Don’t overcook the recovery

As Muscovites start to wind down for the summer and their attention turns to relaxing at the dacha, little do they realise that the Russian economy is seemingly shifting beneath their feet.

In the spring, Russia seemed to be a laggard. First-quarter real growth was estimated at 2.9pc, following a plunge of 9.7pc in 2009. To call this a recovery seems a stretch, especially in comparison with the other vibrant Brics such as China. Even Europe and especially the US were lauded by the Organisation 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 head into summer, the spectre in advanced economies has shifted to serious concern with the famous “double-dip” recession. Wall Street has plunged almost 15pc since late April. As US unemployment remains at high levels, most economists predict anaemic growth at best. Japan is in deflation, and Europe is increasingly mired into a debt-induced recession.

Meanwhile, in Russia, the sluggish first half of 2010 may turn out to have been an illusion – at least in part. Real indicators such as rail traffic and construction materials are booming. UBS is forecasting 2010 real growth of 7.5pc, and even the OECD raised its forecast in late May to 5.5pc for Russia. There is thus a high probability that Russians will be returning from their dachas to a torrent of increasingly positive economic news.

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 29pc of gross domestic product. The 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 rouble, there is a 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 rouble deposits.

This does not imply smooth sailing, however. As 2008 made clear, the globalised economy is too interdependent for a country such as Russia to remain oblivious to the deteriorating prospects in the advanced economies.

The real dilemma for Russia and the 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 endeavour to maintain a 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. This will continue causing excess liquidity that will either provoke inflation – as in Brazil – or exchange rate appreciation.

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

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.

The key problem will be to rein in a budget that has been loosened massively, with the government now spending about $100bn annually more of its oil and gas export revenue than pre-crisis, when it put a sizeable part of its oil and gas revenue into foreign-invested state funds.

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.

Previously published in The Moscow Times

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