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Monday, June 02, 2008

The Specter of Inflation Looms Above Vladimir Putin's Russia

The Moscow Times reports on the specter of inflation looming above Vladimir Putin's Russia:

It's early evening at the upscale Scandinavia restaurant, and its courtyard a few meters off Tverskaya Ulitsa is starting to fill up with customers.

Bustling servers bring out plates piled high with beef burgers, while diners indoors tuck into the pricier steaks and fish.

But behind the scenes, the Swedish restaurant is starting to feel the pinch.

"We haven't marked up the prices on some of the favorite dishes for six years," said Marina Averchenkova, the restaurant's public relations director. "But as long as we work a lot with imported products such as meat and wine, prices in Europe have put us in the situation where we have had to raise our prices."

With the state expecting inflation to top 15 percent in May, rising costs are forcing thousands of enterprises to hike prices even as they struggle to keep costs down.

Prime Minister Vladimir Putin says Russians can live with double-digit inflation for years, but it is a claim that may be put to the test if the government does not act urgently to contain soaring costs.

After eight years as president, Putin has passed on to Dmitry Medvedev stewardship of a booming economy. But it could prove to be a poisoned chalice. The country is facing sky-high inflation — driven by food prices — that threatens to undermine many of the Putin-era successes.

It is not a Russian phenomenon, of course. Across the globe, food costs have escalated on the back of years of underinvestment in agriculture, poor harvests and higher demand for grain from emerging economies, such as China. Tens of thousands of people across the world marched on May 1 against the rising cost of food and falling wages and pensions. In Russia, too, there are signs of growing unrest as inflation starts to bite.

Real inflation is believed to be higher than the official figures, and a recent poll indicated that about 67 percent of Russians identify inflation as the most urgent issue facing the country today.

Inflation rose for the first time in years in 2007, hitting 11.9 percent. The Economic Development Ministry remains hopeful that inflation will be contained at 10.5 percent this year, while economists say it could reach 11.5 percent to 14 percent. Even the figure of 14 percent is arguably optimistic, given that consumer prices have risen by 7.5 percent so far this year.

While prices have risen rapidly for some time now, particularly in higher-end segments of the economy, such as property, it was only last fall that the specter of inflation truly reared its head. With State Duma and presidential elections fast appearing, the authorities got down to work fast on growing food prices.

But their efforts — which included price caps on food and hikes on several import and export tariffs — have been widely derided by economists as populist and cosmetic. With a new government installed this month, hopes have been kindled that the bureaucrats will now start to take substantive steps to tackle inflation.

For sure, the government is taking inflation seriously. But officials have shown a deep-rooted disinclination to do anything that would alienate the population and threaten economic expansion.

Over the past 18 months, the country has seen a significant increase in money supply; the ruble has depreciated against the euro and the yen, and the government has pursued an aggressive spending program as it seeks to uphold economic growth, which has averaged at more than 7 percent in the last eight years.

It is no coincidence that inflation has struck in the middle of a debilitating international financial crisis that has rocked confidence in the global financial sector and brought the United States to the brink of recession.

Faced by the prospect of tougher lending conditions for banks and, in turn, their consumers, the Central Bank responded by printing more rubles — a decision that released liquidity into the system to shore up the financial sector but further fueled inflation.

But there is good news, too. Central Bank chief Sergei Ignatyev said Wednesday that the money supply has risen by a mere 0.7 percent in the year to April, compared with 11.2 percent over the same period last year, giving the Central Bank the confidence to predict slowing inflation over the rest of the year.

Nevertheless, there is no easy solution, and policymakers remain divided on how to tackle the problem, which has a real potential to undo the government's popularity.

Problem No. 1: Overheating Economy

Liberal members of government have warned repeatedly that the state's aggressive appetite for spending — on wages, infrastructure and other national projects — is fueling inflation.

"Real budgetary expenditure rose by 26 percent last year. It's too much and is greater than the total growth of our economy," Deputy Finance Minister Dmitry Pankin said at a forum this week. "This is influencing inflation."

It is a point made by his boss, Finance Minister Alexei Kudrin, time and time again. The keeper of the country's purse strings, Kudrin has navigated the country through eight years of prosperity and has fiercely opposed the government's tendency to support big-spending programs, which would ensure continued high growth. The government has also poured money into pensions and state sector salaries, further measures that fuel inflation.

With global growth under threat because of the financial crisis, Russia is selling itself to foreign investors as a place where the rewards are still rich. It is a silver lining that many believe the country can ill afford to ignore.

