Russia (growth rates of 7% and 7.5%, respectively. The deceleration was strongest among the monitored regions in St Petersburg where the growth of 2005 (1.2%) was only a fraction of that in 2004 (14.3%). The highest growth in purchased services was recorded in the Kaliningrad and Murmansk provinces (10.7% and 10.4%, respectively).

Inflation continues to decelerate in 2005

Inflation continued to decelerate in the Northwest Federal District following the general trend in Russia. As in 2004, it remained slightly above the Russian national average.

It was a well-known fact that in the first half of 2005 inflation in Russia significantly outstripped the level planned by the Government. For this period, consumer prices grew by 8%, which was close to the annual forecasted level. Because of this, measures were taken in the second half of the year to restrain price growth.
The main factor controlling inflation was stabilization of ruble exchange rate: by the end of 2005 the rate against the dollar was approximately the same as it had been at the beginning of July. An agreement with large oil companies was made on freezing prices for fuel until the end of 2005.

Favourable international prices contribute to the growth of foreign trade

Foreign trade activity grew in all the regions in 2005 due to the favourable rise of international commodity prices.

The major export articles for St Petersburg’s companies in 2005 were metal products (38%) and machinery, equipment, vehicles (30%), and forest products (9%). The bulk of imports comprised raw material and processing equipment. The trade balance in St. Petersburg showed a record deficit.

In the Leningrad province exports were the highest in the NWFD and exceeded imports by 1.9 times. Oil products and oil comprised 79.3% of the total value of exports. The second most significant export item was forest products. Machine building products dominated the structure of imports.

In Karelia the foreign trade turnover grew by 19%. Exports grew by 23%, and imports grew by 2%. Pulp and paper accounts for 35% of exports and timber and timber products for 27%. The main imports included machinery and equipment (60%) and petrochemical production (14%). The growth in exports occurred because of a notable rise in international commodity prices (including the prices of timber, paper and metals), and because of a physical increase in Karelian exports.

The Murmansk province found itself in a similar foreign trade situation, where growing world prices influenced the trade turnover. The annual increase of imports (46.3%) was higher than that of exports (27.5%). Its share, however, remains relatively small in the foreign trade turnover (11.6%). In exports, metals occupy the largest share (54%), while imports were dominated by sea vessels (34.3%).

In 2005 Novgorod’s foreign trade turnover continued to grow very rapidly in US dollar terms, thanks to a major rise in export prices and to an increase in the physical volume of exports of fertilisers, round wood, sawn timber, metals and chemicals. The structure of Novgorod’s exports remained relatively stable. Recent trends include a rise in the share of metals, and a decline in the share of machinery, in total exports.

In Kaliningrad significant increases in oil extraction and oil prices ensured a rapid growth in exports. In total, oil and oil products comprised about 73% of the total exports of goods. In addition, similarly to the previous year, a significant part of the total exports was made up by the ‘transit’ export of oil from other Russian regions. Most of this revenue does not remain in the Kaliningrad region. Although the trade deficit increased again the growth of imports decelerated. Furthermore, the growth of the ‘exports’ of goods produced in the Kaliningrad region and intended for sale to the Russian mainland slowed down. This trade has been based on Kaliningrad’s SEZ and it may continue to decelerate as a result of the new SEZ regime.

Public Sector and Social Development
Improvement in budgetary situation

2005 showed improvement in the budgetary situation of monitored regions (except for Murmansk), although the figures for the first half promised even better results. In the second half of 2005 only the Leningrad province increased its surplus relative to budgetary income.

The improved budgetary situation of monitored regions reflected the positive economic developments in 2005, which resulted in a strong increase in regional tax revenues. St Petersburg also benefited from the fact that some major firms moved their headquarters to the city. The budget deficit of the Murmansk province, on the other hand, was partly due to unfavourable changes in tax and budget legislation. Dependency on federal financial assistance is still a problem in Northwest Russia – especially in the Murmansk and Novgorod provinces.

Welfare developing positively but unevenly

The population’s incomes grew more or less rapidly in all monitored regions. This positive development is explained by the good overall development, but the monetization of some in-kind social benefits also contributed to this growth. The trend of stagnated income was finally overcome in the Murmansk province although this seems to be partly related to more accurate calculation of incomes. Regardless of the increase in the basic standard of living indicators the negative demographic trends persists in the NWFD.

Furthermore, income growth has not benefited everyone in the NWFD. There are major intra-regional and inter-sectoral differences in wages. A considerable share of the population of the entire region earns less than the official subsistence minimum. Generally, income differentiation is still increasing and although it decreased or stopped in some regions it is probably only a short term effect as a consequence of the monetization of social benefits.

Unemployment remained roughly at the level of 2004 in all regions. In the Murmansk and Novgorod provinces the situation improved somewhat. Generally speaking, relatively high and persistent unemployment, together with reasonable growth of the economy might be a sign of matching problems in the labour market. In St Petersburg unemployment is approaching a minimum level (given that zero unemployment is, in practice, impossible due to normal labour market friction).

Opinion: Where will Northwest Russia be in 2020?

