June 20, 2016, 00:01 / Opinions

How the Central Bank reduces risks

Director of the Research and Forecasting Department of the Bank of Russia Alexander Morozov on the benefits of anti-inflationary policy

Vedomosti

The Bank of Russia is often accused that the regulator’s monetary policy has aggravated the crisis and is preventing the economy from entering a growth trajectory. Let's look at the facts.

To do this, it is enough to compare the crisis of 2008–2009. and the current recession in the Russian economy, which is not even perceived as a full-fledged economic crisis. During the crisis of 2008–2009. The Bank of Russia allowed the ruble to weaken slowly and predictably. This cost the loss of approximately $200 billion in international reserves, but did not prevent the ruble from depreciating to a fundamentally sound level, determined by the state of the economy and balance of payments. The ruble depreciated by 27.8% against the bi-currency basket. GDP fell by more than 11% at the low point of the crisis, in the second quarter of 2009, with interest rates reaching 30–40%.

At the end of 2014 and the beginning of 2016, the situation developed according to a fundamentally different scenario. In 2014, Russia faced two strong shocks: the collapse of oil prices and the almost complete loss of access to external financing while it was required to make large-scale repayments on external debt. At the cost of a sharp fall in the ruble exchange rate (by 47.7% against the bi-currency basket) and a significant increase in interest rates, these shocks were stopped. The fall in GDP was only 3.7% in 2015 (and 4.5% at the low point). Interest rates, although they increased, were two times lower than during the 2008–2009 crisis.

At the beginning of this year, oil prices fell again to multi-year lows, but the Russian economy barely noticed. The ruble depreciated, but interest rates remained unchanged and then began to decline. A new economic decline did not occur, contrary to fears and most forecasts. It is unreasonable to deny that the policy of the Bank of Russia helped this development of events.

I would like to assert that the current direction of monetary policy is fully consistent with the current economic conditions. This means that inflation is steadily declining towards target values, without harming current economic activity, including credit and investment, and without creating significant risks for financial stability.

I'll start with economic activity. The latest macroeconomic statistics released in recent months have for the most part been better than expected. The moment of resumption of positive economic growth is approaching. Credit statistics and information on changes in non-interest lending conditions indicate the maintenance of sustainable lending growth or its acceleration (as in the case of issuing consumer loans) while banks reduce requirements for borrowers. These facts alone indicate that monetary policy, at a minimum, does not prevent the emergence and development of positive trends in the economy.

Moreover, there is reason to believe that the policy of the Bank of Russia is bringing the moment of investment growth in the Russian economy closer. Why? The level of nominal interest rates in the economy, which are directly or indirectly affected by the key rate of the Bank of Russia, makes ruble assets (including deposits and bonds) attractive. Together with the gradual increase in confidence in the anti-inflationary policy of the Bank of Russia, this reduces the cost of raising funds in the bond market, contributes to the process of de-dollarization in the economy and increases the stability of the national currency. A number of surveys of enterprises confirm that this creates the necessary conditions for the resumption of growth in investment in fixed capital.

There is an opinion that the key rate of the Bank of Russia affects only the cost of credit resources and therefore the lower the rate, the better for the economy. As a result, the problem of economic growth comes down to the rapid growth of lending and the credit burden in the economy. This is a very simplified approach. Firstly, it does not take into account the reasons why there is no growth in investment. Access to credit resources is far from the most important of them. Secondly, the level of debt burden in the economy is already quite high. Stimulating its further growth will increase credit risks, which is fraught with a credit crisis. Thirdly, the impact of the Bank of Russia key rate on inflation and the exchange rate is denied or ignored.

In fact, the moderately tough policy pursued by the Bank of Russia helps to improve the situation with the debt burden, stabilize financial markets, reduce the volatility of the ruble exchange rate, creating the basis for the restoration of economic activity.

It is important to note that while the key rate of the Bank of Russia has remained unchanged since August 2015, monetary conditions in the economy have softened significantly. In essence, the effect of easing DCL is equivalent to the effect of lowering the key rate. This mitigation continues to this day. The main reason is the ongoing transition to a structural liquidity surplus in the banking system due to the use of reserve fund funds to cover the budget deficit. To put it simply, banks no longer need the regulator’s money. They are replacing them with cheaper deposits from households and non-financial companies. Since February, there has been a gradual recovery in the annual rate of ruble lending to non-financial organizations. Housing mortgage lending is growing at a good pace, and there are signs of increased bank activity in consumer lending. Interest margins are recovering, risk appetite is growing, banks are finding it possible to reduce loan rates and requirements for borrowers. It is risky to rush these processes by sharply and prematurely reducing the key rate. Importantly, the economy is increasingly showing signs of a coming recovery in business activity. This can be seen both in the survey results and in the leading indicators. This indirectly indicates that the current LTCFs do not have a restraining effect on the economy.

Now about inflation. There is obvious success here, inflation is on the required trajectory to reach the target of 4% by the end of 2017. However, inflationary inertia is still too high. The risk of being stuck at 6-7% for some time is still real. The fact is that enterprises and the population make financial decisions based on their own ideas about current and future inflation, and not on the forecasts of the Bank of Russia. A large discrepancy between inflation expectations and the forecasted inflation of the Bank of Russia can lead to inflated expectations of demand in the economy and the adoption of erroneous decisions on the volume of output and indexation of selling prices. I would like to avoid this, because as a result everyone will lose. This suggests the need to further strengthen confidence in the ongoing anti-inflationary policy and in favor of prudence when making decisions on monetary policy.

It must be emphasized that the Bank of Russia sees its task not in short-term stimulation of the economy by distributing cheap money and zeroing interest rates, but in creating conditions for sustainable economic growth in the medium term. Ensuring a consistently low inflation target of 4% and reducing interest rates on this basis will reduce business risks associated with inflation, exchange rates, and interest rates. The lower the risk premium, the more investment projects will become attractive due to the ability to adequately take into account the macroeconomic risks associated with their implementation.

Moreover, responsible monetary and fiscal policies can boost long-term growth by reducing uncertainty and macroeconomic risks in the economy. Countries that successfully implemented inflation targeting policies were able to increase their economic growth rates compared to the period before inflation targeting. Why? Low inflation is more sustainable than high inflation. With low inflation, the volatility of the exchange rate and financial markets is lower, which means that there are fewer risks for entrepreneurs and a greater number of investment projects have a chance to be realized.

I hope that the emerging trust in the policy of the Bank of Russia will allow the Russian economy to quickly move through lower inflation to economic growth.

The author is Director of the Research and Forecasting Department of the Bank of Russia