Russia's slowdown - another domestic demand story
Today I am in to Moscow to do a presentation on the Russian economy. It will be yet another chance to tell one of my pet-stories and that is that growth in nominal GDP in Russia is basically determined by the price of oil measured in rubles. Furthermore, I will stress that changes in the oil price feeds through to the Russian economy not primarily through net exports, but through domestic demand. This is what I earlier have termed the petro-monetary transmission mechanism. The Russian economy is slowing – it is mostly monetary In the last couple of quarters the Russian economy has been slowing. This is a direct result of a monetary contraction caused by lower Russian export prices (measured in rubles). Hence, even though the ruble has been "soft" it has not weakened nearly as much as the drop in oil prices and this effectively is causing a tightening of Russian monetary conditions. This is how the petro-monetary transmission mechanism works. What happens is that when the oil price drops it puts downward pressure on the ruble. If the Russian central bank had been following what I have called Export Price Norm the ruble would have weakened in parallel with the drop in the oil price. However, the Russian central bank is not allowing the ruble to weaken enough to keep the price of oil measured in rubles stable and as a consequence we effectively are seeing a drop in the Russian foreign exchange reserves (compared to what otherwise would have happened). There of course is a direct (nearly) one-to-one link between the decline in the FX reserve and the decline in the Russian money base. Hence, due to the managed float of the ruble – rather than a freely floating RUB (and a clear nominal target) - we are getting an "automatic", but unnecessary, tightening of monetary conditions. This means that there is a fairly close correlation between changes in oil prices measured in rubles and the growth of nominal GDP. The graph below illustrates this quite well. I should of course stress that the slowdown in NGDP growth not necessarily a problem. Unemployment has continued to decline in Russia since 2010 and is now at fairly low levels, while inflation recently have been picking up to around 7%. Hence, it is hard to argue that there is a massive demand side problem in Russia. Yes, both nominal and real GDP is slowing, but it is certainly not catastrophic and I strongly believe that the Russian central bank should target 5-8% NGDP growth rather than 20 or 30% NGDP growth (which is what we saw prior to the crisis erupting in 2008-9). In that sense the gradual tightening of monetary conditions we have seen over the last 2 years might have been warranted. The problem, however, is that the Russian central banks is not very clear on want it wants to achieve with its policies. It is all about domestic demand rather than net exports Many would instinctively, but wrongly, conclude that the recent drop in oil prices is a drop in net exports and that is the reason for the slowdown in economic activity. However, that is far from right. In fact net export growth has remained fairly stable with Russian exports and imports growing more or less by the same rate. Hence, there has basically been only a small negative impact on GDP growth from the development in net exports. What of course is happening is that even though export growth has slowed so has import growth as a result of a fairly sharp slowdown in domestic demand – particularly investment growth. In that sense the present slowdown is quite similar to the massive collapse in economic activity in 2008-9. The difference is of course that what we are seeing now is not a collapse, but simply a slowdown in growth, but the mechanism is the same – monetary conditions have become tighter as the ruble has not weakened enough to “accommodate” the drop in the oil price. It should be noted that the ruble today is significantly more freely floating than prior and during the 2008-9 crisis. As a result the ruble has moved much more in sync with the oil price than was the case in 2008-9. So while the oil price has gradually declined since the highs of 2011 the ruble has also weakened moderately against the US dollar in this period. However, the net result has nonetheless been that the price of oil measured in ruble has declined by 25-30% since the peak in 2011. Furthermore, the drop in the oil price measured in rubles has further accelerated since March. As a consequence we are likely to see the slowdown in economic activity continue towards the end of the year. Overall I believe that the gradual and moderate tightening of monetary conditions in 2010-12 was warranted. However, it is also clear that what we have see in the last couple of months likely is an excessive tightening of monetary conditions. The Export Price Norm is still the best solution for Russia I have earlier argued that the Russian central bank should implement a variation of what I have termed an Export Price Norm (EPN) and what Jeff Frankel calls Peg-the-Export-Price (PEP) to ensure a stable growth rate in nominal GDP. I think simplest way of doing this would be to include the oil price in the basket of currencies that the Russian central bank is now shadowing (dollars and euros). Hence, I believe that if the Russian central bank announced that it would shadow a basket of 20% oil prices and 40% dollars and 40% euros to ensure stable NGDP growth for example 7% and allowed for a +/-15% fluctuation band around the basket then I believe that you would get a monetary regime that automatically and without policy discretion would provide tremendous nominal stability and fairly low inflation (2-4%). In such a regime most of the changes in monetary policy would be implemented by market forces. Hence, if the oil price dropped the ruble would automatically be depreciated and equally important if the NGDP growth slowed due to other factors – for example a fiscal tightening or financial distress – then the ruble would automatically weak relative to the basket within the fluctuation band. Obviously there might be – rare – occasions where the “mid-point” of the fluctuation band could be changed and market participants should obviously be made aware that the purpose of the regime is not exchange rate stability but nominal stability. In such a set-up the central bank’s policy instrument would be the level for the mid-point for the fluctuation band around the basket. Alternatively the Russian central bank could also opt for a completely freely floating exchange rate with NGDP targeting or flexible inflation targeting. I, however, would be skeptical about such solution as the domestic Russian financial markets are still quite illiquid and underdeveloped which complicates the conduct of monetary policy. Furthermore, an EPN solution would actually be more rule based than a freely floating ruble regime as a freely floating ruble regime would necessitate regular changes in for example the interest rate (or the money base) to be announced by the central bank. That opens the door for monetary policy to become unnecessarily discretionary. Russia’s biggest problems are not monetary It is correct that Market Monetarists seem to be obsessed with talking about monetary policy, but in the case of Russia I would also argue that even though there is a significant need for monetary policy reform monetary policy is not Russia’s biggest problem. In fact I believe the conduction of monetary policy has improved greatly in the last couple of years. Russia’s biggest problem is structural. The country is struggling with massive overregulation, lack of competition and widespread corruption. There are very esay solutions to this: Deregulation and privatization. Every sane economist would tell you that, but the political reality in Russia means that reforms are painfully slow. In fact if anything corruption seems to have become even more widespread over the past decade. Russian policy makers need to deal with these issues if they want to boost real GDP growth over the medium term. The Russian central bank can ensure nominal stability but it can do little else to increase real GDP growth. That is a case for the Russian government. On that I am unfortunately not too optimistic, but hope I will be proven wrong. PS My story that the drop in oil prices measured in ruble is about domestic demand rather than export growth is of course very similar to the point I have been making about Japanese monetary stimulus. Monetary easing in Japan might be weakening the currency, but it is not about lifting exports, but about boosting domestic demand. That be the way seem to be exactly what is happening in the Japan. See for example this story from Bloomberg from earlier today.