All of the monitored regions have gone through major changes since the breakdown of the Soviet Union. The means of coping with the changes and the results have varied considerably. Relatively speaking, the most successful regions are St Petersburg and the Leningrad province whereas the provinces of Novgorod and Kaliningrad have fared decently and the Murmansk province and the Republic of Karelia are lagging behind.

What will the future hold for these regions? Making a reliable forecast on the situation in Northwest Russia up until 2020 is naturally impossible in a rapidly changing business environment and in the context of an unstable global economy. However, we can draw out the factors that will most likely be the key in determining the development in the monitored regions. These factors can be divided into common and region specific factors. We will begin by looking at common factors.

Relations between the EU and Russia are very important to Northwest Russia due both to its geographical location and to the fact that the EU is Russia’s largest trade partner. Trade wars between the two could seriously harm the good export development of Northwest Russia. This would have also a serious effect on the transport sectors of e.g. St Petersburg and the Leningrad province. Russia’s accession to the WTO would diminish the threats resulting from possible problems in EU – Russian relations.

A factor of a more internal nature is the Russian government’s actions towards the regions. These actions have a direct effect on the potential of the regional governments to influence the development of their region through e.g. promoting investment. Additionally, the internal conflicts in Russia might have at least indirect consequences on Northwest Russian regions if foreign investors are sensitive to these kinds of factors.

Social problems are one of the most serious issues affecting the regions in the longer term. In Russia, ageing and population decreases will pose one of the biggest challenges to the economy and society as a whole, especially considering that the problem is more or less severe in all monitored regions. The demographic problems will negatively affect the regional economy by increasing expenditure on pensions and healthcare, reducing the number of workers in the active population and hampering the growth of home market demand. Recently, some measures to tackle this problem have been proposed by president Putin.

St Petersburg has gone through a major makeover which has turned it from a centre of military production into a centre of food production, retail trade, transport and services. The city will most likely be one of the economic centres of the country due to its large home market, diversified and dynamic economy, good location, and developed education and research systems. Currently, certain major firms are moving their headquarters to St Petersburg. It is most likely that in the next fifteen years the trade, service and transport sectors will further strengthen their position. However, there is also the possibility of a renaissance of some old high tech sectors (such as power engineering) alongside the fast growing modern branches of high technology (e.g., IT and household appliances).

In the Leningrad province the localised nature of success poses a problem. Those parts of the province where no competitive enterprises exist or none have been established remain in a state of poverty. Another structural problem is the low population density which quickly leads to a labour shortage and slows down the development of internal demand. Despite these threats the province’s industrial processing production and consumer goods production will probably continue to develop in a positive direction in the longer term. The region’s transport sector is also likely to increase its role due to the region’s proximity to St Petersburg and the development of its seaports.

The concentration of growth within specific localities is also a problem in the Novgorod province as they do not produce sufficient positive spill-over effects. Also, the region’s proactive investment climate is not a self-evident means for inducing inward investments, given that interregional competition is tightening. Currently it seems that the woodworking and electronic industries will be the most promising sectors of Novgorod’s economy in the future while the chemical industry (which was previously strong) will regress. In order to keep up the good and stable growth the region will have to find ways to keep investors interested as the level of investments is insufficient to maintain the current production level, let alone modernize the region’s economy more generally.

The Kaliningrad province is currently one of the fastest transforming regions in Russia. The consequences of changing its special regime from custom benefits of processed goods to tax breaks for large investors are still somewhat ambiguous. It can be expected, however, that there will be natural selection between the effective and less effective firms. Russian – EU relations are of special importance to the Kaliningrad province via its visa regime and other practical issues affecting mobility and transit of freight. Within the next fifteen years it can be expected that the Kaliningrad region will continue to grow some 5-6% annually if the oil prices and federal policy remain favourable. The main industries will still be the oil industry, import substitution manufacturing and the service sector.

The Karelian economy is currently based largely on export orientated metal and forest related industries. One reason for the weak development of Karelia has been its unfavourable investment and business climate. If these conditions are not addressed, even maintaining the current level of growth will be difficult since production technology is ageing. To achieve a higher level long-term growth path the region has to improve its business climate, promote inward investments and activate cross-border cooperation. Additionally, social problems are currently a major obstacle to growth in the region.

Natural resources in the Murmansk province are constantly being depleted, which makes their commercial usage increasingly expensive and weakens competitiveness. The region must find more effective ways to utilize natural resources and, in the longer term, establish new economic foundations. These could include transport and entrepreneurship, but they will need strong impetus to be able to develop in this way. Furthermore, social and environmental problems are becoming increasingly severe. At the moment, a realistic goal for the region is simply to maintain its current levels of production.

All reports are available at www.economicmonitoring.com

P.O.Box 1210
FIN-00101 Helsinki
Telephone exchange +358 9 43131
(from HSE's desk telephone 99, from HSE's mobile 50 951)
Fax +358 9 4313 8707

Compiler Trade Web Site: Tutkimuksia
Helsinki School of Economics/index
Studies on emerging markets /Index
Tutkimuksia / Hakemisto

 TERMS & CONDITIONS / KÄYTTÖOIKEUDET. © Oy Compiler Ab. All rights reserved.