How Russia’s Economy Is Being Strangled by Its Central Bankers

A whole new set of economic data now makes it possible to form a clear view of the state of the Russian economy as the first quarter approaches its close.

Industrial output is flat. 

The story of this recession is of a steep fall in industrial output in the second quarter of 2015. 

This steep fall caused world headlines with the usual commentators taking it as proof of an impending collapse. 

In reality the fall in industrial output hit bottom in June 2015. Output has been steady since.  

There has been some excitement because of an increase in industrial output of 1% in February over the level of output in February 2015.  

Part of that rise was statistical: the result of the extra day in February caused by the fact 2016 is a leap year.  

However it is unlikely that this explains all of the output rise in February. 

Industrial output in February 2015 was higher than in subsequent months in 2015, with output in the second half of 2015 continuing roughly at the level it fell to in June 2015.  

The fact industrial output in February 2016 was slightly greater than in February 2015 therefore points to at least some recovery from the output levels the economy hit in June 2015, at which the economy has been stuck ever since, even if the rise is being exaggerated to some extent by the effect of the extra day.

With output flat the statistics will soon anyway show a decline in the rate of output fall if only because of the base effect.  

Since the main fall in industrial output happened in the second quarter of 2015, even if output remains flat the statistics for the second quarter of 2016 should show either zero growth or at worst only a small further contraction in output as compared with the level of output achieved in the second quarter of 2015.

The Economics Ministry is more optimistic. It is predicting that output in the second quarter of 2016 will be higher than in the second quarter of 2015 and judging from the results in February it is probably right.

If so then that will confirm that a certain recovery in output is indeed underway.

Whilst industrial output remains flat, agricultural output is continuing to surge as the farm sector reaps the benefits of the devaluation and the counter-sanctions.

I notice that the famous US economist Paul Krugman has recently taken to questioning some of the claims made about the supposed evils of protectionism  If he wants an example of how protectionist measures can work he need look no further than the positive effect the counter-sanctions are having for Russia’s agriculture sector.

Employment has been steady  The unemployment rate is still 5.8% – the same as in the second half of last year. Predictions of mass lay-offs have never come true at any point in this recession. They were again widespread at the start of this year following the second oil shock. They have again failed to come true.

The annualised rate of inflation continues to fall and is now 7.7% – half its rate of a year ago.  

This too is however in some respects a misleading figure. Weekly inflation has been rock steady for several months at 0.1%, which would translate to a real inflation rate of around 6% over the year as a whole.

It is widely predicted that because of the base effect the annualised rate of inflation will rise above 8% in June. Assuming the weekly rate of inflation remains 0.1% that would again however be a purely statistical effect with the rate of actual price rises in the shops remaining stable.  The Economics Ministry is now predicting that inflation over the year as a whole will be below 8%.

That the underlying or true annual rate of inflation is actually 6% or thereabouts is implied by a claim made by the Central Bank in its latest quarterly Statement.  

The Central Bank says the annualised rate of inflation in March 2017 – ie. a year from now when all statistical distortions have been eliminated from the figures – will be 6%, setting the scene for a further decline to 4% by the end of 2017.

That could be seen as an admission that the true annual rate of inflation is indeed 6% or thereabouts.

In comments published on 18th March 2016 Central Bank Chairman Nabiullina appears to have gone further, admitting that the annualised rate of inflation could actually fall below 6% by the end of 2016. Her precise words were as follows:

“Annual price growth rates may accelerate in the middle of the year, but only on the back of the low base effect of last year. This is a statistical effect. 

In the second half of the year, as our forecast suggests, annual inflation is set to resume its decline, provided there are no new shocks emerging. 

Some pressure on 2016 prices is envisaged from increased excise duties, those on fuel in the first place. Yet its input is expected to be minor: circa 0.5 percentage point into annual inflation inclusive of all types of effect. 

Our baseline scenario suggests that annual inflation will total under 6%, decreasing to the 4% target in late 2017.”

