While politicians talk, prices soar says Larry Brainard
Despite a mixed inflation history, recent price trends out of the CIS states have come with a bit of a shock. With the exception of Armenia, all the CIS is now experiencing double digit inflation. To be sure, the global surge in food prices is being felt throughout the area, but complacency on the part of the region’s policy-makers is also to blame. After an extended economic boom, it is increasingly clear that CIS structural reforms are lagging, a point highlighted by comparison with central Europe’s transition economies, where single digit inflation is the norm.
In the three largest CIS economies – Russia, Ukraine and Kazakhstan – the rise in inflation can be dated from the middle of last year [see chart]. Ukraine shows the most spectacular price surge, with a near doubling of inflation in the past six months, while in Kazakhstan it appears that inflation is levelling off after a sharp jump at the end of 2007. The trend in Russia is a steady, seemingly inexorable upward movement.
Ukraine’s runaway inflation illustrates themes found in most other CIS economies: loose fiscal policies, high dependence on imported food, sizeable foreign capital inflows and a central bank fixated on controlling the country’s FX rate rather than fighting inflation. The populist bent of Yuliya Tymoshenko’s new government is also to blame. Local pundits suggest that the prime minister is already laying the foundation for a run at the presidency in 2010, when elections are expected.
Russia’s inflation prospects are of particular interest, not only because of the country’s pervasive economic influence in the region, but also because its financial markets have attracted the greatest involvement of foreign investors. Russia’s success, or lack thereof, in coming to grips with its inflation problems will influence the investment climate throughout the CIS region. With this in mind, we now turn to an assessment of Russia’s inflation outlook.
Long on words
Inflation was elevated to a top subject of policy debate this January when the final 2007 result of 11.8% was announced. This proved an embarrassment to the government, not only because the outcome was substantially above the official 9.0% target, but also because senior government officials had been assuring the public up to the last moment that an outcome close to the target level was likely.
By the end of January inflation-fighting measures were the topic of the day for the government. At a much-publicized meeting on January 31, finance minister Alexei Kudrin pledged to keep inflation this year at or below 8.5%. But on the same day that Kudrin was pledging a tough fight against inflation, Alexei Ulyukaev, first deputy chairman of the Central Bank of Russia (CBR), gave a closed-door meeting of top commercial bankers a different message.
According to Ulyukaev, as long as the global credit crisis persisted, the stability of the Russian banking system would be a more important priority for the CBR than fighting inflation. Events in the interim prove the maxim that one should listen to the deputy, not the boss. Despite frequent lip service to the importance of fighting inflation, the real driver of monetary policy in the past three months was the goal of assuring adequate domestic liquidity by injecting government funds into the market.
Crisis that never was
Back in January the spectre of financial instability in western markets sent the government a very clear picture of what should be avoided in the transition to the new presidential administration by early May. The fear of a possible liquidity crisis for Russia’s financial system led to exceptional measures to prevent this possibility by injecting substantial liquidity into the money markets.
Liquidity-creating initiatives comprised four primary actions: deposits into banks from state-owned corporations, auctions of surplus Treasury funds to the banks, and a broadening of the CBR’s refinancing window and Lombard lists to previously excluded securities. Estimates by Troika Dialog analyst Alexander Kudrin put the theoretical maximum liquidity creation of these measures at some Rb15.0 trillion ($650 billion) – a very large sum indeed. A final source of liquidity was provided by the federal budget, whose expenditures grew rapidly – up 58% in Q1/08 over the same 2007 period.
From the perspective of ensuring stability, the government’s initiatives must be viewed as an unqualified success. In April, private capital inflows revived, recording a $10 billion surplus after a $22.8 billion outflow in Q1/08. The bond and syndicated loan markets have reopened for Russian borrowers, albeit at higher spreads, and the lack of demand for deposits at the first two Treasury auctions confirms that the banking system is no longer facing a liquidity shortage.
