Explaining Russia’s Economic Slowdown

The Russian economy is steadily converging on stagnation in the past few months. For real, this time. Businesses are becoming more pessimistic, and industrial production in the first two months of this year is 1.5% lower than for the corresponding period last year. What explains this? Alexander Mercouris explains:

Might this not be a good moment to discuss economic questions? … The reason growth has been so subdued is because monetary and fiscal policy is so tight.  This in turn is because ever since Russia came out of the post financial crash slump the Russian government and the Central Bank have been prioritising inflation reduction over growth.

Basically what was happening before the crisis was that the government focused on getting its own financial house

in order and building up its reserves whilst leaving businesses to sort out and fund their investment plans often by borrowing on the international money markets.  The financial crisis showed the danger of this approach so the priority since the crisis has been to strengthen the domestic financial system to the point where it is possible for it to sustain a long term investment programme by drawing on its own resources.  This is only possible in a low inflation environment.

Though the inflation has roughly halved from what it was before the crisis, there was a significant inflation spike last year, which has forced the Central Bank to raise interest rates and to take further measures to restrict monetary growth.  That inflationary spike was in turn caused by three factors (1) the poor harvest, with its effect on food prices  (2) the over rapid credit growth at the start of 2012 and (3) the delay in the annual tariff increases to mid year and the way in which these were staggered throughout the autumn and winter.

Of these three factors (2) and (3) were surely a consequence of the political needs of the election period.  It is a commonplace that governments seeking re election loosen the purse strings to create a “feelgood” factor with the bills being paid once the election is out of the way.  Russia has just seen a very pale example of this.

Anyway the result is that Russia not only has real interest rates, which by international standards are extraordinarily high (in most of the developed world interest rates are currently in negative territory) but, adding to the downward pressure, the government is also tightening fiscal policy by introducing its budget rule.

The result is that demand and investment and therefore growth are being choked off.  Not surprisingly the policy has its critics (Deripaska is being particularly outspoken) but it is a standard trade off that historically all advanced economies make.  Japan during its glory days in the 1950s and 1960s repeatedly experienced growth pauses as the Finance Ministry and the Central Bank regularly tightened fiscal and monetary policy to deal with periods of surging inflation.  Like Russia, Japanese policy in the 1950s and 1960s was haunted by recent memories of hyperinflation in the 1940s and early 1950s and of national dependence on foreign lenders.  Of course an even more famous example of tight monetary policies being used to choke off inflation at the expense of growth (in that case even at the price of outright recession) was the Volcker Shock in the US in the early 1980s.

I don’t think there is any serious possibility of Russia going through a contraction anything like as severe.  My own view is that with monetary and fiscal policy as tight as they are, all other things being equal, inflation should fall in the second half of the year.  The Central Bank has given itself a medium range target of 5-6% but with policy this tight I would not be surprised if it overshoots it. One way or the other, if inflation falls, interest rates will come down, monetary policy will loosen and growth will resume though this time in a much more subdued inflationary environment.  This ought over time to make it possible for businesses to borrow in order to invest and for banks to lend for the long term without concerns at both ends that the value of loans will be eroded.  It should also encourage saving fostering capital formation through deposit growth.

In other words far from being an indicator of weakness the growth pause shows that the economy is being intelligently and responsibly managed and is not being sacrificed to reckless notions of growth at all costs.  Without pointing any fingers, it is an altogether more responsible policy than what one sees in some other places.

I would finish by saying that this policy also makes a great deal of political sense.   Though the policy comes in for noisy criticism from the likes of Deripaska (who as an industrialist has an obvious interest in getting the cost of borrowing brought down) Mark Adomanis has posted a useful graph from Levada on his blog that shows that inflation is far and away the most serious issue of concern for Russians.

Anyway that is my take of the present position.  I’d be interested to know if anyone disagrees or thinks differently and of what those who actually live in Russia and who have more direct experience of the economic situation there think of all this.


