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. Last Updated: 07/27/2016

Becoming a Motor of the Global Economy

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The International Monetary Fund's latest annual report on Russia describes a remarkable trajectory no less exceptional than that of post-World War II Germany or Japan.

Russia's contribution to world growth, in terms of purchasing power parity, will be half as large as that of the entire European Union and much higher than Japan's or Brazil's, the report says.

"Russia's macroeconomic performance continues to impress. Much is owed to high oil prices and large capital inflows but also to good economic management. Most important in view of the dependence on oil prices, the stabilization fund is providing a notable measure of stability," the report says.

The IMF goes on to underscore the factors behind this success: "High oil prices and sound fiscal policy underlie Russia's long spell of robust growth."

It attributes this growth to the country's still considerable catch-up potential, as resources are reallocated to more dynamic sectors in the economy. "The resulting nexus of strong productivity growth, rising real incomes and higher consumption has been a key source of self-sustaining growth, especially in recent years as capacity constraints have slowed energy exports," it says.

Indeed, the IMF explains that gross domestic product growth has strengthened and become better balanced. But it goes on to note that although the ruble is still undervalued in real terms, competitiveness is eroding.

The IMF also confirms that Russia's external vulnerability is low by most measures. It is as if Finance Minister Alexei Kudrin and Central Bank chief Sergei Ignatyev, having taken the lessons of the 1998 financial crisis to heart, have ensured that the country has impeccable security provisions and margins of safety.

With foreign exchange reserves now at almost $450 billion, Russia's reserves stand at 400 percent of short-term debt, which is higher than any emerging-market economy except for China and India. And in terms of another indicator of precaution -- reserve coverage relative to broad money, or money supply including ruble bank deposits -- Russia has the highest of all emerging-market economies at about 80 percent; China and India are at about 25 percent.

Of course, the IMF has its concerns, most of which seem justified. These pertain chiefly to the relatively low level of investment, the uncertainty in the investment climate, the back-loading of spending cuts in the medium-term fiscal plan and the need to remove legislative and regulatory obstacles to the future development of the financial sector.

But the IMF's major preoccupation is inflation -- and with good reason. The IMF observed that the decline in inflation halted after March; it was cut in half from almost 14 percent in April to 7.4 percent in March. In fact, since the IMF report was issued, the inflation situation has deteriorated.

Inflation rose last month by 1.6 percent, which brings the 12-month inflation rate to 10.9 percent. Food inflation was 3.3 percent in October (13.5 percent for the 12-month period). The price surge can be partially explained by the exceptionally large increases for some food products: In October alone, vegetable oil rose by 26.3 percent and butter by 12.7 percent. Global food-price inflation is of course outside the control of the authorities and presents a worldwide challenge.

Food-price growth, however, is not the only reason for the acceleration in inflation. For instance, the services price index has risen even faster over the 12-month period.

As much as the Central Bank would like to place the blame on world agriculture, they cannot ignore Milton Friedman's insight that "inflation is always and everywhere a monetary phenomenon." Generally, the price level cannot rise unless fed by an accommodating monetary policy.

Sure enough, monetary policy has been lax with negative real interest rates, and money supply has been explosive: Ruble broad money rose by 52 percent in the year to the end of October.

Consistent with classical monetary theory, the IMF is convinced that rapid appreciation of the nominal ruble is the only available tool for disinflation. Although, in principle, there is a tradeoff between control of the money supply and a relatively fixed exchange rate, in fact, it may not be so simple. The problem is that guaranteed ruble appreciation encourages capital inflows, including foreign borrowing, which, in turn, accelerates money supply growth. Unlike the oil trade surplus, these inflows are not sterilized into the stabilization fund.

This is exactly what happened when the Central Bank inadvertently encouraged a massive increase in capital inflows by stating its view that the ruble should strengthen, which effectively created a "one-way" bet by speculators. The accelerated money-supply growth clearly created inflation potential and turned into an actual acceleration of inflation in the period from August to October, triggered by higher global food prices.

The law of unintended consequences thus asserted itself as the Central Bank's policy of ruble appreciation effectively helped "import" the current bout of inflation. The IMF, in recommending that "keeping inflation on target would require returning to a more flexible exchange rate," has no easy remedy for avoiding a feeding frenzy by speculators on an appreciating ruble.

That said, it would be hard to argue with the IMF and others that the ruble is set to appreciate in the long term, certainly in real terms. The question is how fast and whether nominal ruble appreciation is desirable in view of the one-way bet problem. After a hiatus in the third quarter owing to global financial market tensions, renewed capital inflows are again fueling reserve growth. And this will continue to translate into loose monetary conditions.

Clearly this is unsustainable, and the Central Bank will have to adjust its policy to control the surge in inflation soon. We have already seen a sharp drop in the dollar in recent weeks in ruble terms, while the euro strengthens. Eventually, the Central Bank will have to introduce more flexibility into the ruble around an appreciating trend. The IMF is unlikely to be satisfied by the pace.

Overall, the IMF assessment of Russia is almost overly positive, attributing perhaps too much importance to internal factors. Of course, things could go wrong, but this is unlikely since the new government has been strengthened recently with the addition of several smart and competent ministers.

The more likely major influence in the next couple of years will be from outside, where a more volatile and recessionary global economy could upset even the best plans of a government trying to pursue growth in the context of financial stability.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.