(underlining added)

If the annualised rate of inflation in Russia has indeed fallen to below 6% by the end of the year, then inflation in Russia will have fallen further and faster than anyone predicted. It will have been the steepest fall in inflation in any major economy since the US experienced the Volcker Shock in the early 1980s.

Regardless, predictions that the rouble’s second devaluation caused by the second oil shock would cause a sharp rise in inflation (with the Central Bank talking of inflation rising to an annualised rate of 16%) have – as Jon Hellevig has explained – simply failed to come true.

According to the Central Bank the economy was due to repay $26 billion in foreign debt this quarter with the month in which the heaviest payments for the year would fall – $12.5 billion – being this March.

There is nothing to suggest any difficulties in making these payments despite the widely reported problems at VEB. The rouble continues to track closely movements in oil prices which suggests that foreign debt payments are not causing strain despite the second oil price fall.

There remains real uncertainty about what proportion of foreign debt is real debt as opposed to merely book debt nominally created through intra-company transactions by Russian companies.

The Economics Ministry is now forecasting that net capital outflow in 2016 will be no more than $30 billion. If so then given that what is called capital outflow is now principally debt payment that suggests the true amount of foreign debt payment in 2016 is significantly less than the $76 billion claimed by the Central Bank or even the $60 billion estimated by Constantin Gurdgiev.

Either way total foreign debt has probably already fallen below $500 billion – or should do so by the end of March – and appears to be on track to fall to $440 billion or thereabouts by the end of the year.

Foreign currency reserves held by the Central Bank have been steady at $360-380 billion.  

There is no information of recent purchases or sales of gold or foreign currency by the Central Bank, and there have been no foreign currency interventions by the Central Bank to support the rouble even during its steepest period of decline at the start of the year. 

Changes in the dollar value of the reserves held by the Central Bank that get announced from time to time are therefore due entirely to movements in exchange rates and in the price of gold, not to any actual increases or reductions in the total amount of gold and foreign currency held in reserve by the Central Bank.

Bank balance sheets continue to improve and in fact there are reports of the banks being awash with money the problems of VEB notwithstanding. Though it is VEB’s problems that have been attracting attention the rise in Sberbank’s share price – it recently touched its peak 2007 level – has gone practically unnoticed.

This improvement in liquidity points to a general improvement in economic conditions. Contrary to claims made in a recent article by Bloomberg it is not the result of extra spending from the Reserve Fund. On the contrary budget spending – which is what the Reserve Fund is used for – is being cut. Nor is the extra liquidity a substitute for an interest rate cut as Bloomberg claims (see below)

So far the only visible effect of the second oil shock on the economy is that it has caused a fall in the country’s trade surplus as the dollar price of the energy products that are the country’s main export halved in the first weeks of 2016 by comparison with their 2015 peak levels achieved in the early summer of 2015.  

This fall in the dollar value of the country’s exports has however been at least in part made up by a further decline in imports, ensuring that the trade balance remains in surplus.

As Jon Hellevig has pointed out it is this fall in imports that explains why the second oil shock has not caused the higher inflation that the Central Bank predicted. 

On the subject of how the devaluation of the rouble is helping the Kremlin’s import substitution policy I must refer to the single most extraordinary fact that came out of Jon Hellevig’s recent article on the Crimean economy’s boom.

This is that Russia saved a staggering $25 billion because Russians chose to go to Crimea and elsewhere in Russia for their holidays rather than go abroad.  

Jon Hellevig has told me in private correspondence that he found this figure so surprising that he felt obliged to check and double check it.  However it turned out to be true.

This is not an unequivocally good thing. It is a shame that because of the fall in the rouble’s purchasing power many Russians have had to forego foreign holidays they doubtless would have enjoyed and which some of them no doubt planned long in advance and looked forward to. However what may not be good for individuals can be good for the economy and this is a case in point.

Taking all these facts together it is impossible to avoid the feeling that the thing that is now holding the economy back is the continuing high interest rates.