  1. An added factor, so obvious it may seem trivial, is the eurozone crisis. The EU accounted for 57.3% of Russian exports in 2008, it buys about four-fifths of Russian oil and gas exports. The impact of Europe’s collapse on Russia can be measured by the EU’s share of Russian exports:
    * 2008: 57.3%
    * 2009: 46.1% (first financial crisis)
    * 2010: 49.4% (recovery pre-euro crisis)
    * 2011: 45.7% (euro crisis)
    * 2012Q1 (latest figures): 44.6%
    The European economy has continued to be in recession since then, with a marked acceleration in late 2012 and this year. It is therefore likely that the EU’s share of Russian exports has continued to decline, with significant knock on effects for government revenue and GDP. Russia is being affected, as Eastern Europe and North Africa are being affected.

    Source: http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113440.pdf

    • Dear Craig,

      There is no doubt that the euro zone recession is having a major effect on the downside. However that does not explain the sharp slowdown in the Russian economy that began in mi 2012. That surely is due to the tightening up of monetary policy which began then.

    • Absolutely no question the EU crisis and real collapse of businesses underway is the single biggest drag on Russia’s economy. This is why I think Putin made a mistake in returning for a third term (despite the need for someone to kick ass and keep the looting surrounding Sochi from damaging the games). Putin will inevitably be blamed for the EU collapse the EUSSR bureaucrats, and not he, created. We’ve already seen Russian oligarchs who got their money out of Cyprus prior to the great Bundesbank bond holder saving bank heist blamed while the real culprits in Brussels and Berlin skate.

      • I do not deny the drag factor of the eurozone and indeed of the world financial crisis. It accounts for why growth rates not just in Russia but globally are well below pre crisis levels. However that does not explain why current Russian growth is at an effective standstill when it was running at over 4 percent per annum in 2011 and the first part of 2012 when the eurozone crisis was as bad as it is now. The single thing that has changed since then is that monetary and fiscal policy have been sharply tightened. In any country high interest rates would have a negative effect on growth and it would be perverse to think Russia is the exception. That is the point I am making. The Russian authorities have decided for the time being to forego higher growth because they want to bring inflation down. They also believe (rightly in my opinion) that this will make growth more sustainable and competitive in the future and help the economy’s development and diversificationation.

  2. Fedia Kriukov says:

    Last time I checked (although I admit it was a while back), the biggest contributor to Russian consumer inflation have been hikes in utility payments as Soviet era subsidies are being gradually removed. Since utilities are still subsidized, the only conclusion is that Russian inflation cannot be reduced to a psychologically safe level in the foreseeable future. Sacrificing economic growth in order to take inflation down from a scary level to a level that is still psychologically unsafe seems to be a foolish policy.

    • Dear Fedia,

      There are many such as Deripaska who would agree with you. However inflation has been halved from its pre crisis level despite continuing tariff increases and one must assume that if the Central Bank believes it can reduce inflation further it can. Utility prices can only be one factor in pushing up inflation and it ought to be possible to create countervailing pressure on the downside. I understand that the government is also further capping utility price increases as a part of the general anti inflation policy.

      • Fedia Kriukov says:

        I wouldn’t assume anything about CBR’s competence. Years ago I read an article that found a correlation between money supply in Russia and inflation, i.e. the tighter the money supply was, the higher the inflation. It seems counterintuitive from the point of view of classical economics, but the article proposed a plausible explanation based on human psychology. Well, whatever the underlying causal relationship might be, it indicates that the Russian economy was not in a state that can be described by classical economics, and there’s nothing to lead me to believe that it fundamentally changed since then. Therefore, when CBR starts unthinkingly applying recipes from first year macroecon textbooks without an underlying examination of the Russian economy to see if it even fits the model described in those textbooks, I can’t help but find it disturbing. It’s nothing but a cargo cult to me. Where’s the guarantee that the current tightening of the money supply isn’t actually inflationary rather than deflationary, and the observed reduction in inflation isn’t caused by something else?

