Inflation's Sun Spots Stain Economic Successes
- By Anders Aslund
- Jun. 25 2008 00:00
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The economic boom has been extraordinary. In the 15 former Soviet republics, average growth for the last nine years has been no less than 9 percent per year. But paradise always comes to an end. Today's original sin is inflation, but suffering varies with policy choice. Macroeconomic policy matters.
This magnificent expansion has proven that capitalism works. Open markets, stable prices and private enterprises sparked economic growth. But the benign conditions allowing this growth -- underutilized production capacities and infrastructure, as well as overqualified and underemployed labor -- have been used up. Food and energy prices are skyrocketing throughout the world, and qualified labor has never been better paid. The world as a whole, but especially the post-Communist region, is facing economies that are overheated.
Eventual social costs will depend on how skillful governments are in their macroeconomic policies. Once again, Leo Tolstoy's words in "Anna Karenina" are proving true -- "All happy families are similar, but every unhappy family is unhappy in its own way." The successes are remarkably similar, while the miseries differ.
The old sin was excessive public expenditures that led to big budget deficits. Only one formerly socialist country has committed this elementary mistake, namely Hungary, which is already being punished with a minimal annual growth rate of 1 to 2 percent. All other governments have learned from Russia's financial crash of 1998.
Until last year, Kazakhstan was a star performer with a steady growth rate of 9 to 10 percent a year. But its commercial banks have borrowed too much abroad, boosting inflation to 18 percent. When international interest rates rose, their debts became untenable. Although none of them has gone under, these banks had to tighten their belts, and so has the country. Growth in gross domestic product has fallen by half to some 5 percent, but Kazakhstan's abundant oil revenues safeguards such a soft landing.
Estonia and Latvia have been the greatest economic successes, but even the sun has its spots. They have fixed their exchange rates to the euro. Therefore, their domestic prices have risen with increasing productivity in the export sector, and they have imported substantial inflation -- currently 18 percent in Latvia and 12 percent in Estonia.
With their fixed exchange rates, these countries cannot pursue any monetary policy, and their huge current account deficits have been financed by foreign direct investment and bank loans. Suddenly, the foreign banks that own the Baltic banks have minimized their loans. Demand, consumption and real estate prices have fallen. The double-digit growth rates have plummeted to 2 to 3 percent. The question is how large bad debts will be revealed, but so far the Baltic states seem to take the hit well. As in Kazakhstan, their success story is likely to re-emerge.
Romania looks worse. As in the Baltic countries, it has a big current account deficit, but it has predominantly been financed with foreign bank loans, which are now drying up, and its budget deficit of some 3 percent of GDP is excessive. So far, its salvation has been its floating exchange rate and an independent central bank that pursues a strict monetary policy, but Romania's growth will suffer.
Ukraine looks worst of all. Its inflation has just reached 31 percent a year, although its state finances are in excellent shape and its growth rate stays at 7 percent. Ukraine's outsized inflation is caused by its Central Bank, which, for some reason, insists on a dollar peg unlike all other countries in the region. Since the dollar has fallen 13 percent in relation to the euro in a year, Ukraine has imported about that much inflation. Furthermore, the Central Bank maintains a refinance rate of only 16 percent, which means a negative real interest rate of 15 percent, an extremely expansionary monetary policy.
Consequently, Ukraine's money supply has ballooned by 56 percent in the last year, as foreign banks lend their subsidiaries in Ukraine excessive amounts, because they can finance their credits at about 5 percent a year abroad and lend in Ukrainian hryvna for 40 percent a year. This folly must end. The obvious solution is to let the exchange rate of the hryvna float freely to impede both the importation of inflation and speculative currency inflows.
Three countries have successfully withstood the current inflationary test -- Slovakia, Poland and the Czech Republic. Their present annual inflation is a moderate 4 to 7 percent, and their high growth rates continue. These countries all pursue inflation targeting, which means that their independent central banks focus on keeping inflation within a low target band, while maintaining tight monetary policy with positive real interest rates. Hence, their floating exchange rates have risen significantly in relation to the euro.
Russia's inflation is too high at 15 percent, and its macroeconomic policy is unbalanced. It relies too much on fiscal policy and too little on monetary and exchange rate policy. The country's inflation is driven by the large current account surplus, and the Finance Ministry has wisely balanced this surplus with a sound fiscal surplus to hold back inflation, but currently public expenditures are rising sharply.
For years, the Central Bank has stated its intention to move to inflation targeting within three years, but it never does. It still pegs its currency to a basket of euros and dollars, although it should be floating the ruble, and the Central Bank maintains a negative real interest rate of 4 percent a year, which guarantees an excessive monetary expansion. The bank should follow the good Central European example and move to inflation targeting immediately to escape the dangers of rising inflation.
Strangely, no international institution speaks up in this inflationary crisis. A decade ago, the International Monetary Fund would have provided authoritative advice, but it has fallen on hard times. Currently, it is directed by a French socialist concerned about declining growth, which is an inevitable development at the end of a boom, while being remarkably relaxed about inflation, which is the real concern. The IMF does not even criticize detrimental dollar pegs, seemingly afraid of disturbing the U.S. Treasury, which fears the dollar will plummet. Nor does it call for positive real interest rates. Each country is on its own.
As in 1998, fixed exchange rates today are wrong, but then the problem was overvaluation, now it is undervaluation leading to excessive inflation.
Floating exchange rates, balanced budgets and inflation targeting are the current victors, while any fixed exchange rate is detrimental -- worst of all any fixation to the sinking dollar. The lesson for Russia is to let the ruble float freely and to tighten its monetary expansion to control inflation.
Anders Aslund, a senior fellow of the Peterson Institute for International Economics, is the author of "Russia's Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed."