Ben Aris in Moscow -

Forget the US sub-prime debacle; the real danger to Russia's economic future is the rising price of bread. €

Russian inflation suddenly surged in September, rising eight-fold month-on-month, and was still accelerating by the start of October. Bread prices have soared across Eastern Europe and governments are facing possible food riots in some countries. The sudden return of the inflation bogeyman that had appeared to be under control could mark the end of nearly a decade of economic prosperity and fast growth for these emerging European markets.

The spike in September's inflation came out of left field. Central banks across the world have been focused on the unfolding global liquidity crisis caused by the meltdown of the US' sub-prime mortgage market. The rise in inflation is a very unwelcome second shock and presents a much more insidious danger.

Russia, Kazakhstan and Ukraine have already imposed price controls on the cost of basic food staples. Kyrgyzstan is on the verge of bread riots. Unless all the governments in the Commonwealth of Independent States act fast, the rapid growth of recent years could stall and rising prices will undo much of the progress made in recent years.

Russia's consumer price index - which measures the cost of basic goods - leapt from 0.1% month-on-month in August to 0.8% in September and was 0.9% in the first two weeks of October. Even the most pessimistic forecasts were predicting price growth of no more than 0.5% for September, while the Russian Economic Development Ministry was predicting 0.4% and the Central Bank of Russia 0.2%.

Most of the increase is due to a shock rise in agricultural products. Grain prices set a new all-time high on the Paris commodities exchange in September, suggesting something is seriously amiss, as the agro-price rises aren't just an Eastern Europe phenomena, but a global problem - a second external shock for the CIS.

The return of inflation, which seemed well under control only in August, is a body blow to Russia's economic development plans. Economic Development and Trade Minister Elvira Nabiullina has already conceded defeat in this year's battle with inflation, saying the government will miss its 8% target and the final result could well go back into double digits.

The problem with inflation is that unlike a global credit crunch, whose effects are primarily felt by the banking sector and only slowly trickle down to the general public, a spike in prices hits the poorest first. Rising bread prices can have huge political consequences; just think of Marie Antoinette.

Food fights

On farms outside Bishkek, the capital of Kyrgyzstan, farmers are slaughtering their cattle to pay off loans that have been affected by the US' financial problems. "It's amazing - the credit markets in New York dry up and Kazakh banks suddenly run into financing problems. They lend money to Kyrgyz farmers and suddenly call in their loans or tighten lending conditions so the farmers in Bishkek have to kill their cows as a direct result of the soaring spreads on lending rates," says Renaissance Capital's Nash. Kazakhstan has been worst hit by the global liquidity squeeze and its problems have reverberated across the region. However, apart from some unfortunate farms and the Kazakh middle class planning to buy an apartment this winter, the effects have - so far - been relatively limited.

The price of bread suddenly soared across all of Eastern Europe in July, causing a series of popular protests, which threatens to spill over into civil unrest. Most of the governments are already reaching for administrative controls to halt the rise of prices, flying in the face of liberal reforms and prompting howls of protests from the food processing sector, which has been the darling of international investors for much of the last five years.

Bishkek is on the verge of bread riots after the cost of a loaf has increased by half since the summer. The government was forced to step in and subsidise flour and grain imports at the end of August and established a Food Security Council in October in a desperate effort to stabilise bread prices. The opposition Green Party called for mass protests under the slogan: "Rise, Hungry Nation."

In an effort to defuse the crisis (and pass on some of the blame), Kyrgyz Prime Minister Almazbek Atambayev blamed what he called the imperfect administrative system for the soaring flour and bread prices in the middle of September. "Certain ministers and department chiefs, just as all executive authorities, did not respond [to the growing prices] on time. It is not a question of particular managers, but the administrative system at large," Atambayev said.

Moldova also introduced emergency measures in July to make sure enough bread was available after it was hit with a double whammy of soaring prices and a fall in domestic food production thanks to a severe drought this summer. Agriculture and Food Industry Minister Anatoly Gorodenko says the situation in the agricultural sector is getting worse by the day. Crop yields are half those of last year due to the drought sending the cost of staple goods spiralling upwards.

The Kazakh government has also been in the hot seat, with the opposition calling for mass demonstrations at the start of October to protest the soaring prices. "Prices are growing, starting from bread, let alone other essential food products and services. Tariffs are also growing. But the government is not taking any real steps to curb prices," leader of the National Social Democratic Party (OSDP) Zharmakhan Tuyakbay said at a press conference in Almaty at the start of October.

