Renaissance Capital -
Today, central banks are focusing more and more on fighting inflation, and less and less on short-term economic growth. It is argued by many economists that the central banks deliver better long-term growth if they fight inflation, even at the cost of lower growth in the short term.
For most central banks, fighting inflation comes down to managing short-term interest rates, which, presumably, have an impact on rates throughout the economy. However, we have seen the Bank of Japan try for years, unsuccessfully, to fight deflation by cutting rates to virtually zero; and more recently the US Federal Reserve, which has also gained very little traction by cutting rates.
Higher rates and fixed currency would result in an inflow of carry-traders, which would cause the central bank to intervene, and, hence, the money supply would grow, defeating the original purpose. Thus, the Central Bank of Russia (CBR) and the national banks of Ukraine and Kazakhstan are between a rock and a hard place - they need to fight inflation, but they cannot simply raise rates, as this would risk an inflow of hot money.
Clearly, this risk is somewhat lower now, as tensions on the global money markets have resulted in international investors finding it more difficult to obtain funding than in the past. Nevertheless, the risk is still present, in our view, and consideration of this risk is making the central banks' policy choice much harder.
One option is to fight inflation by allowing the national currency to appreciate. This is a standard IMF-prescribed remedy, and is called "the nominal anchor." The logic behind it is that lower import prices pressure domestic producers and the overall price level stabilises. We think this policy would be very easy for the CBR to implement; possible, at least now, for the National Bank of Ukraine (NBU); and somewhat possible for the National Bank of Kazakhstan. However, there are complications. Not only is the political pressure not to do it from domestic producers very high, but the effectiveness of this policy is arguable.
This is especially true for Russia, where the economy is clearly overheating, and lowering the cost of imports would hardly, in our view, result in lowering prices domestically. Also, this policy is more effective when it also results in an outflow of hot money looking to fix profits. However, speculation is not really present en masse now in any of our three sample countries, even though recently this build-up has started to be seen. Furthermore, for Ukraine and Kazakhstan, letting the currency appreciate would exacerbate their current account deficit problem, in our view. That said, the situation in Ukraine is so bad, that the authorities there are still likely to use all measures available, including revaluation, whatever the cost.
PPI: It's all about oil
In all three of Russia, Kazakhstan and Ukraine, historically PPI has been sustainably higher than CPI, and is highly correlated to oil prices. In fact, the oil price is arguably the single, largest factor influencing PPI dynamics. The correlation exists, although somewhat weaker, even in the case of Ukraine where we would expect to see PPI dynamics largely dependent on the timing and magnitude of gas price increases. It is important to note at this stage that given the continued rise in oil prices to $120 per barrel in early May, the pressures on producer prices persist.
Our new forecasts for PPI dynamics in Russia, Ukraine, and Kazakhstan are primary based on new oil price forecasts, new state tariff strategies (which basically refer to Russia and Ukraine), as well as structural development of the economies.
CPI and PPI: Not a very strong link for Russia and Kazakhstan
In Russia and Kazakhstan, there appears to be a relatively weak link between CPI and PPI, ie increases in producer prices are not usually associated with increases in consumer prices. We believe this is a function of relatively efficient trade and distribution of the goods and services sectors, as well as relatively large import volumes. Based on this view, we think a logical conclusion is that during times of high PPI and relatively low CPI, it is the producers who absorb most of the impact of rising costs and whose margins are hurt. In Ukraine, however, the correlation between CPI and PPI is much higher, and an increase in PPI is eventually translated into an increase in CPI; thus, producers appear to be able to pass on their cost increases to consumers.
Global food prices: Still on the rise, and still impacting CIS countries
The dynamics of food prices in Kazakhstan, Russia and Ukraine have responded to increases in global food prices (with an approximate time lag of one year), with Ukraine demonstrating the highest sensitivity to global trends. The impact of global food prices on local prices is the highest in Ukraine, while in Russia it is the smallest (our estimates suggest that a 1% increase of world food prices would lead to a 0.67% CPI increase in Ukraine, 0.42% in Kazakhstan, and 0.31% in Russia).
As it is difficult to accurately forecast global food prices, we use the FAO forecast that food prices will continue growing in 2008, increasing some 32% (compared with 23% on average in 2007 and 9% in 20061). We also believe that the supply of agricultural commodities will eventually adjust to a demand shock, and we will see a much slower rate of food inflation in 2009. Historically, food prices do not fully replicate movements in oil prices, but recently the dependence of food prices on fuels has increased. Our base-case view remains a decline - or slowdown - of oil prices in the medium term will help to reduce or slowdown food prices, too.
