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the bank was ready and willing to use interest rate policy as required to stem speculative capital flows that threaten to undermine currency stability inflation woes one small consolation at least in this ongoing mess is that pressure on russia s producer prices have been easing and factory gate prices have even been falling according to the preliminary data from the state statistics service the price of goods leaving factories and mines was in fact down an annual 10 8 percent in august following a record 12 3 percent drop in july evidently the with the 2008 spike in oil and energy prices the logic behind this is easy to see what is not so easy to see is why domestic prices take so long in responding to general capacity utilisation signals and why the economic development ministry still seems comfortable with the expectation that average inflation will range between 12 percent and 12 5 percent in 2009 only marginally down from last year s 13 3 percent stunning and while consumer price inflation has been tame in recent months this good behaviour may not last long since it could rise more than expected in november according to deputy economic minister andrei klepach who does not seem to completely share alexei ulyukayev price optimism consumer prices could rise by about 0 3 to 0 4 in november klepach said in comments recently and this prediction seems to be near the mark since according to the latest data we have consumer prices rose 0 1 in the week to 9 november bringing to an end a period of just over three months without inflation looking into the future price growth may be further spurred by an influx of budget spending in the fourth quarter as well as by a planned 30 increase in pensions which is due to come into effect on 1 december in fact despite the fact that inflationary pressures have been easing in russia in recent months chiefly due to collapsing consumer demand and outlfows of capital following the crisis that hit the country a year ago the official outlook for russia s inflation in january 2010 is only that it will be significantly below the level of january 2009 this kind of argument is hardly reasssuring since inflation last january was at an annual rate of 13 4 although the short term outlook is for only a mild acceleration with consumer prices increasing by between 0 2 and 0 3 in november and by about the same amount in december why not devalue well one way not to solve the problem according to european bank for reconstruction and development chief economist erik berglof would be a ruble devaluation since despite recognising that the country has a very difficult couple of years in front of it berglof argued recently that this devaluation is the wrong way to think about the recovery in russia as he said russia s failure to wean itself off its reliance on commodity exports has condemned the country struggling to find economic growth in the face of a large drop in demand for its key export products if you want to have a flexible exchange rate you need to get out of this dependence on commodities berglof said it s a major concern that in the last 10 years russia has become actually more dependent on commodities unfortunately not much progress has been made well this is exactly the point and is why i have been arguing over the last two year about how all those wage increases which the russian administration seemed to rejoice in since they bought short term popularity and fuelled consumption simply stoked up the domestic inflation bonfire and in the process did untold damage to domestic competitiveness however it is evident russia s industries cannot now simply be transformed overnight and this is where i find a weakness in berglofs argument since some remedy is needed to straighten out the distortions and get of commodity export dependence but what if it isn t devaluation then surely we will need to see very substantial wage deflation in order to attract the now much needed inward foreign investment the current position whereby prices rise by an annual 10 and living standards are maintained by a sharp rise in the value of the ruble making imports cheaper is quite simply unsustainable for reasons which should be evident from looking at the chart below if you look at the green line which shows the real trade weighted effective exchange rate we will see how this has risen sharply since 2003 with the exception of the drop in the value of the ruble in the second half of last year if we then look at the blue line which shows the non oil and gas current account balance we will see how this has been steadily deteriorating again with the exception of the short sharp shock occassioned by the crisis of last autumn however as we can also see the green reer line has now once more resumed its upwards march the consequence of all those financial inflows and the associated rise in the ruble and with the upward march comes the ongoing structural damage to the economy precisely the can t of structural damage which erik berglof would like to avoid and even unwind of course not everyone agrees with berglof and the russian association of regional banks whose 450 members include the russian units of barclays and citigroup has called for a devaluation of as much as 30 percent billionaire vladimir potanin realist and owner of 25 percent of oao gmk norilsk nickel said in recent interview with the russian newspaper vedomosti that the interests of the economy will lead the currency to depreciate in the mid term allowing exporters to cut costs and modernize production nonetheless energy including oil and natural gas accounted for 69 1 percent of exports to countries outside the former soviet union and the baltic states during the first seven months of this year according to the federal customs service while metals were responsible for another 12 so the commodities dependency is massive and this situation can t be turned round easily getting carried away by global liquidity bank rossi are also not 100 convinced by the merits of berglof s reasoning as witnessed by the fact that they facilitated a 35 percent depreciation in the ruble during the second half of last year see chart below and as the collapse in raw material prices and the dramatic change in local credit conditions first pushed russia s economy into recession the ruble s trading range was widened to between 26 and 41 against the dollar euro basket however as i keep stressing the central bank is now locked on the horns of a massive dilemma since as risk appetite returns with it comes the enthusiasm for buying the so called high yield currencies like the south african rand the russian ruble and the hungarian forint instruments denominated in all these currencies offer investors substantial returns at the present time thanks to offering some of the highest interest rates among globally traded currencies indeed buying russian rubles was one of the key recommendations made by angus halkett currency strategist at deutsche bank in london in a research report published back in april and the market seems to have followed his advice the so called carry trade works by investors borrowing in currencies with low interest rates and good prospects of continuing depreciation the usd at the moment for example in order to buy higher yielding assets in countries with high domestic interest rates and continuing prospects for ongoing appreciation in general engaging in one or other form of the thousand and one