Erik DePoy of Alfa Bank -
2007 may be remembered in the history of the Russian market as the year in which inflation made its big comeback. Although price growth has clearly been much more rapid in the past - as those of us who were here in the 1990s so vividly remember - the difference this time around is that it has become a key electoral issue, and one that is not so easily addressed or explained away. From an investor's standpoint, the spike in price growth may be something of a rude awakening. After all, until just recently we were treated to a steady stream of positive news concerning Russia's fiscal strength. Now, however, we discern a few cracks in the faÃ§ade.
For the government, which has jumped headlong into the election season, the timing could not have been more unfavourable. Unfortunately, the monetary authorities have few levers with which to restrain price growth, aside from the main instrument of allowing the ruble to appreciate, which creates problems of its own related to export competitiveness. For now, the principal issue is the extent to which the official target will be exceeded. In September, 12-month CPI jumped to 9.4% from 8.6% in August, representing the largest monthly increase since January 2005. Then in October, monthly inflation totaled 1.6%, bringing annual the CPI to 10.9%, which is already well above the government's initial 9.0% target for 2007. Subsequently, officials began talking more realistically of an annual rate approaching 10.5-11%, and some are now even wondering whether this new, higher target will be breached.
So, why has inflation suddenly taken off this year? Hadn't the government already gotten a grip on the situation? As it turns out, the ultimate causes are mostly external and part of a global trend that has finally caught up with Russia. For the most part, Russia has been importing inflation as a result of 1) increased world demand for grain boosted by rising production of biofuels; 2) increased milk demand reflecting changes in consumption patterns in Africa and Asia, primarily China; and 3) the cancellation of export subsidies on milk products by the EU. This inflation has filtered into Russia in the form of higher prices of food and dairy goods, particularly in the regions where transport bottlenecks can magnify price anomalies.
Some have blamed excessive printing of money by the central bank. However, for the first eight months of this year, cash in circulation rose a modest 13.8% (versus 17% a year ago), and money supply constraints will hardly improve the situation. Moreover, pensions were raised starting from October 1, which, despite the social importance of this measure, increases pressure on the food products market. In the run-up to the elections, budget expenditures will either be increased or incurred strictly to the time budget, and shifts in the schedule cannot be used in the current year (last year only 19% of annual budget spending was implemented, and price growth was partially rescheduled for January).
We can only conclude that external factors have played the main role in this year's price growth, with global growth in money supply being chief among them. The aggregate US money supply has been growing at an annual rate of 10-11% over the past two months, which has forced foreign central banks to crank up the printing presses or face an unacceptable strengthening of their currencies. Most recently, the massive liquidity injections by the Federal Reserve and the European Central Bank in response to the credit market's problems have only compounded this effect.
Some have even argued that all of this money printing is tantamount to a new round of competitive devaluations, hearkening back to a factor that made the Great Depression of the 1930s such a global phenomenon. All of this new fiat money sloshing around the global financial system has bid up the prices of a range of goods including, but clearly not limited to, basic foodstuffs like grain, milk and meats. The Russian authorities' response has been to 1) freeze prices for staple foodstuffs and encourage retailers to limit their mark-ups, and 2) cut duties on certain imports (eg. milk and dairy products). Ostensibly, these are temporary measures coinciding with the electoral cycle, but it is unclear when and to what degree they will be removed. If past history is a guide, the outlook is not encouraging; price limits were imposed on domestic gasoline prices nearly two years ago, but so far there is no sign of them being lifted anytime soon. Whatever the outcome, these measures are bound to only delay the negative impact of higher inflation, not eliminate it.
How much of a threat does inflation pose to Russia's investment case? Shorter term, the government can approve wage and pension rises, while continuing to inject liquidity into the banking system without major repercussions. But longer term, these measures are only a palliative that eventually threatens to boost inflationary pressure. An environment of rising prices also limits the ability of the monetary authorities to respond to any future liquidity squeeze. In this case, we might face the prospect of tighter liquidity (ie. elevated interbank rates) alongside higher prices, which could force companies to cut investment due to higher borrowing costs. Over time, this might begin to weigh on overall GDP growth and threaten the steady rise in investment and personal income that has underpinned Russia's macro story over the past few years.
Erik DePoy is Strategist of Alfa Bank
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