Building a Post-Crisis Economic Paradigm

As in the rest of the world, analysts of the Russian economy are beginning to accept that the country is not going over the edge of a cliff. From a spiral of increasingly dire forecasts trying to play catch-up with worsening data early in the year, these same analysts started revising for the most part their projections upward from July onward. The process is hesitant and ongoing, as it has been in most other countries.

For Russia, it is useful to recall that the gloom and doom when real gross domestic product fell by 9.8 percent in the first quarter over a year earlier were overdone since about 7 percentage points of that drop was accounted for by inventory destocking (largely from Gazprom, which is likely to be temporary). Focusing on month-to-month rather than annual data, it looks as if the economy has stabilized, with evidence of a return to growth starting to appear in the second quarter, and becoming apparent in July. Physical data, such as those on industrial production, rail loadings, natural gas production and metals sector performance, all point to a return to growth.

Personal income indicators have also shown a good recovery, largely reflecting an increase in government social benefits. Following a long period of lending compression in the country’s financial system, the credit crunch started to ease in July. Loans by the aggregated banking system were unchanged for the month and should start rising in the coming months as deposits have grown and banks are flush with liquidity. As resources gradually start flowing into the real economy again, this should provide additional positive momentum for economic recovery.

The shift in the government’s budget position from an 8 percent of GDP budget surplus in the first nine months of 2008 to a planned deficit of almost 8 percent in 2009 is arguably the biggest government stimulus package globally on a relative basis. The opening up of credit markets, looser monetary policy and fiscal stimulus all suggest that economic growth can resume more strongly than many observers, including overly cautious government officials, would suggest. With positive growth in the second half, the real decline in GDP this year should be no worse than 5 percent.

Of course, it goes almost without saying that the oil price remains a major risk. Globally, oil inventories are close to all-time highs, and utilized capacity is historically low. Financial demand in commodity markets clearly makes economic sense as a hedge against dollar depreciation, but at some point there has to be physical demand. Additionally, an increase in global economic activity is a necessary condition for continued improvement in Russia.

Those who seek certainty are likely to be confounded by the period of instability ahead. Even the best economists and financial analysts don’t know what letter of the alphabet would best describe the recovery — V, U, W or L. Historical parallels are inexact, and economic theory about debt crises is of only limited help. Volatility on exchange, commodity, bond and equity markets is more likely over the next couple of years than a nice linear trend.

For Russia, the uncertainty is poignant although contradictory. It is poignant because the country has been severely, even if temporarily, affected by the external crisis. People are worried, and there is an unfortunate but understandable lack of confidence in their government. This is manifested in uncertainty about the ruble exchange rate in the face of decelerating, but still high, inflation, which is projected to be 10.5 percent for 2009. It is also contradictory because Russia — as a large, low-debt, emerging economy — should inherently be in a better position than most of its Group of 20 partners. Whereas many highly indebted advanced economies may face a double-dip recession, this is highly unlikely in Russia’s case, barring a plunge in energy prices. So the recent financial market euphoria may actually be warranted, although you would not know it when even senior officials warn of trouble ahead and difficulties for the banks because of escalating bad loans.

Leaving aside longer-term issues and given the wait-and-see attitude of the Russian population, the real test in the short run is whether inflation can be brought down permanently to rates prevailing in leading financial centers. This is critical because so many seem to think that another ruble crisis is inevitable— as indeed it will be if the exchange rate continues to appreciate relative to those of other countries in real terms. This uncertainty about the future strength of the ruble — perhaps more than any other single factor — clouds the country’s economic prospects as it keeps nominal interest rates too high and discourages savings and investment.

The key policy variable in this regard is the budget. Excessive government spending — especially if it occurs all at once — is the major risk. From a budget of about 10 trillion rubles ($318 billion), only 4.7 trillion rubles ($149 billion) were spent in the first seven months of the year. This implies that 5.3 trillion rubles would need to be spent in the remaining five months or an increase in the monthly rate of expenditure by 64 percent. As a consequence, the fiscal deficit would jump by 2.5 trillion rubles in the period from August to December. The economy would be overwhelmed by excessive government spending with most of it bunched in late November or early December.

Even though in reality the budget deficit may be smaller than the planned 3.4 trillion rubles, a huge spike in ruble liquidity could occur by year-end. This could obviously create turmoil on the foreign exchange market and translate into high inflation in January and February. It looks as if the economy will once again receive money at year-end that it does not need, while the financial system will experience undesirable volatility.

The budget deficit has become a serious threat to stability on the foreign exchange market. Hence, greater exchange rate volatility can be expected during periods of traditional growth in public expenditures. The issue is then whether the government is prepared to curb its spending in order to stop the inflationary expectations. Finance Minister Alexei Kudrin is already sending appropriate signals regarding the 2010 budget, but he must stand up to the spending pressures from his colleagues in the government and lay the foundation for the country’s new economic paradigm.

If successful, the economy can have a chance to increase its competitiveness through higher productivity. This could lead to a long-term strengthening of the ruble and lower interest rates, which would help stimulate investment and private demand. In other words, even while some advanced economies risk an extended period of stagnation, Russia has the possibility of entering a virtuous cycle along with other emerging economies. The ball is in the government’s court.

Martin Gilman, former senior representative of the International Monetary Fund in Russia, is a professor at the Higher School of Economics.