Kazakh Prime Minister Karim Masimov floated the idea of setting up a state bread monopoly if efforts to stabilize bread prices failed to work soon. "If we see no specific steps or intervention in a week's time, I will make a decision introducing a state monopoly in this sphere," he told a cabinet meeting October 1. Deputy Agriculture Minister Dulat Aitzhanov told journalists that, "The monopoly would be introduced in bread baking."

In Ukraine, too, the soaring cost of bread was an election issue in September's vote. The Ukrainian Communist Party latched on to the rising costs and used it as a club with which to beat President Viktor Yushchenko and, in a bizarre twist of logic, also blamed opposition leader Yulia Tymoshenko for the price rises, despite the fact that Tymoshenko's bloc has been in opposition, while the Communists have been part of the ruling coalition running the country for the last year.

"The current hike in prices for fuel, bread, meat, milk, and consequently, for all staple goods and services, owes to political, and not economic reasons," Communist leader Petro Symonenko said during the elections. "The illegitimate elections provoked by the president and [the Yulia Tymoshenko bloc] led to a total price hike affecting the living standards of Ukrainians."

Tymoshenko simply turned the same crisis back on the government. "We are convinced that the Yanukovych government has deliberately been provoking a crisis on the bread market in complicity with the monopoly agents in order to profiteer on the bread and flour market," Tymoshenko countered from the campaign stump.

Meanwhile, Russian pensioners fear this winter after the cost of bread is expected to soar by 40% by the end of this year. Prime Minister Viktor Zubkov said in October the cost of a loaf of bead had risen to 17 rubles (68 US cents) from 10 rubles, while milk rose to 41 rubles ($1.64) from 27 rubles, without specifying the time-range over which the increases had taken place.

After Agriculture Minister Alexei Gordeyev said in July that this year's wheat harvest would be 2.4m tonnes less than last year's 76m tonnes, grain traders went into a panic, causing the price of grain to explode. In effort to head of a crisis Russia's Ministry of Economic Development and Trade (MEDT) says it will hike the price of grain export duties by up to 30% to stop grain leaving the country and slashed import duties to bring more grain in.

More worryingly, the government has lent heavily on food producers to check prices rises. An industry source told bne: "Wimm Bill Dann has been getting a lot of pressure from the Federal Anti-Monopoly Service not to pass on rising costs to the consumer. They are complaining like hell, as this is a non-market solution to the problem."

However, the sector has caved into the pressure rather than face the wrath of the government; food processors "voluntarily" promised to contain price increases in the middle of October.

Inflation shock

If the international credit crunch were not causing enough problems, the rise in inflation has made things much worse and in the long run threatens to do a lot more damage than the temporary disappearance of credit.

While Russia was amongst the countries least affected by the global liquidity shortage, the resurgent inflation threatens to derail the government's entire economic development plan and hurt all of Eastern Europe. The entire region it at a turning point and if they fail to tackle the inflation issue, July could mark the end of nearly a decade of recovery and growth.

For most of the last 15 years, the Russian government has been battling to control inflation and seemed finally to have the problem in hand at the end of the last year. Inflation came in at 9% at the end of 2006, below the self-imposed 10% target - the first time inflation was in single digits in Russia's modern history.

Defeating inflation has been crucial to Russia's long-term economic recovery. The only way the state had to bring the number down was to cut government spending to the minimum possible levels. In particular, the state has been miserly with tariff increases for the power sector and spent next to nothing on the dilapidated infrastructure, which has barely been touched since Soviet times.

At the same time the oil sector has been taxed to the hilt. With 80 cents of every dollar over the price of $27 a barrel of oil now going to the treasury, oil companies have seen little benefit from oil prices that topped $90 a barrel in the middle of October. The government has "sterilized" this money by siphoning it off into the Stabilisation Fund - in other words, placing it in a coffer where it can't be spent and drive up inflation.

This policy has been successful in bringing down inflation and until September the government was on target to reduce inflation for 2007 to 8% or less. However, this policy has also almost caused problems. Without investment, Russia's Soviet-era infrastructure is close to collapse. The problem is most acute in the power sector where fast economic growth means that the existing generating capacity can only just meet demand and as soon as next year the country will be facing regular brown- and blackouts, which will stymie further economic growth.

When inflation finished 2006 at 9% and was still falling over the first half of this year, the Kremlin breathed a collective sign of relief. Finally, it reckoned, Russia could start spending some of the $400bn accumulated in reserves without losing control over inflation again.

