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. Last Updated: 07/27/2016

It Doesn't Add Up

Of all the transition economies, Russia has been among the last to begin a recovery. Russia's late start made the good news about the 2000 economy all the more welcome: Real gross domestic product grew by more than 7 percent, inflation fell to about 20 percent, the ruble was stable throughout the year and the government's budget moved from deficit to surplus. The question of the day is, do these figures mark a sustainable, long-term expansion, or were they simply the result of a lucky combination of fleeting circumstances?

In 2000, thanks to strong world oil prices, Russia enjoyed a surplus of exports over imports of about $45 billion. Of that amount, the Central Bank added about $20 billion to its hard-currency reserves. The remaining $25 billion or so was spent by Russian firms and individuals to buy foreign assets or on other forms of what is popularly called "capital flight." Unfortunately, continued growth of hard-currency reserves in combination with large-scale capital flight is not consistent with long-term real output growth, low inflation and a budget surplus. Something will have to change — but what?

Suppose that energy prices stay high and the ruble is held near its current level of about 28 to the dollar. To keep the ruble from strengthening, the Central Bank must continue, like last year, to buy up all the surplus dollars that come on the market, adding further to its hard-currency reserves. But adding to reserves in this way has an unwanted side effect, in that the rubles used to buy the dollars increase Russia's domestic money supply. From January 2000 to January 2001, the money supply increased by some 62 percent.

It is a well-established principle that in the long run, an increase in the money supply will lead to a proportional increase in price levels, except to the extent that the money is absorbed by real output growth. So why was inflation in 2000 just 20 percent, rather than the 55 percent that we 7 growth from a 62 percent jump in the money stock?

The answer is that the rate at which money circulated through the economy — what economists call "velocity" — slowed at the same time the quantity of money increased, thereby easing inflationary pressure. The slower velocity, in part, reflected greater public confidence in the ruble. Because inflation was moderate and the exchange rate was stable, people did not rush as quickly to convert every ruble they earned into dollars or to spend it on goods. The slowing of velocity also reflected a greater demand for money in the business sector as the share of trade conducted by barter fell and the use of cash increased.

Preliminary data suggest that velocity has already reached a value below seven in the first quarter, almost down to the record low of 6.5 in early 1998. But at that time, the annual rate of inflation was less than 10 percent. If we go back to the last previous year of 20 percent inflation, velocity was about seven. On the whole, then, it seems unrealistic to expect velocity to fall much more this year.

Without the help of falling velocity, the Central Bank can't afford to let the money stock grow by another 60 percent in 2001. Inflation would soar. But there are few other options available for absorbing the extra dollars entering the economy as a result of the huge current account surplus. Diverting some money from the budget to pay off Paris Club debts will help a little, but not enough. If oil prices remain high, the only real way to avoid increased inflation is to let the ruble appreciate, perhaps to 25 per dollar, perhaps even stronger.

Unfortunately, having to choose between inflation or a strengthening of the ruble puts the Central Bank between a rock and a hard place when it comes to developing the real economy. Over the past two years, one of the main engines of recovery has been import substitution fueled by the big devaluation of 1998. But import substitution will stop if inflation pushes up Russian wages and production costs while the exchange rate remains unchanged, or equally, if inflation remains moderate but a strengthening exchange rate makes imports cheaper in ruble terms.

One or the other of those alternatives seems bound to happen in 2001. Economists use a concept called the trade-weighted real exchange rate to measure the competitive position of domestic goods relative to imports. The real exchange rate depreciated by about a third after the 1998 crisis, working the magic of import substitution. However, inflation has since eroded about half of that gain.

Assuming that oil prices stay high, either a strengthening of the ruble or an acceleration of inflation will probably wipe out the last of the advantage by the end of 2001.

Of course, oil prices might very well fall. But a drop in oil prices would have its downside, too. The government's budget would swing back into deficit. Servicing Russia's foreign debt would become far more difficult. And it would become harder to find the funds needed to renew the country's crumbling infrastructure or combat its looming demographic problems.

We began by asking whether the economic gains of 2000 are sustainable. It looks very doubtful that they are. In 2001, either inflation will accelerate, or growth will slow, or oil prices will crash, or maybe even all three. The numbers just don't add up any other way.

Edwin Dolan teaches economics in the MBA program of the American Institute of Business and Economics in Moscow. He contributed this comment to The Moscow Times.