Problems in monetary policy

In 1999 the government and the Central Bank faced first with a problem of repayment and servicing foreign government debt as well as domestic. High devaluation and default on foreign payments led to a sharp decrease in foreign credits that made a negative impact on federal budget financing. Besides, the absence of liquid domestic financial markets (after the GKO market was frozen) resulted in that the government securities market stopped to provide a possibility of rapid ruble funds attraction and support a stability of domestic financial system. Therefore, the CBR in 1999 was very restricted in instruments of monetary policy and, consequently, it could not be a large variety of CBR actions in 1999.

One of the most strong negative effect of the financial crisis was on a banking system. Government securities amounted to 60% of all banks liquid assets and after trades on a GKO market were terminated bank liquidity came near zero. Moreover, an announcement about a forced restructure of government securities and a widening of boundaries of the "corridor" (that means a devaluation of the national currency) brought a panic among the population and mass withdrawal of bank deposits. During August-September 1998 household deposits in domestic currency decreased by 25 bln. rbl. and foreign deposits - by $1.4 bln.

There was an aggregation process in banking sector in 1999 - an amount of credit organizations declined by more than 1000 entities along with a rise in aggregate banking assets by 50%. A share of Sberbank assets accounted for 25% of total banking assets and was closed to the same indicator of 1998. Therefore, a structure of banking system with the major role of Sberbank remained unchanged. Financial results of banking system were negative and also did not significantly change in 1999 compared to 1998. Net losses amounted to 32 bln. rbl. while Sberbank had a net profit of 14 bln. rbl. as at the end of 1999. Banks credits to enterprises in domestic increased by 120 bln. rbl. or by more than 2.4 times, but foreign credits reduced by $2 bln. A share of private banks (excluding Sberbank) in total ruble credits was 64% in 1999, a share in foreign currency credits - more than 80%.

Along with above mentioned factors, that had already emerged in 1998, macroeconomic parameters should be influence by high inflation expectations in 1999. These expectations were based on high inflation rates in the second half of 1998. Optimistic forecasts at the end of 1998 predicted a consumer price index growth in the rage of 80% to 100% in 1999.

Central Bank Policy

Monetary policy experienced fundamental changes at the beginning of 1999 compared to even after crisis situation in Russia. The Central Bank stopped in fact to maintain an independent policy on stabilization of financial conditions. In contrary, the main targets of the CBR became to support federal budget balance and to provide credits to the government for payments on foreign and domestic debts. Such a policy was defined by objective reasons (non-liquidity of domestic financial markets and impossibility to borrow on international capital markets) as well as subjective reasons (changes in policy preferences of the government and the CBR).

In the first quarter of 1999 despite monetary base did not expand net credit to the federal government increased by 47 bln. rbl. while net international reserves (NIR) declined by 14 bln. rbl. This significant amount of additional money inflows into the economy through the direct CBR credits worried western experts about consequent increases in other monetary parameters that would speed up an inflation rate. In January-March 1999 an average monthly inflation was 5% that corresponded equaled to 60% (December/December) on annual basis and money supply raise by 25.5 bln. rbl. or by 6%.

Since the beginning of the year the Central Bank tried to maintain a stable dynamics of the exchange rate and did let the ruble to devaluate sharply. In January 1999, there was a jump in exchange rate - the ruble with respect to the dollar depreciated by 17% in nominal terms. This occurred, primarily, due to a post-crisis high demand on foreign currency and, in some aspects, due to an influence of seasonal factors. However, the real exchange rate remained unchanged and this was consistent with the CBR's plan on 1999.

In the second quarter of 1999 base money raise sharply by 53 bln. rbl. or by 26% as well as M2 - by 93 bln. rbl. or by 20%. Credits to the federal government continued increasing and during April-June amounted to 23 bln. rbl. However, inflation reduced and an average rate was less than 2.5% in Q2 1999. Moreover, nominal exchange rate did not grow at all and real appreciation reached 7% during this period.

These disproportional increases in monetary parameters were backed by a form of CBR credits that primarily were supplied for the government foreign debt payments and were nominated in dollars. In other words, the CBR bought dollars in open market operation (or spent its international reserves) and paid out government debts without converting these funds into rubles. Certainly, this procedure led to ruble inflows to the Russian economy but did not affect an inflation rate.

During the Q1 1999 CBR purchases of foreign currency on open market were $120 mln. while in the Q2 these purchases reached $2.5 bln. (Remember, that in the forth quarter of 1998 CBR bought $1.5 bln.) At the same time, gross foreign reserves in the first quarter fell by $1.4 bln., in the second quarter they rose almost by the same amount. As a result, in the first half of 1999 international reserves decreased by only $70 mln. This dynamics of international reserves showed that the CBR was strictly restricted in choosing methods of monetary policy. In fact, the CBR could only switch between spending foreign reserves and foreign currency purchasing with a consequent domestic market saturation by rubles.

