RUSSIAN INFLATION REACHES DOUBLE DIGITS

UNCLAS MOSCOW 005200 SIPDIS SENSITIVE SIPDIS STATE FOR EUR/RUS, EEB/IFD TREASURY FOR TORGERSON E.O. 12958: N/A TAGS: EFIN ECON RS SUBJECT: RUSSIAN INFLATION REACHES DOUBLE DIGITS ¶1. (U) This message is sensitive but unclassified and not for internet distribution. -------------- Summary -------------- ¶2. (U) At a public event October 26, Deputy Prime Minister and Finance Minister Aleksey Kudrin stated that inflation since the beginning of 2007 had reached 8.9 percent and would be close to 11 percent by the end of the year. He acknowledged that rising food prices have exacerbated the growth of the consumer price index (CPI) and said domestic monetary factors "would put the final result above 9 percent even without higher food prices." Kudrin said that wage increases, which have tended to exceed productivity, and government spending, which will be 3 percent of GDP higher than originally budgeted, were the main components of the climbing CPI. Kudrin downplayed the role government policies have played in the rising inflation and did not announce any broad changes. Some of our contacts echo Kudrin's assessment that Russia's increasing inflation is rooted in monetary factors, but add that government policies are in fact a key driver. End Summary. -------------- 2005 All Over Again -------------- ¶3. (U) Deputy Prime Minister and Finance Minister Kudrin said that the GOR would exceed its 2007 inflation target of 8 percent. Kudrin had reportedly conceded as much during recent Cabinet meetings, as had other ministers and Central Bank officials, but without giving a range. However, in his remarks before the Federation Council and the National Economy Association, he said the year-end figure would exceed 10 percent. ¶4. (U) Rising world food prices, droughts, and the end of various EU agricultural subsidies have contributed to higher commodity price levels in Russia, Kudrin said. He added, however, that even without the inflationary push of higher food prices Russia's inflation for 2007 would exceed 9 percent. Inflation for the year had reached 8.9 percent by October 22, Kudrin said, and base inflation for October would be 1.5-2 percent. He observed that even "if inflation goes no higher, we will have returned to levels seen two years ago." -------------- GOR Spending, Monetary Policy to Blame -------------- ¶5. (U) Kudrin said the main causes for the rising inflation were monetary factors. He told the Federation Council wages had risen faster than productivity in recent years. He observed that these "salary overhangs" went directly into the economy, which, in conjunction with almost USD 70 billion in net capital inflows, helped trigger 52 percent growth in the money supply during the first half of the year. Kudrin also conceded that government spending, particularly for public sector employees, had also spurred inflation. (Note: Amendments to the 2007 budget law show that the GOR's spending for the year will equal 20.3 percent of GDP, whereas the original 2007 budget law forecast expenditures totaling 17.5 percent of GDP. End Note.) ¶6. (U) The Finance Minister estimated that monetary factors accounted for 3.4 percent of the CPI's growth, whereas in the EU they account for only 2 percent. Nevertheless, he announced no changes in the GOR's efforts to control inflation and observed that the USD 6 billion in net capital inflows during October indicated investors were not concerned about Russia's macroeconomic policies. -------------- Underinvestment Also Drives Inflation -------------- ¶7. (SBU) Troika Dialog Chief Economist Evgeny Gavrilenkov and ING Bank Economist Tatyana Orlova told us Kudrin is right that Russia's inflation is at root a monetary phenomenon, but that government policies are in large part to blame. Gavrilenkov observed that the Central Bank's (CBR) stated priority of ensuring sufficient liquidity during 3Q07 in the wake of subprime mortgage concerns had been inflationary. The CBR sought to sustain confidence by expanding the list of instruments banks could use to secure short-term funds and reducing lending rates. For example, from January through July, currency swaps between banks and the CBR totaled USD 1 billion, but swelled to USD 18.4 billion from July through September when the CBR lowered rates. Gavrilenkov also suggested that Kudrin had understated the inflationary impact of government spending. He noted that the amendments to the 2007 budget law showed that expenditures for the year are on track to exceed those of 2006 by 4 percent of GDP. ¶8. (SBU) Gavrilenkov and Orlova emphasized that underinvestment had also exacerbated inflation. Gavrilenkov, again, agreed with Kudrin that salary increases have outstripped productivity gains. He said that Russian incomes on average have risen at double-digit rates in recent years and consumption has followed suit. As a result of this, however, domestic producers have not been able to keep pace with the demand for higher quality products. Producers have made some investments to expand capacity, according to Gavrilenkov, but imports of consumer goods-including food-have filled the gap left by domestic producers and have also exacerbated inflation. ¶9. (SBU) Orlova said that increasing the capacity and competitiveness of Russian firms would need to be part of a long-term inflation-fighting strategy going forward. She speculated that if the GOR had made "the hard choices" in 2000 or 2001 to reduce investment barriers-from broad energy and transportation infrastructure improvements to support for small and medium-size enterprises-domestic firms would be better positioned to satisfy domestic demand. In such a scenario, she explained, competition between domestic goods and imports would tame inflation. As it stands, however, imports into Russia and their prices are growing. Orlova mentioned that domestic demand for food has more than doubled in real terms since 2000, domestic production has increased only 20 percent. She said that rising global food prices will make themselves felt in Russia since an estimated 40 percent of the country's food supply is imported. -------------- Comment -------------- ¶10. (SBU) Kudrin's public comments attempted to downplay the effect the GOR's spending has had on inflation. However, Putin's promise to increase pensions, the recent establishment of development institutions, like Special Economic Zones and the Investment Fund, along with a growing number of state-owned corporations, like the Nanotechnology Corporation and the Olympic Games Corporation, as well as plans to improve infrastructure ensure the GOR's spending spree and concomitant inflation will continue for the foreseeable future. End Comment.