varieties carry trade is pretty standard practice during times when returns for real economic activity are low and central banks hold down rates and supply liquidity indeed we may include here the kind of carry practiced by banks in borrowing from the central banks only to then lend for a small but very low risk interest rate commission to their national government who at this stage in the business cycle will normally be running a fiscal deficit so more than funding recovery the watchword at the moment is very much carry on carrying but for those on the receiving end the consequences of so much carry are far from innocuous since the process simply funds all sorts of economic distortions and far from allowing normal market corrections to occur it simply amplifies the problem things are now becoming very detached from the so called fundamentals whatever those might be in the topsy turvy world in which we now live since it simply is not plausible that the currency should be rising in this way in a country with nine percent plus consumer price inflation and which badly needs to move away from commodity export dependency the only conclusion which could be drawn is that the russian economy now needs massive structural reforms and on any imaginable scenario in the world in which i live these are simply not going to be implemented on the other hand russia s central bank may have to accept a stronger ruble next year as rising commodity prices prove too powerful a force for policy makers to counter and as consumer demand plays a bigger role in the bank s decisions the authorities will try to do what they can to smooth the appreciation but it s very hard to go against the flow said guillaume tresca paris based emerging market strategist for calyon the investment banking unit of credit agricole capital inflows are massive policy makers have indicated they will cap the ruble s gains and prime minister vladimir putin has said his government won t allow an excessive appreciation as exporters struggle to tap into a global trade recovery even so efforts to fight the ruble s advance may prove unproductive the international monetary fund warned on nov 12 adding that underlying factors justify its strength there is a growing consensus that russia s central bank is now close to accepting the inevitable and will allow the ruble to continue appreciating to help domestic demand and cap inflation as clemens grafe chief economist at ubs in moscow puts it a higher exchange rate because it transfers incomes into people s pockets could actually be more beneficial fiscal resources near to running on empty according to preliminary estimates from the ministry of finance the federal budget deficit totaled 4 0 percent between january and september slightly below the expected level in part due to the under execution of budgeted expenditures in the first three quarters of 2009 the federal non oil deficit which excludes drawing on oil revenues amounted to 11 0 percent this is managable especially given the comparatively low level of russian sovereign debt to gdp however as the world bank point out under the likely scenario of a sluggish global recovery and modest growth russia will face a tightening budget constraint and need to reduce expenditures and the fiscal deficit over the medium term further funding the planned increase in social expenditures mainly related to increases in pensions may well requires spending cuts in other expenditure categories the ministry of finance baseline federal budget estimates with conservative oil assumptions icorporate plans to reduce the federal budget deficit from 8 3 percent of gdp in 2009 to 3 percent in 2012 but the medium term fiscal outlook also indicates an extensive drawdown of russia s reserve fund to finance the deficit given the size of the anticipated deficit the reserve fund is likely to be depleted by the end of 2010 and borrowing will be required to offset the gap estimates of the ministry of finance indicate that the combined external and internal borrowing to cover the fiscal deficit will amount to 1 0 percent of gdp in 2009 1 6 percent in 2010 2 5 percent in 2011 and 1 5 percent in 2012 all of this is manageble but the depletion of the reserve fund does mean that if downside risks materialise and in particular if there are more writedowns in the banking sector needing government support that there is now little in the way of a cushion between managed adjustement and unstable dynamics outlook a hard road to travel if one thing is clear hear it is that attaining a recovery in russia s economic fortunes at this point is going to be no easy feat as trust investment bank put it in their latest report october data for the world s largest energy exporter suggest an almost complete absence of clear signs of recovery since industrial output slumped and capital investment fell october capital investment was still down 17 9 percent while industrial output dropped an annual 11 2 percent in october worse than the september reading even unemplyment was up again at 7 7 although as the world bank pointed out this is the result of the same seasonal factors which lead to the fall in unemployment over the summer on the other hand this is by no means a one way street since disposable incomes climbed a monthly 6 percent in october and rose 3 9 percent compared with the same period last year registering their biggest annual jump since september 2008 according to provisional data from the federal statistics service while wage declines eased with wages falling an annual 4 5 percent compared with a 4 9 percent annual decline in september and retail sales which had previously fallen for nine consecutive months the longest period of declines on record suddenly sprang back to life with october retail sales rose 3 2 percent from september and declined by 8 5 percent on an annual basis as compared with a 9 9 percent drop the month before other data also show this mixed picture monthly gdp indicator data from vtb capital based on the pmi surveys for the russian manufacturing and service sectors continued to show economic contraction on an annual basis in october butthe rate of decline eased for the fifth consecutive month the indicator showed a 0 6 annual contraction the slowest rate seen suring the current eleven month period of continuous decline the seasonally adjusted total activity index remained above the no change mark of 50 0 for the third month running in october indicating growth of private sector output the index improved fractionally over september to 54 2 indicating reasonably robust growth although it remained below its historic trend of 56 6 this was driven by a faster rise in services activity while the rate of growth in manufacturing production slowed to a weaker pace on a quarterly basis the indicator showed 0 4 q o q growth for the second month running commenting on the survey aleksandra evtifyeva senior economist at vtb capital reported the gdp indicator continued to point to an improvement in economic activity in october the manufacturing sector s performance deteriorated slightly while activity in the services sector is approaching pre crisis levels this might be one of the consequences of higher oil prices and a stronger rouble as low export orders were the main drag on manufacturing another encouraging development highlighted by the october surveys was the deceleration in the pace of job cuts the employment sub indices now stand at around 47 which is already higher than l...