It is the high interest rates that are stifling investment and demand, both of which need to increase for the economy to grow. At the moment both are still well below their levels this time last year, though there are tentative signs of recovery.

At its recent meeting on 18th March 2016 the Central Bank decided to hold interest rates at 11% where they have been since August.  

The Central Bank has also released pessimistic forecasts for the economy, predicting a further contraction this year and low or zero growth next year, with the economy only fully returning to growth in 2018.  

This can only mean that the Central Bank intends to keep interest rates high both this year and next.

Why is it doing so?

The Central Bank’s recent Statement justifying its decision to hold rates at 11% shows it running out of reasons.

The Central Bank has consistently claimed that its reason for keeping rates high is the risk of higher inflation caused by the devaluation of the rouble caused by the oil price fall.  

Following the second oil shock, when the rouble again devalued at the start of the year, the Central Bank predicted inflation would take off and used this as its justification for keeping interest rates high. Indeed it even warned interest rates might need to go higher.

As the Central Bank rather grudgingly admits – but as Jon Hellevig predicted – what has in fact happened is the precise opposite: the further devaluation of the rouble at the start of the year far from causing inflation to rise has had no discernible effect on inflation at all so that the annualised rate of inflation, instead of rising as the Central Bank expected, is instead continuing to fall:

“………inflation slowdown is continuing. Under the Bank of Russia estimates, the annual consumer price growth rate is down from 9.8% in January 2016 to 7.9 % as of 14 March 2016. 

This is lower than the forecast for inflation for the year ahead, which, the Bank of Russia released in its March 2015 press release (circa 9%).

In 2Q 2016, as the Bank of Russia forecast suggests, quarterly inflation will continue to decline.

However, annual inflation may accelerate temporarily in the middle of the year as a result of the low base effect.

Provided there are no new shocks emerging, subsequently annual inflation is set to resume its decline.”

However, despite now admitting that inflation is going in the opposite direction to the one it expected, the Central Bank continues to justify its high interest rate policy with claims of future inflation risks caused by possible further falls in oil prices:

In making its key rate decision, the Bank of Russia Board of Directors took as a premise the expectations for oil prices which are lower than its December forecast.

The current oil market still features a continued oversupply, on the backdrop of a slowdown in the Chinese economy, more supplies originating from Iran and tighter competition for market share.

Despite growing oil prices and ruble strengthening in the latest period, the accumulated weakening of the ruble, impacted by the drop in oil prices, between late 2015 and early 2016, is still putting pro-inflationary pressure on the economy, contributing to continued high inflation expectations

The risks remain that inflation may exceed the target in late 2017. These relate to a further worsening in the oil market developments; persistent elevated inflation expectations; the global food price performance; changed rates of indexation of regulated prices, wages and pensions, as well as the uncertainty around a balanced federal budget over the medium term. 

To enable the accomplishment of inflation targets, the Bank of Russia may conduct its moderately tight monetary policy for a more prolonged time than previously planned.”

It is not difficult to see the contradictions in all this.

The Central Bank continues to worry about “high inflationary expectations” even as it admits that inflation is actually falling. It frets about the possible effect on inflation of a further fall in oil prices even though it admits the rise in inflation it predicted because of the second oil shock has failed to materialise. Why suppose that a third oil shock – if it happens later this year – will cause higher inflation when the second oil shock failed to do so?

At some level one senses genuine bafflement on the part of the Central Bank that inflation is not behaving in the way the Central Bank expected it to do.  

Amongst Russia’s three big economic policy making institutions – the Economics Ministry, the Finance Ministry and the Central Bank – the Central Bank has been consistently the most pessimistic – and the most wrong – in its economic forecasts (the most optimistic and the most right has been the Economics Ministry).

That suggests the Central Bank is working with an outdated model of the economy that makes mechanical predictions about inflation based on levels of the rouble and the oil price, which would explain why it is getting the inflation rate wrong.

Even allowing for this the Central Bank’s refusal to believe the good news is odd.