Now for the hard part
The unpleasant reality that faces the CBR now is that the initiatives that helped avoid a liquidity crisis make fighting inflation that much more difficult. Since the beginning of the year, consumer inflation has moved up steadily from 11.8% to an estimated 14.4% in April; on current trends inflation will move into the 15–20% range in the coming months.
Meanwhile, producer price inflation is soaring. Continued rapid growth in fixed investment (up 22% in Q1/08) has led to inevitable shortages and price hikes for construction materials (cement is up 70%, for example). Producer prices for all subsoil mining output (including metals, oil and gas and aggregates output) are up over 50%.
In order to come to grips with inflation, monetary policy must move from a passive role to an active one. The CBR has been successful in buffering the financial sector from external forces, and this has ensured near-term stability. But an effective anti-inflation policy must force banks to implement necessary – and for some, painful – restructurings of their activities.
Mission impossible?
The policy dilemma is this: in the longer run, low inflation is essential for financial stability, but it is not clear how the CBR can get from here to there, especially in the context of today’s global financial crisis. Having flooded the financial markets with liquidity, the CBR must now find ways of soaking up this liquidity in order to counter the rising trend of inflation.
Russia’s inflation is primarily driven by monetary factors, especially too-rapid expansion of monetary aggregates. Tighter controls of liquidity via a move to positive real interest rates are acknowledged by the CBR as essential steps in this transition. The problem is that the implementation of these steps always seems to be 2–3 years in the future and always results from external economic developments, not CBR policy decisions.
With rising inflation and very ample domestic liquidity, it should come as no surprise that real interest rates are highly negative and falling. Real interest rates peaked last April at -2.4%, and since then real rates moved below the -8.0% level. The rather timid CBR move on April 28 to hike the headline refinancing rate 25 bps (to 10.5%) cannot be seen as a serious initiative in view of the highly negative position of real interest rates.
That monetary policies are too loose is also suggested by trends in monetary aggregates. Since peaking in mid-2007, M2 growth has trended down, though the latest data convert to still-high real growth of over 30%. Domestic credit to the non-financial sector and households continues to grow rapidly – the latest 52% growth rate is only down slightly from the 56% peak set last December. The divergence of M2 growth from domestic credit is explained by a significant slowdown in household deposit growth, itself a reflection of rising inflationary expectations.
Limits of appreciation
The CBR has repeatedly emphasized its commitment to limit the real appreciation of the ruble exchange rate. Accordingly, since mid-2007 the appreciation in the ruble’s real, effective exchange rate has been kept at a stable 4.0% rate. Many think the CBR should let the ruble appreciate much faster, viewing this as a more palatable policy option than hiking interest rates. Those holding this view include market participants as well as many government officials.
Under current conditions, though, the effectiveness of ruble appreciation is questionable. For one thing, administered prices are now being raised substantially, unlike earlier periods when they remained unchanged. It is also evident that prices of non-tradables, such as construction materials, are leading the rise in producer prices; ruble appreciation will have little impact on such price trends.
As Trusted Sources managing director of research Christopher Granville points out, former President Putin and other top officials have been sticking to the policy line against speeding up the rate of ruble appreciation. But the next level of officialdom appears to be singing a different tune. In part these views reflect the impatience of such lesser officials that a serious anti-inflation programme is still not being implemented.
The way ahead
The conflicting objectives of preserving banking sector stability and fighting inflation will for the foreseeable future hamper the transition to an active CBR monetary policy. Until such time as the global financial crisis is passed, stability will trump fighting inflation in the line-up of policy priorities.
This leads to a rather gloomy outlook for Russian inflation. Lacking an active monetary policy to restrain monetary expansion, inflation will continue to run ahead of expectations. In short, inflation has to get worse before it can get better. The transition to more effective monetary policies shows every sign of needing the shock therapy that this unpleasant inflationary trajectory will sooner or later bring to bear on Russian markets.
Larry Brainard is chief economist for Trusted Sources, an investment intelligence service