Vladimir Pantyushin, Chief Economist at Renaissance Capital -

Consumer inflation has declined substantially in Russia, with the headline rate already below this yearís official target of 8.0%.

! The main factor behind this improvement was consistent currency appreciation by the Central Bank of Russia. It appears that the result was delivered through lowering inflationary expectations.

! Nevertheless, inflation remains high (at 7.4% YoY in March).

Further improvements will be harder to achieve, as monetary and fiscal policies remain lax. High wage growth and a need for tariff increases will also limit additional gains in the battle against the inflation beast.

! Recent success and a lack of alternative anti-inflationary instruments will keep rouble appreciation as the governmentís only choice.

! Companies with primarily rouble-denominated sales and a bulk of foreign currency-denominated expenses stand to gain the most from these developments.

Introduction

The times are changing quickly. Just a year ago, a hot conversation topic in Russia was ìHow in the world will the government meet its inflation target?î Currently an appropriate statement would be ìInflationís upper limit has been reached; shouldnít we be shooting for the lower one?î But is everything really so bright and shiny in the battle for the price economic concerns demands of the Russian population this election season?

Indeed, the latest CPI figures display remarkable progress. The headline rate has declined sharply, from 9.5% at the end of 3Q06 to 7.4% in March (Figure 3). Since a spike a year ago, it has shaved off almost 4 ppts. Food inflation, still the main contributor, has also subsided visibly in the last two months, despite massive budget payments at the end of last year, which usually filter into higher demand for basic goods.

Besides, the adjustment of regulated tariffs introduced, as usual, on 1 Jan did not seem to affect the services component of the CPI as much as it had in the past. The monthly price increase for services was only 4.7% this January compared to 6.2% a year earlier and 8.8% in Jan 2005.

Although phone tariffs spoiled the picture in February, this was the one-off effect of a switch in local rates from unlimited calling plans to multiple options. This brought an average 26.6% price increase for the unlimited plan included in the CPI basket, adding around 0.3% to February inflation.

Nevertheless, money supply, budget expenditures and regulated tariffs remain problem areas. The growth of money supply is high, with M2 YoY rates lingering around 50% for several months. Budget allocations have also increased substantially and are scheduled to grow even more in the near future.

In this report, we look at where the effects of inflation have appeared. Then, we analyse the actions that lead to the CPI decline and their transition mechanism.

Where: CPI components

To take a closer look at the results of changes that occurred in the recent months, we analyse the behaviour of three CPI components tracked by Rosstat: foods, nonfoods and services. From the peak of headline inflation last February, the largest decline appeared in the food section, where inflation dropped by 7.1 ppts vs 2.6ppts in services and 0.5 ppt in non-foods. This has been particularly significant because of the share of foods in the consumer basket.

To estimate the contributions of the components to the overall index, these results have to be weighed by their respective shares. By combining the evolution of the three CPI components since the beginning of last year with their weights in the consumer basket, we find that the contributions to the decline of inflation over the last 13 months have been 3.0 ppts for foods, 0.2 ppt for non-foods and 0.6 ppt for services.

These results also confirm that foods remain the major inflationary component.

Although the latest statistics reveal that its inflation level and its contribution to the overall figure declined to the all-time low, the nominal rates remain high. According to our calculations, two-fifths (3.3%) of the 7.4% headline CPI rate at the end of March was attributed to food prices. This component not only is the largest of the three in the basket with 40.2% weight in 2007 but also remains the major determinant of its dynamics (Figure 4). The latter becomes evident when comparing the correlations between CPI and its components, which equals 95% for food, 74% for non-food items and 56% for services for the period since Jan 1999.

The contribution of non-food prices to the CPI has been quite consistent, at around 2.0% since the beginning of 2004. This has been the lowest and the least volatile component, and we believe it will likely retain these features in the future.