Explanations I have heard for the Central Bank’s insistence on keeping interest rates high despite inflation falling faster than it expected is that it is not really worried about inflation at all but is keeping interest rates high in order to support the rouble and to encourage higher saving.

These are worthy aims. However the major difficulty in attributing to them the present interest rate policy is that they are not the aims the Central Bank is giving to justify it.

Central Bank officials have occasionally spoken about the need to encourage higher saving in the economy. However they do not cite this as their reason for keeping interest rates presently so high.  

As for supporting the rouble, they tend to deny that this is a factor in their decisions at all.  

Instead they focus exclusively on inflation, as the Central Bank did in its recent Statement, and as Central Bank Chairman Nabiullina did in her recently published comments explaining the decision.

I would add in passing that there is in fact little evidence that the current high interest rates are providing much support to the rouble, whose rate continues to track even the tiniest movements in the oil price.

As for the saving rate, it is indeed a worthy aim to seek to increase it. However my opinion is that the reason it has been less high than it might otherwise have been is Russia’s historically high inflation rate which has deterred saving, in which case it will rise as inflation comes down.

My view remains that the true reason the Central Bank remains reluctant to reduce interest rates is the one given a short time ago by Central Bank Deputy Chairman Yudaeva – that the Central Bank is worried that the financial community – ie. market traders and analysts – does not believe it is serious about achieving its 4% inflation target. Central Bank Chairman Nabiullina is now reported to have said the same thing.

As to that I will say what I said before: it is understandable that the Central Bank after the humiliation it suffered when it briefly lost control of the rouble in December 2014 should want to regain the credibility it fears it lost with the financial community. With both output and employment steady it may also feel under no real pressure to do otherwise

The problem is that the people who work in the financial community have almost to a man and woman an institutional bias in favour of the bleakest possible view of the Russian economy. Trying to appease them is hopeless and should not be a reason for deferring an interest rate cut if that is what economic conditions point to.

That economic conditions do now point to the need for an interest rate cut is a view that is now starting to take hold. 

It is an open secret that the Economics Ministry wanted an interest rate cut in March and was disappointed when it didn’t get one. 

Now Sberbank – Russia’s biggest bank and its largest financial institution – has broken ranks and is apparently now also calling for a cut.

As for the improvement in liquidity discussed previously, Bloomberg is simply wrong to treat it as a reason to put off an interest rate cut.  On the contrary it is a market signal that an interest rate cut is not only possible but is becoming overdue.

In saying all this there is one point I do however want to make.

No one so far as I know is suggesting a loose monetary policy. Certainly I am not. Nor do I think that Russia should relax its fiscal discipline or try to reflate its economy through a spending binge or a credit boom or a bubble.  

At this point in its economic history Russia simply doesn’t have the economic room for manoeuvre that more mature economies like those of the US and Western Europe have, and Russia cannot afford to take the kind of risks that those economies routinely take.

What that means in practice is that Russia has to maintain rigorous discipline in managing both its monetary policy and its budget. 

As it happens I believe that excessively loose monetary and fiscal policies in the West – culminating in structural budget deficits, quantitative easing, negative interest rates and talk of “helicopter drops”  – are misguided and are the cause of many of the problems the Western economies suffer from now.  

Whether or not I am right about that, I am absolutely sure that if anything like that were attempted in Russia – with its far weaker financial system and its much lower levels of trust in its institutions and currency – the effects would be quickly disastrous.

However interest rates of 11% – twice the likely underlying annual rate of inflation of 6% – is monetary overkill by any standard, especially when the trend for inflation is clearly downward.  

In my opinion interest rates can and should be brought down from these excessively high levels so as to restore growth to the economy. Moreover provided this is done in a careful and prudent way I believe it can be done without compromising the anti-inflation strategy or taking unacceptable risks with the exchange rate.  

That also appears to be the view of the Economics Ministry and of Sberbank.

It is what at its latest meeting on 18th March 2016 the Central Bank however missed its chance to do.

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