Indeed, economists are already predicting that Russia's growth will slow this year, although the effect will be much less than in the West, as banks see overseas funding dry up, resulting in fewer loans.

A split in the government on the pace of growth spilled into the public in April when Kudrin and Economic Development Minister Elvira Nabiullina squared off over whether the economy was overheating, the state at which growth becomes unsustainable. Kudrin's conclusion, that the economy is overheating, is shared by many economists.

"Inflation has really been able to run away … because the economy is simply growing too fast," said Rory MacFarquhar, chief economist and a managing director at Goldman Sachs.

He said the economic growth could be slowed to a more sustainable rate by reining in government spending and curbing credit growth.

But it appears that Kudrin is fighting a losing battle. Putin has outlined massive investment for transportation infrastructure this month, and more is to come. Oil, meanwhile, has soared to more than $135 per barrel, delivering windfall profits for the state.

"As long as the price of oil is so high, this is an argument that Kudrin cannot win," said Martin Gilman, former representative of the International Monetary Fund in Russia.

If inflation cannot be contained, however, the economy faces a very real risk of slowdown.

Problems will arise if inflation reaches 15 percent to 20 percent, the level at which it could start to dent investor confidence, said Oleg Vyugin, chairman of MDM Bank and the former head of the Federal Service for Financial Markets.

"If inflation is kept under current limits and it is manageable, then it is possible to avoid [damaging the economy]," Vyugin said. "But if businesses see that the government is not in a position to control inflation, then there will be serious damage."

Problem No. 2: Monopolies

The many monopolies have also been a major contributor to inflation by introducing aggressive price hikes for services.

The government regulates prices in a range of sectors, from electricity and gas to telecommunication services. The prices are usually set at the beginning of the year and in some sectors are subject to reforms and liberalization, which implies double-digit growth in prices in many cases.

"I think the government has to come up with a reasonable plan on how to regulate these tariffs taking into account the [current level of] inflation," Vyugin said.

In addition, anti-monopoly rules should be enforced against companies that try to regulate prices, he said.

Earlier this year, Putin sought to blame monopolies for high food prices, claiming that they effectively created a cartel to keep costs high. It is a theme he took up again in his candidacy speech for prime minister, calling for tougher implementation of the anti-monopoly policy.

But he also ruled out curbing the power of the country's natural monopolies, which include companies such as Gazprom and Transneft, arguing that the money for reform and upgrading of the country's infrastructure had to come from somewhere.

Solution No. 1: Appreciation

One way to bring down costs would be to allow the ruble to strengthen against other currencies, namely the euro and the dollar. For example, a liter of German orange juice that sells for 2 euros at home costs 74 rubles to import at the current exchange rate of about 37 rubles to the euro. But the same liter would cost only 72 rubles if the ruble appreciated to 36 to the euro.

This difference is potentially significant because food is a main driver of inflation in Russia and, Putin said recently, big Russian cities import up to 70 percent of their food.

The Central Bank tightly controls the ruble's exchange rate by buying and selling rubles to keep the ruble steady against major foreign currencies.

Until the government relinquishes control of the ruble, it will not be able to target inflation in the long-term, some economists said.

"They really do need to let go of the exchange rate," MacFarquhar said. "But there is a very deep-seated reluctance to get into the position of overvaluation after 1998," the year of the Russian financial crisis.

Vyugin said the Central Bank should have let go of the ruble months ago, given the money pouring into the economy in the shape of investment flows, on the one hand, and services and trading boosted by high oil prices on the other.

"When the economy experiences this kind of double inflow, the currency has to be appreciated," Vyugin said.

Many major investment houses are banking on exactly that. Goldman Sachs, Deutsche Bank and Merrill Lynch recently advised clients to buy rubles in anticipation of a policy change on the currency. They predicted that the currency could appreciate by as much as 4 percent in the next six months.

But to rein in inflation for good, the ruble would need to be appreciated by about 20 percent, some economists said. Politically, such a measure would face stiff opposition. Domestic exporters, which make up a powerful lobby in the government, benefit from a weaker ruble, which adds to their competitiveness abroad. On the flipside, domestic exporters, particularly in the oil industry, are also seeing inflation eat into their competitive advantage by increasing their costs.

The Central Bank is reluctant to appreciate the ruble. Fearing ruble speculation that would result in greater inflows of money, the bank said last year that it no longer considered the exchange rate policy to be an effective way to battle inflation.

