Moscow Must Act to Cool Its Economy

Op-ed in the Financial Times

February 26, 2008

An extraordinary global boom is ending and the world faces the twin spectres of declining growth and rising inflation. In the United States and Europe, recession is the dominant worry, as economic growth dwindles and the credit squeeze bites.

Emerging markets, by contrast, are still enjoying high growth rates and their main concern is inflation. Last year Russia had a healthy growth rate of 8.1 percent. That rate continues and has not been much harmed by the subprime crisis, even if a fear of a liquidity squeeze lingers.

However, Russia's annual inflation surged from 7.4 percent last March to 12.6 percent last month and it continues to rise. Relatively high inflation is permissible in countries that are quickly catching up with wealthier economies because their price levels gradually converge. Measured in current US dollars, Russia's gross domestic product actually increased by 27 percent a year from 2000 to 2007, although its real growth has been 7 percent. The balance of 20 points amounts to real appreciation, which is the sum of inflation and nominal appreciation.

Russia's inflation is mainly generated by vast current account surpluses, which have boosted its international reserves to $480 billion, the third largest in the world after China and Japan. When Russia introduced full convertibility of its currency in July 2006, large volumes of capital flew in. Surging world food and energy prices have also hit Russia's prices and after nine years of economic boom its labor and housing markets are overheating.

For a long time, Russia could ignore double-digit inflation as inflation was under control and declining and its fiscal policy was seen as responsible. Today, however, the price level has become quite high by international standards, with Moscow rated as one of the three most expensive cities in the world, and inflation is edging up.

Although the Russian elections are completely controlled by the authorities, they have inspired populist policies. Until last year, President Vladimir Putin could pride himself on fiscal responsibility. But last October he suddenly abandoned that policy. Russia had a budget surplus of 8 percent of GDP during the first 10 months of 2007, but in November the government pumped up public expenditure before the elections.

Initially the Kremlin reacted in an equally populist way to the surging inflation. It introduced export tariffs and quotas on foodstuffs to keep domestic prices down. Yet those actions had a knock-on effect, further delaying Russia's entry into the World Trade Organization. Last October it imposed price controls of numerous foods. Fortunately the Kremlin has now acknowledged that more serious economic measures are needed, and it has authorized Alexei Kudrin, minister of finance, to combat inflation. Russia needs to restore its conservative fiscal policies quickly to cool the economy. The best choice would be to prohibit the borrowing spree by Russian state corporations in the West, which reached $60 billion last year. Not only is this the main source of capital inflows, but these funds are being wasted on the harmful renationalization of good private companies.

The main cure, however, must be to allow the rouble to appreciate more. Russia's real effective exchange rate has admittedly increased by about 7 percent in each of the past two years, but that is not enough. Mr. Kudrin has repeatedly advocated a larger appreciation, hoping to bring inflation down to 7 percent by the end of 2008.

But the Central Bank of Russia holds back, strangely arguing for keeping the exchange rate tied to a basket of euros and dollars, worrying that the current account surplus will disappear too fast.

The Russian government has long envisaged a floating exchange rate aiming at inflation targeting in the medium term. This is the right time to make that transition. Then, the central bank could adopt an active monetary policy with positive real interest rates. Its refinancing rate is now only 10.25 percent a year, significantly less than inflation. Russia's high prices should also be fought with deregulation.

Russia is not alone in this dilemma: Several other countries in the region suffer from similar ailments with renewed double-digit inflation, notably Kazakhstan, Ukraine, and Latvia. Yet Russia must act soon to cool its overheated economy and combat its inflation before more serious financial problems arise.