Purchases of services provide roughly 3.0% to the headline CPI figure. Despite occupying only a quarter of the consumer basket, services generate 40% of the overall inflation. Recently, their contribution has been on a par with foods, both in terms of level (3.0% vs 3.4% for food) and dynamics (their respective correlations with the CPI are 80% and 83%). Annual regulated tariff increases and high wage growth (which represents a bulk of service providersí costs) would be factors limiting further improvement in this component. Since the share of services in the consumer basket increases consistently, we believe their importance in the overall inflation is set to grow.

Whodunit?

As things turned out, we saw a near-perfect confirmation of the predictions we expressed last spring in our report: ìInflation: Catch me if you can.î First and foremost, the Central Bank of Russia (CBR) has shifted its priority from maintaining the nominal exchange rate to lowering inflation. This monetary policy change is visibly displayed in the composition of the rouble appreciation we present in Figure 5. Before 2006, the bulk of real appreciation came through inflation. In fact, despite consistently strong current account balances since 1999, the rouble posted nominal appreciation only in 2003 and 2004. Last year, however, a pro-active currency policy shifted the weight to nominal appreciation.

Secondly, the way appreciation has been delivered has left little doubt that the CBR is determined to go all the way to achieve the annual inflation target (9.0% last year).

There have been three distinct periods when rouble appreciation took place in 2006 (Figure 6).

(1) Aprilís revaluation was a rather cautions first shot. Nevertheless, it displayed the intention of the CBR to use the currency tool to combat inflation by letting the rouble strengthen by 1.8%.

(2) The September move is the most revealing. It was delivered as a prompt response to a disappointing August CPI figure. On the day of its release (5 Sep), the CBR apparently bought $8bn on the market while letting the rouble strengthen. This has come across as a bold statement that the improving inflationary trend will not be derailed.

(3) The final adjustment came in November and produced 1.6% appreciation.

Although one might argue that the November appreciation simply mimicked the euro, this would miss the point. The dollar is still king in the Russian currency market. Other currencies, including the euro, play a minor role.

These episodes, as well as the consistency in the CBRís tactics (unlike the digressions displayed in the past) have resulted in the successful delivery of the CPI target last year. To get an additional confirmation, we have analysed the dynamics of currency purchases (Figure 7) as well as the CBR dual-currency trading basket.

Both confirm the bankís heavy involvement in the three episodes discussed above.

How: The transition mechanism

Currency policy is, in effect, the only effective anti-inflationary tool available to the Russian authorities at the moment. To prove this formally, we obtained a confirmation of the interconnection between the exchange rate and inflation by applying statistical tests to the recent figures.2 The results provide strong support to our view that exchange rate variations cause changes in the inflation.

The analysis of relevant statistical indicators answers the question of what produced lower inflation only partially. Indeed, the CBR let the rouble appreciate substantially last year (by 9.3% in nominal terms) but money supply has nonetheless accelerated.

Money supply to GDP ratio has been consistently growing at above 20% YoY. Real wages and disposable income rates have also stayed well into the double-digit territory. This indicates that non-monetary factors have played a major role in the deflationary process. We believe the main contribution came from a change in inflationary expectations, which itself has been a reflection of the CBRís resolve to tame inflation last year.

We obtained good results with a forward-looking expectations model in an attempt to estimate the effects of these changes. It appears that consumers respond to exchange rate adjustments with a lag of three months but do anticipate future price dynamics based on its current trend. In other words, people convert recent currency movements into their expectations of imminent inflation dynamics. Our estimates for 1% nominal rouble appreciation attribute 0.05 ppt to the direct affect on CPI and another 0.12 ppt to inflation decline via the adjustment in inflationary expectations.

On the one hand, this finding leaves the bulk of the adjustment process outside of the measured indicators area. Obviously, this casts a cloud of mystery on the whole process. On the other hand, the CBRís actions in the currency market ñ as well as its political commitment to tame inflation ñ have been unambiguous, in our view.

Short-term expectations

The possibility of an up-tick in headline inflation this year still remains possible. In the short term, food prices and weak monetary policy are the two main danger zones.