In a speech to the Duma before his confirmation as prime minister early this month, Putin dismayed many economists by saying the government's anti-inflationary efforts would focus on boosting investment in agriculture, enterprise and curbing the power of monopolies. He made no mention of ruble appreciation and suggested that the state's goal was to return to single-digit inflation "within the next few years" — an indication that the prospect of ruble appreciation had been shelved.
A few weeks later, the Central Bank muddied the picture further, saying it would conduct daily interventions in the local forex market to head off speculators and make the exchange rate more flexible. In doing so, the bank introduces greater volatility into the market, making it harder for dealers to predict the bank's next move. It is also a first step toward an inflation-targeting regime.

But perhaps the biggest turnabout came this week, when the Central Bank indicated that it would start to broaden the ruble's traded range on a very gradual basis and might let the currency appreciate within months. Nevertheless, the bank has made clear its determination to pursue every other available avenue first.

Gilman, who teaches at Moscow's Higher School of Economics, argued that a drastic ruble appreciation was not the answer. "Firstly, it would be a signal to investors that the ruble is a safe one-way bet," he said. "But the longer-term problem is that Russia is not going to be running a current account surplus for very much longer. Do you want the ruble appreciating by 20 percent if Russia is going to be running [a] deficit? Is that really an intelligent policy?"

Solution No. 2: Monetary Tightening

The Central Bank's primary tool to fight inflation so far has been to tighten monetary policy by raising interest rates.

Interest rates have been hiked twice this year, and more increases are expected. But economists call this measure ineffective in a climate where the exchange rate is tightly managed. Higher interest rates combined with a weaker ruble would encourage investors to pour more money into Russia, negating the effect of such a move in the first place.

"Whenever you have interest rates hikes in a fixed exchange system, it generates capital inflows and monetary expansion rather than monetary contraction," said Vladimir Osokovsky, chief economist at UniCredit Aton. "For example, in the U.S., you cut interest rates and the dollar depreciates, [which leads to] monetary expansion. … Here, the monetary expansion and contraction is driven by capital inflows and outflows rather than the efforts of the Central Bank."

Raising interest rates will work only when the ruble is allowed to float freely, he said.

Of secondary importance is that consumer credit is a relatively nascent phenomenon in Russia, where only a minority of the population hold credit cards and mortgages account for a mere 2 percent of gross domestic product, compared with 40 to 50 percent in the West. While higher interest rates in the West would discourage spending, in Russia the effect of such a move is minimal.

"The Russian authorities are between a rock and a hard place," Gilman said. "There is very little that monetary policy can do to change this situation."

In the meantime, the Central Bank has announced that it will raise bank reserve requirements aggressively from July 1, forcing banks to set more money aside and thereby slow lending growth. Corporate lending has grown at a phenomenal rate, up by 70 percent in the first quarter alone, and banks have historically been able to capitalize on cheap interest rates abroad to lend at a higher cost at home.

Solution No. 3: A Coordinated Policy

The Central Bank is inching toward an inflation-targeting regime, but it has indicated that this will only start to happen toward the end of this year. Inflation targeting would effectively imply a relaxation of control over the exchange-rate mechanism and a tightening of control over capital inflows. "That's what the Central Bank is doing, and that is what they have to be doing from a macroeconomic viewpoint," said Osokovsky, of UniCredit.

But it is a long-term solution, and there would be a significant time lag before it would begin to have an impact on inflation.

The U.S. economy, meanwhile, is playing a significant role in fueling Russian inflation. With the ruble tied closely to the dollar, the key international reserve currency, Russia is effectively importing loose U.S. monetary policy. Since the beginning of the year, the U.S. Federal Exchange has desperately tried to inject dynamism into its flagging economy by dropping interest rates to just 2 percent. This has led to an avalanche of dollars into the economy, which feeds into countries such as Russia that tie their currencies to the dollar. It is unlikely that the Fed will tighten its monetary policy before the U.S. economy starts to pick up.

"U.S. monetary policy is very soft today, and a lot of funds in the Middle East and Asian countries have accumulated dollars and are now trying to spend them," Vyugin said. "It's a source of inflation."

There is little Russia can do to influence U.S. monetary policy, but Gilman suggested that Russia could build an informal coalition of countries to put pressure on the United States.

How that pressure would be applied is another matter entirely. Both Russia and Saudi Arabia have enormous dollar reserves and would be in the strongest position to threaten gently to sell off dollars and even diversify into other currencies.

The United States, however, would most likely think Russia was bluffing, Gilman said. If Russia then went ahead and sold a few billion dollars, the value of the dollar might plunge or U.S. bond prices might drop like a lead balloon, which would hurt the housing market as interest rates rise, he said.

"It is kind of like an atomic bomb. It is a very dangerous weapon," he said.

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