There is no economic crisis, but rather a receding financial crisis
This is an abridged version of a Russia economic update which originally appeared at Awara. The full report can be downloaded here
The main conclusion for the moment is that Russia is not in an economic crisis, while it sure is in a financial crisis, or rather recovering from such. We have witnessed a sharp devaluation of the ruble, high interest rates and a soaring inflation, which are elements of a financial crisis. But there has not been any wave of bankruptcies, shrinkage of industrial production or ensuing mass unemployment, which would mean an economic crisis or recession. Industrial production actually grew in 2014 by 1.7% in the year and by an impressive 2.1% in Q4 2014. This year by February there has been only a slight decrease by 0.4%. This compares with the deep crisis in 2008 when industrial production crashed in an immediate shock in just four months by 20%. (October 2008 through January 2009). The result was a near doubling of unemployment from 5.4% in Q2 2008 to 9.4% in Q1 2009. This time around there has been no significant growth in unemployment, the reading for February being 5.8%, which is actually the exactly same level as in February 2014, but up from the historical low point of 5.2% of May 2014.
First quarter GDP expected at minus 1.5- to minus 1%
The Russian Central Bank expected a Q1 GDP decline of minus 2% in a report released March 13th, but only a few days later the deputy chairman of the CB Ms. Ksenia Yudaeva said in an interview that the bank estimated a GDP decline of only -0.7%. Other domestic and foreign analysts have been far more pessimistic. We have reason to think that the predictions of the CB are the most accurate ones considering their access to the latest real data. Considering this and other factors, we would conclude that a GDP reading on the level of minus 1.5% to minus 1% is expected for Q1.
Predicting the annual GDP is difficult at this point due to so many uncertainties. The main factor is how fast the Central Bank will realize that the key lending rate is way too high above the present inflation rate. Presently the punitively high key interest rate at 14% is suffocating the economy. This is twice as much as the present running rate of inflation. (See below). If the rates are not timely drastically lowered then we could expect an annual GDP at the level of minus 3% or more. With a timely reaction the GDP for 2015 could come in at about zero. Sooner or later the understanding will arrive and therefore by 2016 Russia will return to positive growth.
These predictions are based on the assumption that the oil price will not take a renewed serious hit. Furthermore the prediction assumes that Russia will not be dragged into a shooting war or such a situation would occur which would have to put Russia de facto into a war economy. Unfortunately such scenarios cannot be excluded.
It’s the inflation, stupid!
Presently the big problem is inflation, or rather the official misapprehension of inflation.
According to most economists the lending rates must be above the rate of inflation in a healthy economy. This is according to the monetary school, which is not necessarily right. At the very minimum they do not give due consideration to the supply side of the economy, that is, the need to create conditions to increase production, transport infrastructure, commercial space etc., in order to bring down prices by growth of supply and increased competition. In fact, I would think that the latter is Russia’s historic problem. Thus it seems to me it that the Russian Government and Central Bank have committed an error in their excessive monetary fight against inflation.
Due to this policy the Central Bank is keeping the key lending interest rate at the excessively high level of 14% (down from peak 17% in December). The Government, in turn, embarked on a sequestration of the budget by erasing 10% of the planned spending in order to fight inflation.
The saddest thing is that there seems to be a cardinal misapprehension about the actual level of the inflation. The figure most often published in the press and the one the officials habitually refer to is the cumulated historic inflation year-on-year, that is, the rolling sum of the past 12 months. Another way to express the inflation rate popular among the Russian ministers is the expected inflation for the calendar year. For some purposes these might be interesting, for example, for the purpose of indexation of pensions. But they are completely off the point for the purpose of setting interest rates. Interest rates affect the future, so you should match them with the future predicted inflation, that is, the rate on which inflation is presently running 12 months ahead.
The cumulative inflation for past twelve months has been 16.7% (per mid-March). But now the government expects an annual inflation for the calendar year of 12% (announced in several interviews by key ministers). Thus they are making a prediction of the inflation pace. Then why don’t go all the way and predict the future 12 month inflation (instead of only the end of year inflation). In fact, all the elements for the future 12 month inflation (the running inflation rate) are already baked in to the year-end inflation prediction. The Government knows that inflation from beginning of this year up to mid-March was 6.7% and predicts a calendar year inflation of 12%. What they are actually saying is that they expect the inflation for the rest of the 9.5 months to be 5.3%. This means an average 0.56% monthly inflation for the rest of the year, which in turn gives a running inflation rate at 6.7% for the 12 months ahead.
This forecast of the inflation rate inherent in the Government’s predictions is what should be the foundation of setting the key lending rate of the Central Bank. Instead the CB is strangling the economy with a rate of 14% which is double the present running inflation rate.
This habit of determining the key interest rates by looking at the past accumulated inflation could be compared with a doctor prescribing medicine to a healthy patient based on his fever readings of the previous week. In other words, the same as steering the economy through the rear view mirror.
The 6.7% predicted future inflation rate might even be too high a figure under today’s circumstances. The inflation rate has fallen dramatically during the last few weeks, now running at 0.8% for March. The punitive interest rates of the Central Bank and the Government budget sequestration will further smother the inflation. On top of this there are strong indications that the inflationary spike of the past few months was to a great deal caused by speculative price hikes instead of a real need to raise prices because of higher production costs. Now that the panic bubble has burst and the wholesale prices on some products seem even to be on the decline. On top of this comes the near 15% appreciation of the ruble since end of January, further aiding to keep prices down.
A key factor dampening the inflation is that most of the food is now produced domestically in Russia thanks to the Russian contra-sanction embargo on import of food from the West. If this was not the case, then the inflation would have followed the ruble depreciation in a dead spiral. The Russian domestic prices initially adjusted to the new suddenly increased demand of domestic products but this inflationary factor has now faded away.
Considering these arguments, it would seem to me that the Central Bank should urgently bring down the key lending rate to a level of 10% and further to 8%. It is only a matter of time when this realization will come.
Ruble appreciation would not be welcome
A further appreciation of the ruble would be a most unwelcome event as the weaker ruble has been a boon for domestic production and has largely kept the country’s budget intact. The excessively high interest rates are luring speculative money to Russia which only serves to artificially strengthen the ruble and fuel stock market speculation. This will not do anything good for the real economy.
Instead of letting the ruble appreciate the Central Bank must use this window of opportunity to lower the interest rates so as to ensure that Russian corporations, entrepreneurs and domestic investors have access to lending with affordable interest rates.
You can access the full Russia economic report here.