At the beginning of summer 1999 IMF experts were afraid that money emission and supporting national currency policies would lead to worsening economic situation and suggested a program for macroeconomic development in the second half of 1999. The key point during a discussion of the program was the upper limit of CBR credits to the government. IMF experts considered that an increase in credits by 20-25 bln. rbl. during the year corresponded to 50% increase in inflation and exchange rate. If credits would be more than this amount inflation would rise much higher than 50% that would influence an additional pressure on the exchange rate and would destabilize the economy. However, the Ministry of Finance supposed that such increases in inflation and exchange rate corresponded to CBR credits in the amount of 50-55 bln. rbl. within the year. During negotiations a compromise variant was taken as a basis but the actual results of economic development in 1999 were closer to the government forecasts.

In the second half of 1999 the Central Bank bought $3 bln. and the federal government paid out $4.6 bln. on foreign debt. As a result, the CBR purchased $5.6 bln. at the market in 1999 but total foreign debt payments amounted to $9.5 bln. Almost all CBR currency purchases were used for foreign debt repayments of the government or of the Central Bank. Approximately $4 bln. were taken directly from the federal government revenues - about $ 1.5 bln. of foreign credits and $3.5 bln of primary surplus. In addition, the federal government disbursed about $1 bln. of commercial banks and CBR ruble and dollar credits. We should also take into account that the dollar equivalent of foreign debt principal and interest payments exceeded $2 bln. The Ministry of Finance bought from the CBR about $2 bln. in 1999. This figures illustrate the tight connection between monetary and exchange rate policies of the CBR and the government budget needs. CBR operations not related to foreign debt payments were residual.

Money supply growth accounted for 57% in 1999 (27% - in the first half of the year) and inflation (consumer price index) reached 36.5% (24.5% - in the H1 1999). Therefore, if during the first half of the year there was no gap between M2 and inflation growth rates then in the second half this gap sharply increased. Did this mean that the demand for money increased and high inflation fears overcome? Or substantial growth of money supply would impose an additional inflation pressure in the first half of 2000?

Indirect answer on these questions can give an estimation of money demand through the GDP and industrial production growths in 1999. GDP growth (December/December) was about 7% and annual GDP growth was more than twice lower. There was a slightly different quarterly dynamics: in the forth quarter of 1999 GDP rose by 6% compared to the same period of 1998 but in the second quarter of 1999 GDP already grew by 5%. Therefore, in the second half of 1999 GDP growth was negligible. As a result, GDP growth explains up to 7% of the gap between inflation and money supply growth in 1999 (assuming constant money velocity). The rest part of the gap (approximately 8%) remained "unexplained".

At the same time, econometric analyses show that this gap can be easily explained by the fall in money velocity that goes with GDP increase. This comes from the fact that the elasticity of money supply growth to GDP growth approximately equals to the elasticity of money supply growth to inflation.(?) However, this is one more fact that doubts this conclusion - producer price index (PPI) amounted to 67% in 1999 (31% in the first half of the year). PPI exceeded an increase in money supply even if a growth in production surpassed GDP growth. (There are two main reasons of rapid industrial production growth in 1999: 1) PPI was significantly less than CPI in 1998, and 2) sharp increase in world prices on Russian export goods in 1999).

In total inflation in 1999 corresponded to the increase in the money velocity taking into consideration a growth in money demand influence by a rise in production growth in the second half of 1999. And growth in consumer prices was slow than a growth in money supply not only because of increase in money demand but also of larger segmentation in money supply growth. Money remains rose generally not on liquid consumer market (households income growth was nearly zero) but on enterprises current accounts that produced a large money demand. Consequently, money supply growth did not bring an additional pressure and increase in prices on consumer market. Therefore, these exists some risk of inflation acceleration in 2000 due to rather vague perspective of production growth as well as outstrip growth in households income that started in the third quarter of 1999.

Chart 5: Monetary Base and Inflation (% change to the previous month)

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Foreign Debt - The Possibility of Crisis

Debt Refinancing

In 1999 the government made foreign debt payments in the amount of $9.5 bln. Besides, the CBR made its our payments on the IMF credit and held auctions on selling foreign currency to non-residents who wanted to repatriate profits in rubles from the GKO/OFZ novation. Therefore, the total amount of capital outflow from the government sector was about $10 bln. in 1999. In 2000 the total outflow from the public sector will exceed $10 bln.

