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Saturday, July 12, 2008

Russia's Consumption-Driven Inflation: Will It All End In Tears?

Russia's inflation rate remained tantalisingly frozen at its highest in more than five years in June as energy and food prices continued to move on upwards. Russian consumer prices were up 15.1 percent from a year ago - matching the rate in May- according to data released earlier this week by the Federal Statistics Service.

As a result he Russian government is struggling to bring inflation down towards it's 10.5 percent target after increased income from rising global energy prices boosted domestic demand and made possible 300 billion rubles ($13 billion) of extra government spending on items like pensions and state wages in the run up to last December's elections. The result has been a massive surge in consumer spending and construction activity which has pushed the rate of expansion in the Russian economy above its long term "comfort" capacity level.

In this post we will look at the general macro economic situation of the Russian economy, and we will see that, with output in the resource sector effectively at or near its peak, the main drivers of Russian growth are now construction and domestic consumption. Since long term labour supply issues mean that Russia is unable to comfortably grow at its current rate of expansion the end product is rising inflation and structural distortions in the development of the manufacturing sector. Policy limitations at the level of fiscal demand management and exchange rate adjustment mean that this whole process is only being accelerated rather than contained and as a result the living standards improving boom could easily, under unfavourable circumstances, be converted into precisely its opposite: an impoverishing bust.

Inflation Hits the Poor Hardest

Welcome as the current rises in living standards are in a comparatively poor country like Russia (see dollar wage chart below), inflation running at the rate Russia now has is certainly not to be sniffed at.

The price of bread has risen 41 percent since June last year, pasta is up 51.3 percent, and milk 35.3 percent. Month on month, petrol costs rose 4.3 percent compared to a gain of 3.5in May. World Bank research suggests that the impact of the world food price shock on Russia has been significant, and has greatly complicated disinflation efforts. In particular the poor (and the poorest regions) have been disproportionately affected. Over the past 5 years, food prices in the Russian Federation have grown much faster than non-food prices. Food price rises accounted for some 82 percent of the overall rise in CPI between July 2007-March 2008, with food prices rising, on average, almost 15 percent (see chart below).

(Please click on image for better viewing)

Contrary to a widespread perception that food inflation mainly affects the more prosperous regions, data from the World Bank shows that food priceshave increased the most in the Volga region, and least in the Far East Federal Okrug. In general, food inflation in western Russia has been higher than in the eastern regions. But the World Bank’s preliminary simulations of the poverty impact of this food inflation shock (based on the international poverty line of $2.15 per day) suggests that, other things being equal, the food price spike could raise Russia’s overall national poverty and vulnerability rates by 1.2 and 4.3 percentage points respectively—resulting potentially in 1.7 million more people in poverty and an additional 6 million vulnerable to poverty, respectively.

Overheating A Problem

At the same time there is now extensive evidence that the Russian economy is overheating. The IMF in their June 2008 Article IV Consultation Report mention three factors: i) the fact that inflation has almost doubled over the past year and now extends well beyond food and energy price increases; ii) domestic demand is increasing at an annual rate of 15 percent in real terms, while GDP is growing at 8 percent, a rate which is somewhat above the level that can be maintained without causing accelerating inflation, according to estimates by both Russian and IMF experts; iii) resource constraints have now become strikingly evident in labor markets, where shortages are causing real wage increases of about 16 percent annually, well above growth in labor productivity (see chart below), and unit labor costs are now rising steadily. Domestic resource constraints are also evident in the rise in import volume growth to almost 30 percent annually.

The World Bank basically take a similar view, and point out that the Russian Economic Barometer index of industrial capacity utilization has risen from 69 in 2001 to 81 in March 2008 (with 42 percent of the firms surveyed for the index reporting utilization of over 90 percent). Also, an index of labor utilization has increased from 87 to 94 with three quarters of firms showing utilization rates of over 90 percent. Meanwhile unemployment was running at 6.1 percent at end of 2007 - its lowest level since 1994.

Systematic Labour Market Tightening

Unemployment has been falling steadily since 2003, while real wage growth has been accelerating beyond labour productivity growth since 2004. Aggregate unemployment statistics for the first quarter of 2008 present a picture of continued tightening in the labor market. The average unemployment rate (using the ILO definition) was estimated at 6.6 percent for the quarter. This compares with 7.0 percent during the first quater of 2007 (see chart below for a month by month breakdown).