Multiple investment plans have been rolled out in the last six months. And the numbers are staggering: the road system will get $195bn; Russia's railways need $204bn; some $380bn will be spent on completely revamping the health system; and the energy monopoly UES plans to spend $118bn on building new capacity in the next five years, but needs a total of $462bn of investment to bring it up to Western European levels.

In September, First Deputy Prime Minister Sergei Ivanov said the country aimed to invest $1 trillion in infrastructure over the next 10 years. And this is not counting the private sector investments that are at least as much, as Russia needs to maintain year-on-year investment increases of over 25% a year if it is going to follow the path blazed by the Asian Tigers in the 1980s. (Currently the government is expecting an increase in investment of about 18% at the end of this year, so more needs to be done here too).

Everything was tickety-boo with this plan until the September inflation numbers were released. Inflation surged 0.8% on month, which may not sound like much. But if the government now tries to spend over $1 trillion into a rising inflation trend, all it will do is stoke the flames and send inflation spiralling upwards. The surge in inflation has already negated much of the state's pre-election wage increases, pension hikes and other increases to social benefits. And if inflation really starts growing fast, it will cut into investment plans and profits, and so start to kill economic growth.

For example, the gap between consumer price inflation (CPI), which measures the rise in costs for the population, and producer price inflation (PPI), which measures the cost increases for industry, is widening at an alarming rate. CPI increased 7.5% over the first eight months of this year while PPI was up 17.7% over the same period. Most of this difference is due to the rapid increase in international commodity prices, say economists.

What this gap means in practice is that company's margins are being squeezed, which destroys resources that would have been used for investment - despite the recent credit boom in the banking sector, the bulk of companies' investment capital still comes from retained earnings.

Agflation

So what is behind this sudden rise in global agricultural prices? And why is it happening now? Opinion among economists remains divided. However, it is clear that several factors have all come to bear at once.

The most obvious driver of prices is the growing demand for agricultural goods by emerging markets. Most of the eight-fold increase in the CPI in September was caused by ballooning prices for food, which accounts for 40% of the Russian CPI number, compared with just 15% in the US or Western Europe. Russia has been sucking in food imports like a giant Hoover. About a quarter of Russia's food needs are now met by imported goods and in Moscow over 60% of the food in the shops is from abroad, according to analysts.

The MEDT's Nabiullina blames the spike in consumer prices to rising demand for farming produce from India and China. In addition, the EU recently slashed or cancelled export subsidies for farming produce exported to Russia, she said.

But there are also long-term forces at work here: high commodity prices are finally working their way through to the agricultural sector. "Until recently, the rally in industrial commodity prices had very limited impact on agricultural stocks. However, it was unclear how and when the continuous rise in energy, equipment and transportation costs will begin to affect agricultural producers. September's rise in CPI is an overdue global price adjustment - and is unlikely to be the final one," says Chris Weafer, head of strategy at UralSib.

What is scaring economists is that what they have dubbed "agflation" could become a new powerful global force, which will be very difficult to contain. HSBC released a report on October 18 suggesting that the inflation problem is affecting the entire global emerging market universe.

"Inflation, the old bogeyman, has returned from the grave to haunt policymakers. The evidence is widespread: BRICs, Argentina, Mexico, South Africa, Vietnam, much of Central Europe, the Gulf States and others are all feeling the impact," says Philip Poole, an analyst with HSBC. "This situation is the result of a combination of evils: surging food price inflation, incomplete sterilisation of domestic liquidity arising from currency intervention and tightening capacity constraints."

Of course, the rate of inflation is nuanced by the shape of each countries' economy and the effectiveness of its government, but the trend is clear: everyone is seeing inflation rise that has nothing to do with their success or failure at managing monetary policy. "The surge in global food prices is clear evidence that inflationary pressure is building up. This build-up of inflationary pressure could have a direct influence on future monetary and interest rate policies worldwide," says Weafer.

One of the short-term impacts of rising prices is that it could add to the global liquidity woes. Weafer argues that if inflation is pushed up globally, then this will make it very difficult for central bankers to carry on cutting interest rates, which has been their preferred tool to counter the global liquidity crisis. "If inflationary pressures continue to rise on all fronts, the upward movements in agricultural prices leave very little room to continue with a soft credit policy; if anything, they send a clear-cut message that global liquidity is well on the road to becoming more expensive," says Weafer.

More insidious is the growth in the biofuels business, which has created vast new demand for grain and consequently sent costs up. "We are facing a possible scenario where the cost of grain and oil become linked in the near future," says Nash. "As grain increasingly becomes the source of biofuels and these start to compete with oil, then increases in oil prices will drag grain prices up with them,' says Nash.

Send comments to The Editor