Roland Nash of Renaissance Capital -

To increase the average living space per person in Russia to the average enjoyed in Moldova would require the construction of the equivalent of two cities the size of Moscow. Russia, a country of 142m people stretching across 11 time zones, has invested, in net terms, less into its national infrastructure since 1990 than East Germany, a country of 16m which is smaller than the Volgograd Oblast.

The investment requirements of Russia over the next decade are truly extraordinary. What is perhaps most remarkable about the revaluation of Russian assets in the last decade, and the increase in Russian GDP is that it has happened during a period of such low investment. 52% of Russia's railway system, still the largest globally, is fully depreciated. In 1992, Russia had 1,302 operating airports, today it has 351. Worryingly for anybody who flies domestically, 50% of Russia's planes are between 15 and 30 years old. The international average for aircraft is 10.

Continued recovery at the current pace is only possible if Russia begins investing. Without investment, infrastructure will not be able to support current rates of economic growth. Equally, the upside from investing in infrastructure is very large. The trip from Shanghai to Berlin by ship via Rotterdam is 19,000 km. The same trip across Russia is 13,000 km. If Russia was to get just 10% of the current trade that travels by ship from Asia to Europe, it would double the entire container traffic in the country. Perhaps the most bullish argument that can be made for investing into Russian assets is that capital can still work harder in Russia than almost any country globally.

Yet there are increasing signs that the Russian economy is already reaching capacity constraints. Core inflation rose from 6.7% in May to 10.4% in September. Producer prices rose 17% in the year to October. There are signs that bottlenecks are appearing, with some sectors facing skill shortages. Wage growth in finance, oil and gas, and mining has been much higher than the average across Russia. Pricing pressure, after falling consistently since 1999, has begun to rise rather ominously in the second half of this year.

The big macro-dilemma facing Russia in the medium-term is, therefore, how is it possible to stimulate the scale of investment required to retool Russia when the economy is already stretched to the point of over-heating?

Catch-22

Without investment, recovery at current rates is unlikely. With investment, it is not clear whether inflation is containable. If inflation starts rising it will threaten the macroeconomic stability on which growth and arguably political populism is based. While, understandably, a lot of official attention is on the elections, the bigger dilemma for whoever is president in six months time may well prove to be how to manage the country's increasingly critical investment needs while maintaining the economic stability on which, ultimately, his political franchise rests.

The two are connected. One of the main reasons why inflation is increasing is because supply-side constraints prevent the sort of competition and adjustments needed to limit price rises. It shouldn't be a surprise, given the under-supply of housing, that the biggest contributor to inflation since 2000 has been the rise in housing prices. Similarly, while cost pressure partly reflects rising domestic energy prices, it is very likely (although difficult to prove) that the slow emergence of SMEs is limiting the sort of competition which would help dampen cost inflation and that poor infrastructure is contributing to rising producer prices.

Relatively high inflation and an appreciating currency need not, of themselves, be reasons for slowing growth. Most countries that go through the sort of rapid expansion that Russia is enjoying have experienced both. Development, and catch-up, implies rapidly rising wages, appreciating assets and a loss in price-competitiveness.

But Russia also faces some unique issues which, coupled with higher inflation, are a concern for the sustainability of recovery. One problem is that investment rates remain worrying low in Russia. At only 20% of GDP, investment rates are roughly half of those enjoyed by the countries that have successfully managed the transition.

Another is that much of the saving in the economy is being done by the government, not the private sector. High oil prices and low costs have meant that the energy sector is responsible for generating a very high proportion of the country's savings. One of the major reasons for economic stability for much of the last decade has been the government's success at taxing away these savings without pumping them back into the economy through increased spending. The problem now is that simply focusing on tight purse strings may not be enough - the economy's savings need to be funnelled back into the economy to fund investment.

Much of Russia's macroeconomic policy over the last year has been focused on stimulating the needed investment. The financial sector has boomed and the public sector is experimenting with a number of different ways to increase investment. Most of the initiatives in both public and private sectors are proving encouragingly successful. In the private sector, despite 50 IPOs in the last two years raising $44bn, the appetite for new companies remains high. The derivatives market has grown from around $300m turnover a day at the beginning of the year to nearly $1bn today. There were only two publicly traded real estate funds in Russia 12 months ago; today there are 12 valued at $36bn.

In the public sector, the much feared pre-election spending spree has so far proven remarkably muted. An estimated RUB200bn ($8bn) is expected to be spent this year over and above what would otherwise have been expected. Similarly, the 'national projects' have generated far more headlines than they have actual government funding. The main mechanism by which the government appears to be expecting infrastructure spending to increase is through Public-Private-Partnerships, perhaps the most market-friendly means of allocating official resources. Not bad for a government run for most of the last four years by Mikhail Fradkov, and another signal that the Kremlin understands economics rather better than it is often given credit for.

The problem is that, despite a high degree of market participation and relatively careful distribution of public finances, inflation is increasing. The needed investment boom is only just starting, and yet already the downward trend in inflation has stopped. Given the politicised nature of inflation (it is still always quoted as the main public concern), it is not surprising that the government is worried.

The first reaction has been to resort to administrative measures. Maximum mark-ups have been applied to basic foods and grain quotas have been applied to keep domestic prices lower. But clearly these are not long-term solutions. Unfortunately for the next President, there is likely to be little choice but to implement the next wave of reforms to free up competition to help limit price rises as investment increases. For the last 10 years, the cheap rouble, low wages, below-market energy prices and an infrastructure built at the cost of 50% investment rates during the soviet period have provided a massive subsidy to Russian industry. It has been large enough to compensate for the inefficiencies associated with administrative drag, an over-large government, and poor access to capital. But as these necessarily temporary advantages are lost, bureaucratic and administrative reform will have to be tackled.

Government investment plans and private sector enthusiasm for opportunities in emerging markets strongly suggest that investment demand will be high over the next 12 months. Growth is likely to get a short-term boost. But if growth is to prove sustainable, the next President is going to have to solve an awkward dilemma - how to manage the massive infrastructure investment needed for growth to continue without igniting the inflation that would undermine recovery? In any country that quandary would be difficult. In an economy as unwieldly as Russia's, it will be a challenge which could well determine the success of the next president.

Roland Nash is Head of Research at Renaissance Capital

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