        I just did a quick check, and it appears Russia’s M2 money supply has been stuck at ~43% of GDP three years 2010-12 (it was only ~23% in 2003 and has been growing steadily until the 2008 crisis). Needless to say, this is extremely low ratio by world standards, even if it’s not as abysmal as it used to be. 1999-2008 period was characterized by falling inflation, strong economic growth, and growing money supply. If that is how the Russian economy works, why would you ever think that there’s a need to reduce the money supply?

        • Mr. Kriukov,

          As background, when I was in American high school our Econ 101 textbooks treated the Federal Reserve (the Russian Central Bank’s counterpart) as a kind of magic pump that merely by ‘buying bonds’ (it was NOT called printing money out of thin air, which is what bond buying does) could ‘stimulate the economy’ albiet at the possible cost of ‘modest inflation’. It was if the 1970s stagflationary period that challenged modern monetary theory had never happened, but this was also before Japan’s stagflation had become permanent.

          Therefore, when I see the same fanatic Russophobes praising the RCB while damning the rest of the Russian government’s economic policies as voter bribing populism, I naturally get skeptical. Didn’t the RCB invest in Fannie and Freddie paper before those two institutions collapsed? Were it not for the Fed’s hyperintervention would Russia have lost billions in sovereign investments in ‘safe’ paper?

          I’ll be curious to see if Russia takes a page from Germany and repatriates all national gold reserves back to the Motherland — or at least settles for parking the remainder not held in Russian vaults in Switzerland or Singapore.

          • Dear Fedia,

            The point is that inflation IS falling. It is roughly half what it was pre crisis and all the indicators suggest it will fall further still. It would surely be lower now than it was were it not for the three factors I discussed in my post.

            As for the pre crisis period, the decline in inflation during that period was surely largely the result of the return to more normal economic conditions after the inflationary crisis of 1998. Up to and beyond the 2008 financial crisis the Central Bank’s focus was in managing the rouble’s exchange rate. It has only begun to focus on inflation targeting very recently, over the last three years or so.

            • Mr. Kriukov makes some excellent points. Inflation has been the bugaboo of the Russian economy since the fall of the Soviet Union. It’s important to note that many of its causes are structural and not necessarily related to monetary policy. Specifically, lack of competition in many industries and sectors, along with burdensome red tape and, of course, corruption. My guess is that a large portion of the reduction in inflation has to do with improvements in these areas. How much of this has to do with sound economic policy relative to simple natural evolution is a matter of debate.

              The problem is that the global environment is now incredibly unstable and Russia can’t take its time anymore in terms of creating a robust economy that’s more insulated from external turbulence. Mr. Kriukov is right that increased money supply doesn’t necessarily lead to increased inflation and, indeed, the opposite may be true if policy is managed correctly. Currently, the credit boom is concentrated on the consumer. Considering how much Russia imports in the form of consumer goods, this will do little to address long term structural problems. As such, this simply leads to what is commonly identified as capital flight.

              A strong argument can be made for looser monetary policy and the creation of long-term pools of domestic capital to stimulate domestic production, as opposed to consumption. If Russia were to set about looking for ways to replace, say, half of the $400 bil. a year in imports with domestically produced goods, it could stimulate minimum 6% GDP growth for the next ten years. Furthermore, this would create less of a dependence on global financial markets and economies. Obviously, there are some value added goods that are better produced abroad, but there’s no reason why Russia can’t produce things like diapers and toothpaste. Indeed, there have been local success stories in certain sectors like automobiles, and some FMCGs. But the untapped potential for more is huge.

              The main impediment, as I see it, is that you still have the neo-liberals in charge of economic policy and the CBR. They are all about those Econ 101 textbooks, concentrating on managing inflation and the exchange rate, with an unnecessarily over dependance on the USD. The only visible alternative is Glazyev and it was pretty clear from the hysterical smear campaign when his name was bandied about for CBR head that his views are anathema to the neo-liberal economic establishment. I guess it is somewhat heartening that he was considered at all.