The level of unemployment, however, varies significantly from region to region, and reflects the large differences which exist in the underlying levels of economic activity. In 2006, for example, the lowest unemployment was registered in the Central Federal Okrug (4.1 percent), and the highest in the Southern Federal Okrug (13.7 percent).

At the same time Russia's robust economic growth has been accompanied by double-digit increases in real incomes and wages. According to Rosstat, average real wages and real disposable incomes increased by 13.1 and 11.8 percent, respectively, during the first four months of 2008.

This growth in real wages and incomes, however, significantly exceeda real GDP and productivity growth, giving yet one more sign of the presence of overheating, and indicating the possibility of producing long term structural damage. Almost all sectors of the economy have been reporting increases in real wages well above 10 percent level, with the largest gains taking place in the public sector, and in retail trade and construction (16-17 percent). The average monthly dollar wage was standing at 649.4$ in the first four months of 2008, an increase of 41 percent over the same period of 2007. This massive rise partly reflects real wage increases, partly inflation and partly nominal appreciation of the ruble against the dollar.

Russians have by now become accustomed to very rapid real income growth - of the order of 15% a year. This is more than twice the recent growth rate in labour productivity (see chart above). In one respect, this disparity has been sustainable: since oil prices have risen strongly, rapidly improving terms of trade have allowed real aggregate demand to outpace the growth of domestic production. However, this does not negate or ameliorate the problem of rapidly rising unit labour costs, or the knock on consequences for the real effective exchange rate, or the difficulty presented by distorting Russia's economic development towards resource extraction and away from the development of a healthy manufacturing industrial base. Also Russians, as I say, are becoming accustomed (and ill accustomed) to such ongoing increases, irrespective of whether they are sustainable, or justified by rising productivity, and this "detach" from the underlying reality in the mind of the average worker is in and of itself a worrying development. Thus reports of strikes and other worker protests indicate increasing worker activism in pursuit of higher pay or other benefits are now becoming commonplace. This is not surprising, as shortages of skilled labour are now becoming quite general, and the overall pool of manpower is on the verge of shrinking as Russia's population enters long term decline.

Meanwhile Russia’s short-term economic growth has been steadily accelerating above its long term trend. In 2007, the economy grew by 8.1 percent on the back of higher global oil prices, robust domestic demand and strong macroeconomic fundamentals. Preliminary data indicate an even faster real growth in GDP (8.7%) and industrial production rising by an annual 6.2 percent in the first quarter of 2008. Again the monthly Key Economic Activities index prepared by the Bank of Russia gives us a pretty clear snapshot.

Fiscal Concerns

One of the problems which both the World Bank and the IMF draw attention to is the way in which domestic demand pressures are being exacerbated by the presence of a procyclical fiscal policy. Ideally, with inflation roaring away, the economy showing strong signs of overheating and monetary policy having inherent limitations, fiscal surpluses are the only effective bulkhead available for restricting the long term damage that an extended period of over-capacity growth might cause.

Recent experience, however, raises serious doubts about the ability of those administering the Russian economy to appreciate the importance of this point. Primary expenditures by the Russian federal government were up by 15 percent in real terms in 2007, while the non-oil deficit - excluding a one-off collection of tax arrears from Yukos - rose by 0.8 percent of GDP. And a further relaxation in the fiscal stance is underway this year.

While it might be argued that the relaxation is limited in comparison with the size of the share of taxes from the oil and gas sector that are being saved as reserves against the future, there is little justification for any kind of fiscal loosening at a time when strong private demand and rapidly raising food and energy prices are already sending inflation through the roof.

The general government surplus declined to 6.1 percent of GDP in 2007, from over 8 percent in 2005-2006. There is also a growing vulnerability of the budget with respect to oil revenues. The fiscal surpluses continue in 2008, but they are coming down fast, making any disinflation process much harder. According to preliminary estimates for the first quarter of 2008, the Federal Budget generated a surplus of 549 billion rubles, or 6.6 percent of GDP on a cash basis, compared to 7.3 percept surplus during the same period of 2007. Record high oil prices helped the Russsian government generate 1.932 billion rubles (or 23.4 percent of GDP) in Q1, and these exceeded by a considerable margin the revenue target stipulated in 2008 Budget Law (20.7 percent). Federal Government spending has so far totaled 1.383 billion rubles, or 16.7 percent of GDP on a cash basis, compared to 17.7 percent stipulated in the Budget Law for 2008, but pressures are building up to spend additional windfalls on the oil account without paying too much attention to the likely impact on inflation of doing so.