Although the outlook for this yearís harvest is superior to that of a year ago, the dynamics of global prices for corn and sugarcane (due mainly to booming biofuel production) is somewhat disturbing. Since foods still make up over 40% of the CPI basket, the influence of such factors may reverse the recent progress. Past experience shows that this could add 1.2 ppts to foods inflation and, therefore, 0.5 ppt to the CPI. Although preliminary evidence from the field and statements by the Ministry of Agriculture officials portray a bright outlook, bad weather, for instance, could produce unexpected deterioration. Also, the effect of loose monetary policy is likely to kick in around mid-year.

The flipside of the recent success is that worsening inflationary situation can alter the expectations and produce a spiralling effect on prices. We believe that the CBR is well aware of this danger, and will react swiftly if it materialises. However, a possibility of a delayed response cannot be written off completely.

Politicians often associate nominal rouble appreciation with competitiveness of Russian industry. A good example illustrating the fallacy of this view is a Lada car. A basic model Lada currently costs about three times more in dollar terms than it did in 1999, when the RUB/USD exchange rate was roughly the same as it is now.

This inconsistency sometimes results in conflicting messages. A number of times high-ranking officials, particularly the president, have voiced concerns regarding nominal rouble appreciation, expressed in reference to the countryís competitiveness. In general, we support the view that sharp currency movements should be avoided. However, massive currency inflows and some one-off factors have left the CBR with a tough choice, where meeting the inflation target has required heavy price on the currency side. Obviously, conditions have improved lately but future problems can cause deterioration. Although the political consensus on taming inflation as the economic priority is strong, lack of coordination and contradictory messages may create excessive political pressure on the CBR. We believe, however, that the likelihood of such a scenario is low.

Longer-term outlook

The Russian government is determined to continue reducing inflation. Most recently, President Putin, in his budget address, expressed the need to reach 3-4% levels in the foreseeable future. However, the current underlying inflationary factors are likely to remain in place. In particular, the process of adjusting regulated tariffs is far from being over. Even though official forecasts are currently projecting foreign trade to reach a zero balance by the end of the decade, this is likely to turn out to be overly pessimistic.

Another potential problem could arise from the import side. If Russia succeeds in curbing its domestic prices, higher inflation levels in its trading partner countries are likely to come to the forefront. In fact, even recently the main factor insulating the domestic market from import inflation has been rouble appreciation. Unfortunately, official figures show significant variation in estimating import inflation (see the last two lines in Figure 14). Our attempt to approximate consumer import inflation via an import-weighted CPI Index for Russiaís trading partners is presented in the second line of the table.

Regardless of the set of figures we use, the recent benign contribution of imported goods to domestic prices would have been much different without the currency factor. In dollar terms, inflation last year have been at least 4.9%.

Wage growth is likely to present another long-term problem. As the demographic situation deteriorates, the tightness of the labour market will increase, thus keeping pressure on wages. Laxer immigration rules are the only viable solution at the moment, but this proposal still lacks support among the population as well as the political elite.

Conclusions

We believe the facts prove government and CBR efforts to battle inflation have produced the necessary results. The change of the intraday dual currency basket on 8 Feb and subsequent rouble appreciation indicate to us that the government will maintain its strategy of currency adjustment in the near future.

Another lesson from the inflation dynamics over the past 12 months is the importance of food prices, the most volatile of the three components in the consumer basket. Since its weight remains at above 40%, future volatility will likely bring some surprises. Although currently negative news from corn and sugarcane markets is balanced by good local harvest prospects, the jury is still out on this yearís outcome.

Monetary and fiscal policies, together with regulated tariffs, are the key inflationary risks, in our view. We believe wages, both public and private, are also likely to maintain pressure on prices, particularly in the service sector.

As the external pressure on the rouble weakens, lower exchange rate appreciation would increase the contribution to CPI from imported goods. As Russian consumers continue to switch to premium products, the share of imported content will likely increase. We believe this will amplify imported inflation in domestic consumer prices.