              I don’t envy VVP’s position. He seems to understand that stimulating economic growth is imperative, but the only way to do so is to essentially replace the entire current economic political establishment. This would ruffle a lot of feathers; a lot of the oligarchs would scream, foreign capital would get nervous and flee (or maybe not). Plus, the question remains, who out there would be able to institute this policy? The establishment has been so thoroughly dominated by the neo-liberals that alternatives have been quashed.

              • Just to support what Jlo has written here:
                Imagine that you wanna create production of any good that takes 100 M EUR to build. With the current RCB rates your company should pay back say 135 M EUR in five years (it’s not exact figure of course). This means that the product you produce costs sufficiently more (how much more depends on ratio of raw materials and labor to capital investments). You have to get your prices up to cover this additional 35M EUR. The higher rates, the more money you have to get from your customers to pay banks (and not to improve your factory). Hence inflation. In latest Russian history reducing RCB rates leads to lower inflation and not vise versa.

              • Excellent piece of analysis, JLo. Where do you put Elvira Nabiullina appointment in this? She seems to me to be half way between the neoliberals & Sergey Glazyev in what has been presented (market orientatated but with a strong push for investing in the economy), but seems to lean more towards Glazyev’s view naturally.
                Is Putin putting some-one that neither side can overly object to while setting the ground for a major reorientation of the economic ministry, or am I being overly hopeful in this?
                Medvedev seems to be the biggest hurdle in a major refocus on more direct participation in the economy, as he seems to have made himself the focus of the neo-liberal clique by default and they seem to make up much of his inner circle of supporters.
                Putin seems to of saddled himself with a hobble here (ofcourse it might be part a deep longterm plan in collecting all the neo-liberal types into one banner & waiting for them to over-reach. He then moves Medvedev to something like the head of the constitutional court, etc. leaving the neo-libs exposed for a purge?).
                Well, I can hope, anyway…

  3. As I have been away in Germany for the last week it has not been easy to keep up with this discussion. Apologies therefore for the belated response to some of the points made. Though I appreciate that we have now moved on I thought I would just make some points:

    1. Firstly, there is more consensus to this discussion than might seem to be the case at first sight. There seems to be general agreement that the essential reason for the recent slowdown is the sharp tightening of monetary policy since the summer. I would add to that it is not only monetary policy that has tightened. Fiscal policy has been tightening as well. Given that this is so, a slowdown is no more than would be expected and is not a serious cause for concern.

    2. The argument between us essentially boils down to whether the authorities are right to prioritise inflation over growth. Basically what is being said is that raising interest rates and tightening fiscal policy and credit conditions will not cure inflation, which has structural causes, and sacrifices the objective of Russia’s reindustrialisation to an unachievable or unnecessary objective, which is reducing inflation. My response is as follows:

    3. To the extent that the argument about the structural causes of Russian inflation has any validity, what it says is that the inflation risks in Russia are very high. What that in turn implies is that there would be very serious risks of a significant rise in inflation if monetary policy were prematurely loosened, which given the importance of inflation to the country’s political mood suffices by itself to explain why the authorities are not prepared to do it.

    4. I say this because some of the commentators here have it seems to me come close to saying that the rate of inflation in Russia is unaffected by the level of interest rates and that loosening monetary policy would leave the rate of inflation unaffected. That would be very remarkable if it were true and it really would suggest that economic conditions in Russia are so completely different from those everywhere else that general principles of economic policy do not apply to Russia. Whilst Russia’s economy has its particular features I certainly would not go that far.

    5. To what extent though is this argument about the structural causes of inflation really true? My immediate objection to this argument is that what it amounts to comes very close to a counsel of despair. It suggests that there is nothing much the authorities can do to bring inflation down at least in the short even though this is the single most important issue that concerns Russians. I dislike counsels of despair on principle and I truly don’t think there are grounds for one here.