Capital inflow to the government sector in 1999 amounted to $2.7 bln. including tied credits and less than $1.5 bln. without tied credits or funds from international financial organization (IFO) and the government of Japan. As a result, the CBR spent about $5 bln. of its reserves to maintain debt payments. In 2000 necessary amount of using CBR reserves also will depend on receiving credits from IFO and the Government of Japan. However, these credits are subject to not only fulfillment of macroeconomic program parameters but more to political aspects. Possibilities of market fund disbursement first of all depend on finishing negotiations on debt restructuring with London and Paris Clubs of Creditors and on ability to achieve political stability in the country.

During 1999 the CBR tried to compensate debt payments by currency purchases on open market. This explains a high interest from investors to monthly debt schedule on foreign debts. The CBR is likely to keep this strategy in 2000 and the main goal of CBR policy will be to balance a smooth exchange rate dynamics and appropriate level of international reserves.

Capital Outflow

During last years capital outflow (defined as an increase in private assets) amounts in average to $20 bln. per year. We expect the capital outflow to be close to this level in 2000. Capital outflow significantly decreased down to $2.1 bln. in the second quarter of 1999 but then increased again in the third and forth quarters (up to $5.3 bln. and $6.7 bln. correspondingly).

Capital outflow from Russia can be divided to fundamental and speculative. The former reflects long-term savings and investment preferences and the later - short-tern. Resources of speculative capital outflow do not leave financial markets, however, resources of fundamental capital outflow are located on real sectors of economies - legal or illegal - in Russia or other countries.

Chart 6: Structure of Capital Flows in 1996-1999, $ bln.

Fundamental capital outflow highly exceeds speculative in Russia. For that reason, it is very expensive and ineffective to fight with a speculative capital outflow. At the same time it is nearly impossible to fight with fundamental capital outflow without solving fundamental problems of the economy. Administrative and force measures can help only in short-tern perspective and to fight with "black" capital outflow. The main part of capital outflow can be defines as "gray" capital flight and it is possible to "win" this battle only by using economic methods. The keys to a success are tax reform that would provide a sharp decrease in nominal tax burden, simultaneous elimination of tax exemptions and improvements in tax administration, a reform in government management targeted to put off government officials from resources distribution, and an improvement market competitions on regional markets and overall Russian market. However, all these reforms, in tern, can not be achieved without reaching overall political consensus.

Budget Policy Problems

One of the most discussed questions in 1999 was whether the government and the CBR managed to control inflation despite the fact that foreign credits were very limited. In Budget Law 2000 it is projected that foreign credits will account for around $6 bln. Nevertheless, this level of credits is very optimistic and highly overestimated. According to more realistic estimations Russia in 2000 can receive about $2.5 bln. that will lead to a foreign financing gap by $3.5 bln. Consequently, the government will have to find additional financial resources and it will have tree possible variants: 1) to increase in primary budget surplus; 2) to take extra credits from the CBR; 3) to disburse necessary funds from commercial banks.

If world prices on energy resources remain high in 2000 than the government will have extra revenues in hard currency from export activities. However, additional financing from budget resources will not exceed $1 bln. According to Budget Law 2000, lack in financing can be backed by CBR dollar credits (as it was in 1999) and CBR credits can not go beyond $1 bln. If the CBR ought to provide the government additional credits (after making appropriate changes in the Budget Law 2000) than CBR foreign currency purchases on open market will increase that imply an inflow of extra money liquidity into the banking sector. And it is an open question whether the Russian economy can absorb such a liquidity.

According to the original time schedule of Russian foreign debt services total payments exceed $16 bln. in 2000 or 65% of budget revenues. In 2001-2003, an average level of foreign debt payments amounts to around $18 bln. Evidently, Russian foreign debt had to be restructured and total payments should to be reduced by approximately twice. In July 1999, Russian government reached an agreement on negotiations with the Paris Club of Creditors (the PCC) about restructuring the Russian debt to the PPC during the period of 1999-2000. It was agreed that negotiations would continue after the President election in Russia in 2000.

Negotiations with the London Club of Creditors (the LCC) successfully finished on February 11, 2000. As a result, total debt to the LCC amounted to $31.8 bln. was restructured into new Eurobonds with face value of $21.0 bln. This restructuring admits a 36% debt reduction to the LCC. However, taking into account a grace period for interest and principal payments Russian debt was reduced in fact by mire than 50%.

