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). -------------- Summary -------------- ¶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. -------------- World Bank, IMF Express Inflation Concerns -------------- ¶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. -------------- -------------- Government Dismisses Concerns, Spending to Increase -------------- -------------- 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. -------------- Monetary Policy Ineffective Counter -------------- ¶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. -------------- Putin Supports "Pro-Growth" Camp -------------- ¶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. -------------- Comment -------------- ¶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