    6. Briefly, it seems to me that it makes far better sense to understand inflation in Russia as the result of the massive inflationary momentum that built up in the late Soviet period and through the 1990s, which has in turn created inflationary expectations, which have still not fully worked their way through. The best way to deal with this problem is to target inflation through monetary and fiscal policy thereby bringing both inflation and inflationary expectations down. That is what the authorities started doing a few years ago (they were not doing it before the 2008 crash) so that for the first time in its post Soviet history Russia now has positive real interest rates. Despite the inevitable setbacks the results over all have been positive. Inflation is now firmly in single figures and with policy this tight I for one expect it to fall further in the second half of this year as by the way does the Central Bank. My personal opinion (and here I accept I am being intuitive) is that once inflation falls below the Central Bank’s target of 5% (which I expect will be achieved before long) and remains there for a period, expectations about inflation will change and further falls will follow. At that point we will see inflation in Russia converge with current European levels.

    7. For the rest, I don’t think anybody seriously questions that if growth is to take off interest rates will have to fall. The point is whether one is prepared to wait until inflation falls (as I do) before that happens or whether one is prepared to accept inflation risks and do it now. The point about waiting until inflation falls before loosening monetary policy is that with unemployment as low as it is now (in St. Petersburg the rate of unemployment is just over 1%) there is no urgency about achieving higher growth now and no spare capacity in the economy that can be easily mopped up. Basically what needs to happen for growth to be sustained over a long period is for productivity to increase through high sustained long term investment in existing plant and businesses and for money to become available for long term investment in new start ups. That is simply not going to happen when the value of loans and savings (and thus the pool of available capital) is being constantly eroded because of high inflationary conditions. Both Putin and Medvedev have spoken of raising the rate of investment in the economy to 25-30% of GDP in order to achieve a 5-6% growth rate. The whole point of bringing inflation down is to make that possible, just as it was the eventual unwinding of the inflationary over hang left over from the Mao period and the 1980s that made possible the exceptionally high rates of investment and growth the Chinese economy experienced from the 1990s.

    8. In saying all this I should say that I am not guessing at government policy. Putin, Medvedev, Ignatiev, Klepach and a host of others have explained it at length. To me at least it makes perfect sense.

    9. By contrast trying to stimulate growth now by loosening policy prematurely risks in an economy already operating at full capacity and with inflation already high risks high triggering even higher inflation, exacerbating the economy’s tendency to go for very short term investment whilst sucking in more imports. There would be a brief spurt in the GDP figures but overall the economy would be weakened rather than strengthened and in a way which moreover might because of the eventual squeeze on living standards have very serious political repercussions.

    10. For the rest, I don’t think there is any question that the government is committed to the country’s reindustrialisation. Hardly a day goes by without Putin pressing for the manufacture of goods (especially aircraft) in Russia rather than their import from abroad. As I said, the whole point of the current counter inflationary policy is to create the financial conditions to make sustained reindustrialisation possible. At the same time the government is pursuing a policy of military modernisation that is straightforwardly and openly justified as a direct budgetary subsidy for the science base and for manufacturing industry. The two policies are not in conflict but are clearly intended to compliment each other.

    11. Nor do I think that it helps much to characterise the people who currently run the economy as “liberals”. Though there are certainly arguments about pace with the Economics and Industry Ministries not surprisingly arguing for a faster pace than the Finance Ministry and the Central Bank, all the people who run the economy would be considered in the US “big government” types. No one for example is suggesting that the government withdraw from providing education and healthcare or that it cease intervening in the economy in an active way. Besides one should be careful not to fall into the trap of thinking that it is only neo liberal free market fundamentalists who worry about financial soundness and price stability. I have just come from Germany where the political centre of gravity is far to the left of what it is in the US on economic questions as on most others but where commitment to financial soundness and price stability is solid across the entire political spectrum.

    Anyway, as I said before, that is my take on the position. Anyone who disagrees is of course welcome to do so. Apologies again for the delay and for the length of this reply.

  4. ….and here we have the policy summarised by Novosti from Nabiullina’s comments to the Duma.


    If inflation is brought down to 3-4% then we are looking at a totally different inflationary environment.