Summer of Nice Weather and Robust Recovery

As Muscovites start to wind down for the summer and their attention turns to relaxing at the dacha, little do they realize that the Russian economy is seemingly shifting beneath their feet. When they return to the normal regime in September as schools open again, they may not recognize where they are.

In the spring, Russia seemed to be a laggard. First-quarter real growth was estimated at 2.9 percent, following upon a plunge of 9.7 percent in 2009. To call this a recovery seems like a stretch, especially in comparison with the other vibrant BRICs such as China. Even Europe and especially the United States were lauded by the Organization for Economic Cooperation and Development in January as it raised its forecasts for those economies. Stock markets were anticipating a V-shaped recovery.

Now as we proceed into summer, the specter in advanced economies has suddenly shifted to serious concern with the famous “double-dip” recession. Wall Street has plunged almost 15 percent since late April. As U.S. unemployment remains at high levels, most economists predict anemic growth at best. Japan is in deflation, and Europe is increasingly mired into a debt-induced recession. As global investors flee from risk, U.S. Treasury bonds have again become the safe-haven asset.

Meanwhile in Russia, the sluggish first half of 2010 may turn out to have been an illusion — at least in part. Since the data are being rebased, comparisons with last year are misleading until the State Statistics Service completes the changes. But real indicators such a rail traffic and construction materials are booming. Prospects for the second half of the year are surprisingly positive. There is thus a high probability that Russians will be returning from their dachas at the end of the summer to a torrent of increasingly positive economic news. UBS is forecasting 2010 real growth of 7.5 percent, and even the staid OECD raised its forecast in late May to 5.5 percent for Russia.

Why is Russia decoupling? First, it is a low-debt economy so there is plenty of room for credit to expand. Second, savings are relatively high at nearly 29 percent of gross domestic product. The sharp drop in public savings last year was offset to some extent by an increase in the private sector saving rate. With falling inflation, higher real returns and a stable ruble, there is a much better chance for these savings to be invested in the domestic economy. Third, in the past few quarters Russian broad money aggregates have shown a rapid recovery as capital returns to the economy, and this is particularly evident in ruble deposits.

This does not imply smooth sailing, however. Russia and the other major emerging market economies are not really decoupled. As 2008 made clear, the globalized economy is too interdependent for a country like Russia to remain oblivious to the deteriorating prospects in the advanced economies. The likelihood of lower and more volatile oil prices is just one critical aspect that should advise caution as the draft 2011 budget and spending plan to 2013 are being finalized. An oil price assumption of $75 per barrel for 2011 seems imprudent in this environment, even if longer-term prices are likely to rocket.

The real dilemma for Russia and the three other BRIC countries is the inconsistency of policy priorities with the advanced countries. If the summer does confirm continuing sluggishness in the West, then central banks, notably the Federal Reserve and the European Central Bank, will endeavor to maintain a very loose monetary policy. This wall of liquidity may at best provide a floor against deflation, but it will flood into those markets with higher yields in real terms. We already see significant money flows into emerging markets. This will continue causing excess liquidity that will either provoke inflation — as we are seeing in Brazil — or exchange rate appreciation.  

These “hot-money” flows, in turn, imply greater vulnerability for a country like Russia since any bad news could trigger the mass exit of local depositors from ruble assets, which was a crucial and unique aspect of Russia’s dramatic 2008-09 downturn.

In fact, by virtue of its totally convertible currency since June 1, 2006, Russia maintains a more open external capital account than the rest of the BRICs and is thus more susceptible to swings in capital flows. It was precisely these flows that drove the collapse of domestic liquidity during the onset of the crisis.  

The International Monetary Fund does not believe that the ruble at current levels is overvalued, but if the pressure from budgetary spending and high oil prices is exacerbated by capital inflows, an overly strong ruble might eventually be the consequence. The IMF has even suggested that capital controls might be useful in the Russian context, but I disagree. They didn’t work in 1998 and wouldn’t work now. Given the population’s long memories of monetary confiscation, the mere prospect of controls would send Russian capital into flight.

Assuming that oil prices remain close to current levels, the issue in Russia is not going to be if the economy will grow but rather will the economy overheat. But the better the news coming out of Russia, the more money that will be flooding in, complicating the management of economic policy.

Thus, the key problem will be to rein in a budget that has been loosened massively, with the government now spending about $100 billion annually more of its oil and gas export revenue than during pre-crisis years, when it put a very sizeable part of its oil and gas revenue into foreign-invested state funds. This is a demand boost of Chinese proportions, and given that it comes at the expense of savings abroad, this puts pressure on the currency to appreciate.

In addition to a tighter fiscal policy, the Central Bank should continue to lower its deposit rates and use monetary instruments to discourage inflows. A priority should be to encourage the development of domestic capital markets and strengthen regulatory requirements. In the longer term, highly indebted advanced economies will probably keep lax policies in place for too long, leading to global inflationary pressures. There may be little that Russia alone — or even in consort with China, India and Brazil — can do to prevent this development. After all, we still live in a world where the financial system is still controlled by the debtors.  

Eventually, the new creditors will assert themselves to ensure that their money is used on their terms. Perhaps Muscovites should use this summer break to prepare better for the coming tectonic shifts.

Martin Gilman, former senior representative of the International Monetary Fund in Russia, is a professor at the Higher School of Economics.

See also:

Russian Central Bank Lowers Key Interest Rate

Putin Says No Privatization at Knockdown Prices

Kremlin Denies 'Collapse' as Ruble Plunges to New Record Lows