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Wednesday, July 12, 2006

Bayer Exposes Russia's Looming Inflation Disaster

Where would we be without the wonderful, courageous columnists in the stable of the Moscow Times? Lourie, Bovt, Bayer, Albats (and poor Felgenhaur, soon may he return!) are the only salient voices of reason coming from inside Russia today. Three cheers for the MT!

Not only is Russia's reported consumer price inflation perfectly ghastly and rising (10%! can you imagine what people would be saying about America if prices were rising like that?), but Russia doesn't even accurately report inflation data, which of course isn't at all surprising when you remember that Russia is the Neo-Soviet Union. Just like the USSR, Russia is using wallpaper to cover cracks in its foundation, cracks that will inevitably bring the whole edifice crumbling down, as the Moscow Times' Alexei Bayer makes clear:

It is a well-known tendency that, if in the rest of the world something occurs one way, in Russia it takes place completely differently, if not the other way around. There is even a proverb about it: "What's good for a Russian is deadly for a German."

And so it has been with inflation. In the 1970s and the early 1980s, when the world economy was grappling with an unprecedented rise in consumer prices, Russia was living under a planned economy, which by definition had no inflation. And so there was none -- at least officially. Elderly communists still recall fondly how they could buy a bottle of vodka for the same three rubles year in, year out.

Now, global inflationary pressures have been remarkably mild, despite record-breaking commodity prices. Inflation has picked up to over 4 percent in the United States, but remains around 2 1/2 percent across Western Europe and even lower in Asia. If it weren't for rising raw materials prices, countries such as Sweden, Holland, Japan and China would have been suffering from deflation.

In Russia, meanwhile, inflation remains stubbornly high. Although it was down to 9.1 percent in June, the Economist Intelligence Unit expects it to average 10 percent this year and 9 1/2 percent in 2007.

With all due respect to government statistics, every Muscovite knows that in many instances prices have been rising a lot faster than the 10-15 percent annual rate reported by the government in recent years. But even at its official rate, inflation represents a nasty tax on people's incomes, doubling the nominal income tax rate of 13 percent. Added to this the fact that many salaries are set in dollars and then paid out in rubles at the official rate of exchange. The ruble has gone from nearly 32 per dollar at the end of 2002 to about 27 per dollar currently, which explains why Russians are complaining about the situation.

For all its self-styled singularity, Russia is as subject to the laws of economics as any other country. In the 1970s, inflation did not disappear; it was merely kept under wraps by rigid price controls. The moment prices were freed, the worthlessness of the Soviet ruble came to the fore and a bout of hyperinflation ensued.

Similarly, there is nothing special about Russia's high inflation today. Inflation is a common problem among oil exporters. Double-digit inflation now plagues Venezuela, Indonesia and Argentina as well.

The roots of high inflation are also similar: high oil prices and an influx of petrodollars. Russia's trade surplus measured $132 billion in the 12 months up to April. To buy up such vast quantities of dollars, the Central Bank has to print more rubles. Extra money could be mopped up by the issuance of government securities, but the domestic bond market in Russia remains underdeveloped. Besides, bonds pay interest, which puts a portion of the money right back into circulation while adding to government spending.

A classic definition of inflation is too much money chasing a limited supply of goods -- which is exactly what has been happening in Russia.

Since liquidity is generated by the inflow of dollars from abroad, raising domestic interest rates is unlikely to dampen inflationary pressures. The only way the Central Bank can realistically reduce inflation is by letting the ruble appreciate. A more expensive ruble will have a triple effect. First, it will reduce domestic money supply, because fewer rubles will be needed to buy the same quantity of dollars. Second, cheaper imports will put downward pressure on consumer prices. And, finally, overall imports will rise, reducing the trade surplus.

That's on the positive side. On the negative side, a cheaper dollar will further reduce dollar-indexed wages. More important, if imports become even cheaper, even the feeble attempts to revive Russian industry that are currently underway will go out the window. I know of a number of high-tech companies that will go bankrupt if the decline of the dollar against the ruble continues.

The Central Bank has had the unenviable task of navigating between the Scylla of inflation and the Charybdis of an overvalued ruble.

The question is whether there is a solution to Russia's inflation problem. The answer is yes, but it does not depend on the Central bank or monetary policymakers.

Inflation is a problem in itself. It destroys savings, depresses investment and wreaks havoc with the price mechanism -- the main communication system of the market economy.

However, inflation is also a symptom of other problems. Global inflation got out of control in the 1970s not because OPEC jacked up oil prices, but because the world's industrial economies were not flexible enough to absorb those price increases. Unions were unwilling to cut wages, while hidebound corporations found it more convenient to raise prices than to cut their own costs.
In this decade, on the other hand, while oil prices have increased more than sevenfold since 2000, a highly competitive global environment has kept consumer price increases to a minimum.

There are only two ways Russia will overcome inflation. The simple way is a severe economic crisis that could hit the country if oil prices decline toward $35 to $40 per barrel. This would trigger a real estate crisis and a drop in consumption -- which in turn will reduce consumer prices.

The complex way entails a fundamental restructuring of the Russian economy. Today, Russia has a great opportunity to use its huge oil windfall to invest into its infrastructure, both economic and social. It needs also to create favorable conditions for industrialists -- both domestic and foreign -- to invest and to be sure that their investment will be protected.

There have been recent examples of commodity-dependent, politically and economically backward nations transforming themselves into industrial ones. Since 1994, Mexico has become an industrial powerhouse and is now enjoying greater democracy and considerable economic and financial stability. Over the same time period, former communist nations in Central Europe have dismantled their inefficient, corrupt and opaque economic systems and have become integrated into Western Europe. Note that inflation in Poland, after staying very stubbornly high for 15 years after the collapse of communism, is now among the lowest in the European Union.

A major source of inflation in Russia is corruption. Since the collapse of the Soviet Union, every item sold anywhere, be it a street kiosk or a fancy Italian boutique in GUM, has had a substantial mark-up that included payments to criminal protection rackets, bribes to city bureaucrats and kickbacks to politicians, customs officials, fire safety inspectors, tax collectors, and so on.

In President Vladimir Putin's Russia, which has become a government worker's paradise, the state has effectively been privatized and every new law or regulation is designed to provide a source of illicit income to an army of corrupt bureaucrats. This corruption mark-up can only be expected to grow. By how much do you think the price of wine will increase once the embattled distributors pay off various agencies providing them with new excise labels?

But there is the rub. You can't seriously expect the thoroughly corrupted Russian bureaucrats and politicians to initiate reforms that will put them out of business and -- horrors -- force them to live on their salary.

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