Q: Mikhail Mikhailovich, some economists claim that a stronger ruble and higher inflation cannot go together, and that in a healthy economy the two are mutually exclusive. How would you explain the paradox?

Zadornov: There is no paradox. The situation is perfectly logical and follows a pattern. Russia’s balance of payments has been improving, and the country is witnessing large inflows of foreign exchange. In the first quarter of this year, according to data from the State Customs Committee, the country earned $19 billion from oil and gas sales alone, or $7 billion more than the corresponding figure for 2002. World prices of ferrous metals are today 30% higher than last year, and those of non-ferrous metals, 10% or so higher. Furthermore, our business people are keeping far less money abroad: Low interest rates on world markets cannot produce high yields on dollar or even on euro deposits. Owing to low interest rates on world money markets, private Russian business like Gazprom and Alrosa have been borrowing enormous sums from abroad. According to the Central Bank, they borrowed $5.5 billion in the first quarter of 2003. Moreover, foreign exchange inflows exceed domestic demand. Over the past five months or so, the Central Banks forex reserves grew by $15 billion, even though the government paid out about $3.5 billion in foreign debts in May.

Given the large dollar inflows, the Central Bank has no alternative but to buy the surplus on the forex market, leading to the ruble’s appreciation: the current exchange rate is approximately the same as 18 months ago. The snowballing money supply (roubles) in the economy has pushed up inflation. The Central Bank has withdrawn some of the ruble surplus by simply requiring that deposits be made in rubles, and by making repo transactions (forex or securities deals where the seller pledges to buy back on a specified date and at a specified price. -Ed). Another part of the ruble surplus went into the state budget in federal and Pension Fund accounts. However, the bulk of the ruble surplus is still circulating in the economy, leading to rising consumer prices.

Obviously, the government and the Central Bank have failed to live up to their commitments to bring inflation down to 10% to 12%; the inflation rate remains at approximately last year’s level of 14% to 15%. Even worse this summer we will probably not see any seasonal drop in prices or zero inflation (a drop usually observed in July through August), as the $15 billion recently bought by the Central Bank is twice the amount originally planned for the whole year. And naturally, the amount of rubles printed is double the figure that had been originally set. While it is true that the economy has been growing and absorbing part of the ruble surplus, a considerable proportion remains on the market.

Question: What, in your view, are the real ironies of our economy?

Zadornov: Let me give you one example: People who want to prevent their savings from depreciating go to the bank, where they will be offered 12% to 15% annual interest on their ruble time deposit – which is no higher than the inflation rate. A bank that accepts deposits must invest the money. Where? Government securities are ruled out - their current yield is no more than six to eight percent. The Central Bank offers approximately the same interest rate.

In other words, banks that buy government securities will make a loss. Investing abroad is not profitable either. The current yield on Russian foreign-currency denominated Eurobonds is seven to eight percent. At such a rate, your ruble appreciation at the end of the year will be zero at best: you are more likely to incur to suffer a loss.

People are being told incessantly to get their savings from under their mattresses and go to the bank. But in the monetary situation in Russia today most banks are not interested in the population’s savings, and won’t accept them on deposit. In other words our economy is exposed to serious imbalances which must be rectified.

To my mind, a top-priority task of the government and the CB should be to axe inflation within one or two years. Unless this is done, it will prove impossible to achieve any other economic goal, such as a doubling in Russia’s GDP. The ruble’s appreciation will only slow down in the case of zero inflation and the main financial instruments will start bringing banks and investors profits instead of losses.

Unless we accomplish the major task of slashing inflation, we will continue to witness another irony. The government recently announced with pride 6.5% production growth for the first quarter of 2003; it also announced a rise in incomes and investments. All that is true. But let us also look at other objective facts, such as the index of the population’s consumer mood. This index has been falling for four months in a row. People grew increasingly dispirited during the first quarter owing to the threat of unemployment and wage delays. The proportion of discontented people has grown 2.5 times. Even though economic growth continues, lots of people still fear for their future. Evidently incomes are being redistributed in a manner that is detrimental to the social situation. This irony will last until inflation is suppressed.

Question: Does this mean that the government will have to sharply cut expenditures on the social sector, the army, science and culture?

Zadornov: Nothing of the sort. First of all you must adopt a monetary policy to limit the money supply. Second, consumer price growth is also attributable to the continuing increases in the tariffs of natural monopolies and the housing and public services. Here we have been struggling within a vicious circle for several years. Only determined action will bring down inflation. Efforts in this direction are needed to eliminate the imbalance between the economy and the social sector.

Question: Which basic targets of the 2003 budget will be attained?

Zadornov: The federal budget will run a large surplus of some 150 billion rubles, as testified by first-quarter results. Probably much less money in ruble terms will be spent on paying and servicing the foreign debt, allowing the state to save a sizable amount. As we proposed in the fall last year, ruble expenses on foreign debt servicing must be reduced, and the cash saved in this way must be spent on supporting the regions. They have to give state-paid workers higher wages from October 1 and purchase fuel for the winter; according to my estimates, this will cost them an extra 15 billion to 20 billion rubles for these purposes alone, not seven billion to eight billion as we had thought. Therefore we must correct the current financial plan in September, increasing funds for the regions.

See also:

Russian Economy

Moskovskiye Novosti, June 11-17, 2003