The recent revision to the 2008-2010 three-year federal budget envisages further relaxation in the fiscal stance. In February 2008, the government approved the amendment to the 2008 Budget Law that foresees an increase in noninterest expenditures by 310 billion rubles and a further decline in projected fiscal surpluses to 3.0 percent of GDP in 2008, and to only 1.0 percent in 2009-2010. Non-oil deficit is projected to be about 6 percent of GDP in 2008-2009, and 5.1 percent in 2010, and this will mostly need to be covered by transfers from the oil and gas account.

Structural Distortions In the Economy?

The structure of Russian real GDP growth has shifted significantly towards non-tradeable sectors in recent quarters, partly reflecting booming domestic demand and the appreciating real effective exchange rate of the ruble. There has decline in the relative importance of resource extraction - oil output has stopped rising, and was 1% down year on year in June - and an increasing dependence on imports and construction. In the earlier years of this century, and in particular during 2003-2004, oil and some industrial sectors were the key engines of economic growth. From 2005 onwards, however, the expansion has largely been driven by non-tradable services and goods production for the domestic market, including manufacturing goods. In 2007 the wholesale and retail trade alone accounted for almost a third of the overall economic growth. Booming construction and manufacturing contributed another 30 percent. Within the industrial sector, manufacturing - which is largely directed towards the domestic market - was a key driver, expanding by 7.4 percent in 2007, compared to only 2.9 percent in the previous year. In contrast growth in the resource extraction industry has virtually ground to a halt, reflecting binding capacity constraints and the comparative remoteness (and cost) of new deposits.

The World Bank in a 2007 study entitled “Unleashing Prosperity: Productivity Growth in Eastern Europe and the former Soviet Union” documented how Russia had experienced a strong productivity surge over the period 1999-2005, a surge which significantly increased headline economic growth at the same time as raising living standards. Total factor productivity growth of 5.8 percent was the motive force behind annual average GDP growth in the region of 6.5 percent. In part this productivity surge is explained by the utilization of excess capacity, but it is also attributable to major structural shifts in the economy and the reallocation of labor and capital to more productive sectors. In addition, efficiency gains within firms were found to have accounted for 30 percent of the total growth in manufacturing productivity over the period 2001-2004. Firm turnover (entry of new firms and exit of obsolete ones) accounted for 46 percent of manufacturing productivity growth. The main contribution to manufacturing productivity growth came from the exit of obsolete firms, releasing resources that could be used more effectively by new or existing firms. However, as we have seen, this minor productivity revolution has been steadily losing steam since 2005, and the new growth drivers in the non-tradeable sector are by no means as forthcoming in terms of productivity benefits.

Changes in the output indices by sector paint a similar picture, with the non-tradable sectors - construction and retail trade - growing particularly rapidly. During 2003-2007 construction and the retail trade reported very high average annual growth rates of 14.5 and 13.0 percent, respectively. This tendency accelerated further in the first four months of 2008. The rate of annual increase slowed slightly in April to a provisional 13.2%, but the January to April average is 15.7% (see chart below).

Growth in these two sectors - construction and retailing - have been increasingly outpacing the rest of the economy, and as the tightening capacity constraint factor has locked-in industrial expansion has become less and less driven by extraction industries, with new growth now being almost entirely a product of the manufacturing sector.

The detailed manufacturing data for the first four months of 2008 show robust growth across a whole range of manufacturing subsectors. The leading manufacturing sectors were rubber and plastics, both of which are products that feed directly into the domestic construction and durable goods boom. Rubber and plastics were growing by more than 30 percent per annum in the first four months of 2008, compared to 13 percent a year earlier. The production of machines and equipment also continued to expand rapidy, in this case by more than 20 percent. Some manufacturing industries, however, have been reporting lower growth rates. The production of electro-technical equipment, the food industry and chemical products, for example. While the overall picture shows dynamic manufacturing growth, the World Bank concludes that rising unit labor costs and an appreciating real effective exchange rate may well be behind the lower growth in some manufacturing subsectors, and indeed it would be surprising if they weren't in cases where import substitution is a viable alternative.

