Russia: The case for a go-stop-go monetary policy
Summary: Given the outcome of the latest CBR meeting, a new rate cut seems quite unlikely in the short-term to support the recovery. The tone was not really dovish, with clear mention that inflation is higher than the expected trajectory and that short-term inflationary risks remain prevalent. However, we think that the option of further monetary stimulus could get back quickly on the table early next year if downside risks to the economy materialize, as we expect. We believe that the CBR will basically adopt a go-stop-go monetary policy consisting in alternating between fighting high inflation and supporting the economy.
To understand the exact extend of the crisis on the Russian economy, we need to look at the evolution of the manufacturing PMI. It is the first time ever the manufacturing sector has experienced such a prolonged phase of contraction, already reaching 14 months in a row, thus surpassing the previous record of the 2008-2009 crisis which lasted about 13 months. As it is the case almost anywhere else, the Russian economy is following a K-shaped recovery, with the recovery occurring at different magnitude across regions and sectors. The latest statistics indicate that the industrial production remains still very depressed, mostly as a result of poor performance from extractive industries (commodity-based companies) that are at the core of the Russian economy, while the manufacturing sector is slowly getting out of the woods compared to the situation in Q2.
The RUB weakness has been a major driver of the recovery, with little negative implications in terms of inflation evolution. The weak currency is supporting the increase in oil and gas budget revenues that are expected to be above the basic level implied by the budget rule presented this summer, according to the Ministry of Finance. In contrast with what has happened in the past, a falling exchange rate does not translate much into higher inflation. Based on the CBR report, a 10% RUB decrease results in less than 1% of inflation – which is much lower than in most EM countries. It does not mean that the weak RUB is not an issue for the economy anymore but if we need to assess the pros and the cons it is bright clear that this trend is mostly positive for the economy.
Another factor of support to the economy has been the strong rise in international reserves, which can serve as cushion in period of crisis like the one we are going through. Contrary to many other EM countries, the CBR has managed to diversify its exposure and reduce its reliance on U.S. assets (U.S. dollar and T-bonds) before the outbreak. As such, around two third of Russian international reserves are in gold, euro, and yuan. On the back of the strong performance of gold in the lockdown period, international reserves have reached one of their highest levels on record in July.
Finally, the reduced GDP exposure to the services sector, which has been hit the hardest by the great lockdown, has been another factor of support to the economy. The size of the services sector in Russia is far to be close to that in high-income countries, which has automatically mitigated the amplitude of the recession.
At the other end of the spectrum, we see many risks in sight at the national and international levels that could jeopardize the recovery and transform the K-shaped recovery into a L-shaped recovery. The pandemic has accentuated pre-COVID structural trends, especially population loss and business concentration. Based on the available statistics for 2020 (that cover only the first seven months of the year), the country is doomed to go through its largest population decline since 2006. In addition, it is likely the pandemic will ultimately increase economic dependence on the extractive sector as the share of the services sector will probably decrease in the short- and medium-term as a consequence of rising bankruptcies.
In this context of structural changes and looming risks, we doubt that the CBR will be able to postpone longer a new rate cut. At its latest monetary policy meeting, the CBR left its key rate unchanged at 4.25% and closed the door for the moment to another rate cut due to the emergence of inflationary pressures – the latest inflation statistics are consistent with an annual 4% inflation target. However, we think that the option of further monetary stimulus could get back quickly on the table early next year as patchy aggregate demand and higher unemployment will become the focal points of interest again. In these circumstances, we believe that the CBR will basically adopt from next year a go-stop-go monetary policy consisting in alternating between fighting high inflation and supporting the economy.