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Prospective for 2000

Capital Inflow and Its Consequences

Stabilization of economic and political situations in Russia led to an improvement of investment climate in the country. Taking into account high world prices on Russian export goods it will be a large trade balance surplus in 2000. It is also likely that foreign investments to the Russian stock market will increase. If the government decides to develop government securities market than we can expect a foreign portfolio investment inflow.

Preserving the dynamics of international reserves in the first three months of 2000 for the whole year a rise in reserves may amount to $15 bln. that corresponds a reserves level of $25-$28 bln. to the end of 2000. However, this optimistic forecast (very popular recently) can happen only if two conditions maintains: 1) oil prices remain high (or huge trade balance surplus), and 2) capital outflow decreases.

Capital outflow from Russia mainly depends on the level of capital inflow - the more the capital inflow the higher is illegal capital outflow. Therefore, the expected capital inflow may not lead to an increase in international reserves but to increase a capital outflow.

We should also notice that such a significant inflow of foreign currency into eternal markets will demand a sterilization from the CBR. Otherwise, capital inflows will affect a money supply growth and consequently affect a consumer price growth. According to our estimations, monetary base growth rate can reach 35%-40%. Increase in money supply will require open market interventions of the monetary authorities to withdraw "spare" inflation component of ruble volume growth. These operations can be made by the Ministry of Finance by issuing government securities (GKO/OFZ) as well as by the CBR issuing short-term bonds (OBR). Emission of OBR will to new growth in money supply due to relatively high interest payments and we do not expect considerable emission of OBR in 2000. On the contrary, GKO/OFZ issuing will exceed the planned level, according to the Budget Law 2000 GKO/OFZ should amount to 15 bln. rbl. At the same time non-market disbursements were planned to amount to 35 bln. rbl. It is likely that the Ministry of Finance will switch from non-market to market borrowings.

Chart 7: Foreign Trade in 1996-1999 and Projection for 2000, $ bln.

Moreover, one of the way of sterilization can be government purchases of foreign currency from the CBR to repay external debt. In this case, if the Ministry of Finance use sources from increased budget tax revenues than there will be no inflation effect of foreign capital inflow. This scheme explains the dynamics of macroeconomic parameters in the first quarter of 2000. Indeed, the CBR purchased about $5 bln. on currency market (140 bln. rbl.) and $2 bln. of this amount was used to fulfill government foreign obligations. However, inflation amounted to only 5% in January-March 2000 that on annual bases equals to 15%-18%.

There exists one more factor that keeps inflation from accelerating with a significant increase in money supply - a very low level of monetisation of the Russian economy. At the beginning of 80-es the GDP ratio to money supply was equal to 40% and in the middle of 90-es this ratio fell down to 15%. At the end of 1999 monetisation level reached 16% that indicates a rather low level even among developing countries.

Chart 8: Foreign Debt Payments of the Russian Federation in 1999-2010, $ bln.

Scenarios of Economic Developments in 2000

Summing up all mentioned above we can state that the CBR only two possible methods of monetary policy in 2000:

1. keeping inflation and exchange rate from high growths and irrelevant increase in international reserves;
2. smooth devaluation of national currency and significant rise in international reserves.

In the first scenario inflation will not exceed 20% (Dec./Dec.) and nominal ruble devaluation will be less than 15% (exchange rate will not reach a level of 30 rbl./$). The level of international reserves to the end of 2000 will amount to $15-17 bln. According to this scenario the ruble will highly appreciate that lead to decrease in export and increase in import because (keeping other things constant) domestic goods become cheaper than foreign goods. The realization of the scheme can happen only in short-run as it is unlikely that the government will support such a strategy (the political influence of exporters on Russian economic policy is very strong). Besides, these is a probability of a decrease in oil prices that will lead to impossibility of keeping the exchange rate stable.

The second scenario is more likely and suitable in long-run. It implies a zero real devaluation and an increase in foreign reserves by $22-25 bln. to the end of 2000. A high level of reserves, low inflation and rather stable exchange rate create optimistic perspectives of Russian economic developments in 2000. Moreover, this strategy do not affect interests of exporters and at the same time do not generate obstacles for import growth. However, as we mentioned above, the realization of this scenario can be blocked by the deterioration of the situation on the world tare markets and by the increase of illegal capital outflows.

Table 3. Forecast of Key Economic Indicators in 2000

	Actual, 1999	Forecast, 2000
		Official	EU "VEDI"
Nominal GDP, bln. rbl.	4545	5300	6000
Real GDP growth, %	1.3	1.5	3.0
Trade balance, $ bln.	33.0	37.0	40.0
Money supply growth, %	57.0	40.0	60.0
Inflation (Dec./Dec.), %	36.0	18.0	20.0
Foreign credits, $ bln.	2.8	4.5	2.5

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