Foreign Direct Investment Remains Strong But Excessively Concentrated

Fixed capital investment in Russia has been growing in recent years (see chart below) although investment as a proportion of GDP (21% in 2007) remains relatively low in comparison with those sustained in other emerging market economies. For example, Korea (38 percent), China (42 percent) and India (34 percent) have all maintained significantly higher rates of investment over quite long periods of time (1980-2007). In addition the bulk of investment activity continues to take place in resource industries, and transportation and communication services. The share of the resource sector rose to 17.3 percent of the total in 2007 (up from 15.2 percent in 2005), while manufacturing industries have reduced their share to 15.7 percent in 2007 (from 17.6 percent in 2005).

Simply put Russia does not appear to be investing in industries that could eventually lead to a more diversified economic structure. On the back of the rapid increase in energy prices Russia has received large quantities of direct foreign investment, but the composition of Russia’s FDI has, over the past three years, shifted towards extraction industries. In 2007, for example, extraction industries received around 50 percent of total FDI inflows, while manufacturing received only 15 percent. Recent estimates from Rosstat show FDIs in the first quarter of 2008 running at only USD 5.6 billion, more than 50 percent down on the corresponding period of 2007. The structure of FDI also changed in the first quarter of 2008 with investments in the electricity, gas and water supply sectors shooting forward to receive a third of the FDI inflow (USD 1.9 billion) - reflecting new investments into TGK (teretorialnaya generiruushaya kompania) and OGKs (optovaya generiruushaya kompania) electricity generating companies - while the manufacturing share of FDI continued to decline (falling to 13.1 percent of the total in Q1 2008).

Monetary Policy and Ruble Appreciation

Russia registered record net capital inflows into both banking and non-banking sectors throughout 2007, significantly raising liquidity in the domestic economy. These flows reflected a mixture of comparatively strong fundamentals, an appreciating ruble, and a low perceived external vulnerability. The also helped maintain dynamic growth in the banking sector, while facilitating an ongoing rise in consumer credit. Despite continuing accumulation by the oil Reserve and National Welfare funds the Russian central bank was unable to fully sterilize the domestic monetary impact of the oil revenues and the capital inflows and there was a rapid growth in the money supply (up 44 percent in 2007) - this is way above the levels of nominal income growth and this has obviously contributed significantly to inflationary pressures.

Russian monetary policy effectively remains hamstrung by an excessive focus on stabilizing the ruble in terms of a euro-dollar basket. At the present time the ruble is allowed to trade within a given band versus the basket - which is made up by 55 percent dollars and 45 percent euros - with the objective of avoiding gains which are thought liable to hurt the interests of Russian exporters. But this policy is now under tremendous strain the rapid rise in the money suppy which this is producing fuels an inflation process which is now increasingly out of control. Indeed it is partly the feeling that the non-sustainability of this position will eventually lead to ruble revaluation which is encouraging some of the inflows - which amounted to a total of $82 billion in 2007 alone.

In order to maintain the trading band the Russian central banks buys and sells the ruble on a daily basis, as a result ruble appreciation has been fairly limited, and the currncy only gained 0.2 percent against the dollar and 0.4 percent against the euro in the second quarter.

The pressure is obviously now on, and central bank Deputy Chairman Konstantin Korishchenko indicated at the end of June that Russia may expand the ruble trading band by as much as 5 in the near future. The aim is explicitly to deter speculation, since Korishchenko's main argument was that the wider range would make it costlier for traders to limit losses should bets go the wrong way.

It is evident that the Russian authorities need to find some way to tighten monetary policy. One route to achieving this object can be to allow for greater exchange rate flexibility, although it is important that this is done sooner rather than later, since the longer the present rate of inflation is allowed to continue the greater the risk of a sharp downward correction in a free floating ruble should we see an easing in the currently very high level of energy prices (which if maintained will almost certainly slow global growth considerably in 2009) and the Russian external balance deteriorate on the back of a non-competitive manufacturing export sector. At that point the win-win dynamic of capital inflows driven by appreciation expèctations could turn into its opposite.