For each country, the impact of world food prices on its overall inflation dynamics heavily depends on the structure of CPI. The weight of food prices used to calculate CPI in developing countries is about 35-40% compared with the 15% used for developed countries. Among our three countries, the largest share of food in CPI is Ukraine (reflecting a large share of food goods in the consumption basket) at 56%. Weights of food in Kazakhstan and Russia's CPI are lower and closer in range: 41% and 39%, respectively. Therefore, Ukraine's inflation is, at least based on the structure of the inflation index, more influenced by world food prices.
Monetary factors have a crucial impact on inflation in Russia and Kazakhstan, and somewhat less so in Ukraine. As we discuss in this section, the development of a banking system is central to helping an economy digest money supply increases.
In Russia, inflation has been traditionally one of the highest in the CIS, and we attribute it primarily to monetary factors. In fact, Russia's inflation appears to depend more on money supply growth, than anything else. High money growth in Russia (recently, due to capital inflows and the exchange rate policy) was fully translated into an increase in nominal consumption and investment. In Kazakhstan, the rapid development of the banking system diminished the effect of money growth and decreases inflation pressure.
In Ukraine, inflation cannot be fully explained by monetary factors. In Ukraine, the link between money supply increases and inflation is less pronounced. The aggregate inflation level appears to be influenced more by global food inflation and fiscal spending.
It is not unusual in developing economies for money supply growth to be higher than in developed economies, which is explained by the relative state of development of financial systems and monetisation of economies. In Russia an increase in money supply historically was accompanied by a similar rise in banking assets. This also generally holds for Ukraine, while in Kazakhstan an increase in monetisation was accompanied by much faster growth of banking assets, which we think is probably related to the rapid growth of the banking sector's foreign liabilities until the second half of 2007.
The rapid growth of banking assets in Kazakhstan seems to us to be more of a bubble than a catch-up or deepening of the financial system. On average, real banking assets grew 40% yearly in 2001-2007, which significantly exceeds the average indicators of development of the banking system in emerging market economies (compared with 19%, on average, real credit growth in fourteen CEE and main CIS countries). International experience implies that a speedy credit expansion increases the risk of a subsequent sharp correction.
As a result of the financial turmoil in the second half of last year, the size of Kazakhstan's banking system has decreased, and we expect very modest, if any, absolute growth in 2008. Therefore, this year, inflation in Kazakhstan is likely to prove more sensitive to monetary factors. Yet, the monetary expansion so far this year has been very modest, with some contractions in money supply on a monthly basis; therefore, we expect the net monetary impact on inflation this year to be small.
Budget expenditures have been on the rise in all three countries over the past year. Traditionally, the impact of fiscal spending on inflation has been the highest in Ukraine, being boosted by frequent election campaigns and with the rather aggressive social spending of Prime Minister Yulia Tymoshenko's government so far in 2008 (also viewed by the NBU as one of the key contributors to this year's overall inflation).
Various effects of budget expenditure policy on inflation dynamics in Kazakhstan, Russia, and Ukraine depend on overall budget policy. Ukraine experienced the largest budget deficit of the three over 2001-2007, averaging 1% of GDP, while Kazakhstan has around a 0% of GDP budget balance, and Russia a surplus of 5% of GDP. In the three countries, a high increase in budget spending together with a budget deficit pushed inflation upward.
In Kazakhstan and Russia, the impact of fiscal spending on inflation over the past year has been less pronounced. However, we expect that going forward the budget policy in Kazakhstan is likely to become a more important factor in determining the level of inflation, as the government is taking a much more proactive stance toward supporting the overall rate of economic growth in the country. The same is true for Russia, in our view: the government is gradually becoming the single largest active economic agent in the country, and higher government spending is increasingly associated with higher inflation. Both in Russia and Kazakhstan, inflation has proven to depend on the volatility of fiscal spending. Going forward, fiscal policies both in Russia and Kazakhstan are likely to have a bigger impact on the inflationary environment, as in Russia the current account surplus is expected to decrease, and, in Kazakhstan, the resumption of large capital inflows in financial sector - similar to the ones experienced prior to summer 2007 - is unlikely in foreseeable future.
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