RUSSIA'S INFLATION AND THE STAGES OF GRIEF:

C O N F I D E N T I A L MOSCOW 001616

SIPDIS

STATE FOR EUR/RUS, EEB/IFD
TREASURY FOR TORGERSON
DOC FOR 4231/MAC/EUR/JBROUGHER
NSC FOR WARLICK

E.O. 12958: DECL: 06/04/2018
TAGS: EFIN ECON RS
SUBJECT: RUSSIA'S INFLATION AND THE STAGES OF GRIEF:
ACCEPTANCE

REF: A. MOSCOW 997


B. MOSCOW 937

C. MOSCOW 709

D. MOSCOW 866

Classified By: Charge d'Affaires Daniel A. Russell, Reasons 1.4 (b/d).

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Summary
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1. (C) The World Bank and the IMF, echoing much of Russia's
business community and economic elite, cite Russia's
spiraling inflation, which reached an annual rate of 15
percent in May, as the Achilles heel of the country's
economy. However, senior Russian officials dismiss these
concerns and appear determined to increase government
spending to address infrastructure and other needs despite
the likelihood of further accelerating inflation. Moreover,
the government is not tightening monetary policy, an explicit
acceptance of high inflation and an implicit acknowledgment
that the monetary tools available to them are ineffectual.
The apparent ascendancy of the "pro-growth" economic policy
camp risks embedding inflation in the economy and may signal
a loss of influence of the GOR's longtime inflation hawk,
Deputy Prime Minister and Finance Minister Alexei Kudrin.
End Summary.

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World Bank, IMF Express Inflation Concerns
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2. (U) World Bank and IMF reports this week concluded that
Russia has so far weathered most of the adverse effects of
the global financial crisis and, thanks to its Reserve Fund,
faces little short-term risk from an external shock, such as
an oil price drop. However, both reports warn that internal
factors, namely rising inflation, pose the greatest threat to
the country's continued economic growth. The annual
inflation rate exceeded 15 percent last month and is poised
to go higher.


3. (SBU) The reports concede that the government is correct
that world food and commodity price growth have affected
domestic price levels. They also note, however, that
Russia's inflation has significantly outpaced both. Rather
than external factors, the reports cite increased budget
expenditures as the primary cause of inflation, with salary
increases in excess of productivity gains as well as
infrastructure bottlenecks and higher real estate prices also
contributing.

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Government Dismisses Concerns, Spending to Increase
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4 (U) Government officials have dismissed the warnings.
Presidential Aide and G8 Sherpa Arkadiy Dvorkovich said the
World Bank and IMF "got it wrong" about Russia's inflation,
which made the rest of their reports "meaningless." Economic
Development Minister Elvira Nabiullina was quoted in business
daily Vedomosti as saying that the 40-percent increase in
budget expenditures last year "have not been inflationary but
an essential part of the economic growth the country needs."
Deputy Economic Development Minister Andrei Klepach told
reporters that "infrastructure and social services are
under-invested sectors, so it is incorrect to say that the
whole economy is overheating."


5. (U) Prime Minister Putin's first Cabinet meeting on May
14 approved the Ministry of Economic Development's 2009-2011
growth strategy. The document outlines spending increases
for infrastructure projects, health care, and education. The
strategy identifies the government as the source of 75
percent of the spending on infrastructure and health and
education improvements, with the private sector contributing
the remainder. In addition, a subsequent Presidium meeting
of the so-called core Cabinet members proposed moving the
planned 2009 expenditures on the 2014 Sochi Olympics, the
2012 APEC Summit and a number of road and bridge construction
projects to this year.

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Monetary Policy Ineffective Counter
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6. (C) Faced with rising inflation last year, the government
took proactive steps, including administrative price controls
on food items, to check inflation. The very different
response this year suggests that the government attaches
greater importance to the country's ubiquitous infrastructure
needs and is determined to address them now, despite the
effects on inflation. The effect of looser fiscal policy
will be to accelerate rising inflation further, with the risk
that it may become embedded in the economy.


7. (C) Moreover, the GOR is not moving aggressively to
contain inflation with monetary policy, an implicit
recognition that its monetary tools are inadequate to the
task. Central Bank (CBR) officials acknowledge as much. The
CBR's Research Department Deputy Director Lyudmila Starikova
describes the CBR's changes in interest rates as "monetary
policy by signal." Raising key interest rates, as the CBR
had recently done, is more a tool to convey CBR's assessment
of economic overheating than a means to rein in price growth.
Starikova explained that the financial sector was not
sufficiently developed for interest rate changes to encourage
or discourage borrowing or saving the way changes to the Fed
Funds Rate or Discount Rate do in the U.S.


8. (C) Many investment houses in Moscow are betting that the
government will choose instead to appreciate the ruble in an
attempt to counteract inflation. Several of our contacts
have told us privately that the ruble may be as much as 20
percent undervalued -- a result of the GOR,s currency market
interventions. A stronger ruble would lower the cost of
imported goods, reducing inflation, but would hurt many
domestic producers, especially in the inefficient but
politically sensitive agricultural sector. Moreover, a
stronger ruble could also attract short-term foreign capital,
causing the monetary supply to increase and, with it,
inflation.

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Putin Supports "Pro-Growth" Camp
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9. (C) Another implication of Putin's apparent support for
the "progressive" or "pro-growth" economic policy camp led by
Nabiullina and Dvorkovich (reftels A and B) is that
"conservative" Deputy Prime Minister Kudrin's influence on
this issue seems to be waning. This could generate concern
in the financial sector. Kudrin, who championed the
three-year budget concept, has a record of consistently
reining in budget spending as a means of controlling
inflation to avoid hindering economic growth.


10. (C) Kudrin's recent acceptance of the proposed
expenditure increases stands in stark contrast to the very
public campaign he led earlier this year against a reduction
in the value-added tax (VAT). Kudrin argued then that such a
measure would have detrimental effects on inflation as well
as the budget. Prior to Medvedev's inauguration, many of our
contacts observed that keeping Kudrin in the Finance Ministry
would be the GOR's best guarantee for fighting inflation
while sustaining Russia's economic growth (reftels C and D).
However, the emphasis has now shifted decisively toward
growth.

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Comment
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11. (C) The GOR appears to be in the resignation phase of
coping with inflation. It is prepared to remedy the
country's crumbling infrastructure, a constraint on economic
growth, while acknowledging that monetary policy can do
precious little to mitigate the effects. However, the risk
is that the resulting inflation may get out of hand,
generating unrest among pensioners and others struggling
against the increasingly high cost of living. The GOR is
considering side payments to address this potential unrest
(septel).
RUSSELL