The recent increases in policy rates and reserve requirements does not constitute significant tightening. The commitment on the part of the Russian central bank to move to formal inflation targeting, once it believes the conditions for such a framework are in place, is a positive step (if one fraught with risk in terms of central bank crredibility) under current inflation conditions, but this does not imply there is not an urgent need to refocus monetary policy on immediate inflation reduction. For the sort of structural reasons outlined in this article a major reduction in credit growth and higher real interest rates are essential - and unavoidable - at the present time.

Oil Dependence and An Ageing Population - The Long Term Risk

In the short term the Russian economy only seems to go from strength to strength. Russia's trade surplus is estimated to have expanded again in May (results due out this week) from April as the world's largest energy exporter benefited yet one more time from record oil prices. The surplus is likely to be in the region of $18.6 billion, compared with $15.5 billion in April and $12.2 billion in May, 2007.

At the same time the price of Russia's Urals crude continues to touch all time highs (it averaged $106 a barrel in the year through July 2, compared with $60 a barrel in the same period a year earlier). Russia produced 9.77 million barrels of oil a day in June, more than Saudi Arabia did, thus becoming the biggest exporter of the fuel. Russia also produces the energy equivalent of about 11 million barrels a day of gas. As a result of such factors Russia's trade surplus hit a record $130.92 billion in 2007. So what could possibly go wrong?

Well the central point would be that the strong rise in oil prices we have seen since the start of the century has only served to increase Russia’s dependence on oil and gas revenue and has not been used to facilitate the kind of diversification which could allow for a more stable development path. As such the Russian economy - despite the outward semblance of "you've never had it so good" boom times - has never been more vulnerable to sudden falls in oil and gas prices.

The share of oil income in total fiscal revenue has increased substantially – from 10 to about 30 percent of GDP. Instead of diversifying, Russia has, de facto, been specializing in oil. Oil now also accounts for about 60 percent of total exports. Higher oil revenues allow for additional spending room, but they also complicate macroeconomic management and lead to an increased dependence on a highly volatile and uncertain source of income. While this has not been a problem during the period of high oil prices, it would be a major source of vulnerability if oil prices suffer any kind of rapid descent from the recent levels, and it does put in place a "ceiling" on Russia inflation-free level of growth capacity given the fact that the resources sector seem to have now reached its "peak output" level.

Soaring oil prices, large capital inflows, and high credit growth are all providing the impetus for a virtuous circle of robust growth in investment, real incomes and consumption but such growth has been producing manifest signs of overheating. The situation is only being made worse by a procyclical fiscal policywhich is stimulating rather than easing demand pressures, while the fixed exchange rate policy in the face of rising oil prices and large capital inflows is leading to very high levels of money and credit growth.

And as we move forward the problems identified here are only likely to get worse. Russia’s well documented demographic trends—declining population, aging, and increasing demand for pension and health services and the changing structure of demand for education are likely to become key drivers of major social expenditures such as pensions, health and education expenditures in the years to come. The net effect of these trends is that under any long-term economic scenario, public expenditures on pensions, health and education are likely to increase significantly. The World Bank estimate that the main social expenditure items are likely to increase by 3 percentage points of GDP - from 14.1% in 2008-10 to about 17.3% by 2016-20. Given this situation stable sources of long-term fiscal revenue and moderation in total public expenditure commitments are essential, as is the development of a growth model to make all the numbers add up.

And sustainability of pensions and health spending isn't the only issue that Russia's demography presents us with. Declining levels of productivity growth mean that it is very likely that increases in headline GDP will only be possible via sustained increases in labour inputs, yet Russia now has, as we have seen, a declining working age population. Long term very low fertility (TFR 1.3-1.4 range, see chart above) means that this problem is set to continue at least over the next twenty years (and probably a good deal longer) which means a Russian economy which is increasingly immigrant dependent (the World Bank estimates Russia currently need a million migrants a year) and which suffers from the almost permament inflationary pressure of running a very tight labour market. Under these circumstances it is impossible to contemplate the present very high levels of GDP growth being sustained in the longer term, indeed, if we have any kind of "adverse event" which precipitates an unwind, precisely the opposite might well occur.

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