TFGG01: RUSSIAN CENTRAL BANK ON GEORGIA, INVESTOR

C O N F I D E N T I A L MOSCOW 002437

SIPDIS

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

E.O. 12958: DECL: 08/15/2018
TAGS: EFIN ECON RS
SUBJECT: TFGG01: RUSSIAN CENTRAL BANK ON GEORGIA, INVESTOR
CONFIDENCE, AND ENGINEERING A "SOFT LANDING"

Classified By: DCM Eric Rubin, Reasons 1.4 (b/d).

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Summary
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1. (C) During an August 14 meeting with the Charge and
ECMIN, Central Bank (CBR) First Deputy Chairman Aleksey
Ulyukaev expressed hope that the conflict with Georgia would
be short-lived, thus helping restore battered investor
confidence. He said controlling inflation was the country's
top economic priority. He claimed inflation was beginning to
fall thanks to the CBR's exchange rate policy and other
factors. The Finance Ministry and CBR were working to
achieve a "soft landing" leading to sustainable, moderate
growth with low inflation. This was the "right" prescription
for Russia, in contrast with plans, like the Economic
Development Ministry's long-term strategy, that focused only
on the growth side of the equation. He said the GOR had made
some shifts in its dollar reserve holdings but expressed
confidence in the ability of the U.S. economy to rebound.
End Summary.

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The Markets and Georgia
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2. (C) Ulyukaev said the volatility that had seized the
country's stock markets in recent weeks was due to
uncertainty about global developments affecting emerging
markets. Investors were moving away from risk. However, he
acknowledged that it was also the result of concerns
regarding the "authorities' influence over the economy" -- a
reference to the recent TNK-BP dispute and the Mechel
incident.


3. (C) Ulyukaev also acknowledged that the conflict with
Georgia was affecting the markets, and through them the real
economy. He added that the outbreak of military action had
also sparked a sharp depreciation in the value of the ruble,
the first in a very long time, and that the CBR had been
obliged to sell USD 5.5 billion to support the ruble. He
expressed hope that the conflict would be short-lived.

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Fighting Inflation is Job 1
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4. (C) Ulyukaev told the Charge that Russia had remained
generally stable in the midst of the global financial crisis.
He expected Russia would remain financially stable as policy
makers focused on the less urgent but equally important task
of recalibrating the country's inflation-fighting
orientation. He said that in an effort to mitigate the
domestic factors behind higher prices, Finance Minister
Kudrin had announced a shift away from ruble exchange rate
targeting toward inflation targeting.


5. (C) Ulyukaev emphasized that controlling inflation was now
the CBR's highest priority. He said economic overheating
began in earnest in mid-2007, as the money supply (M2)
registered 60-percent growth and budget expenditures reached
20 percent of GDP, compared to 16 percent of GDP a year
earlier. Aggregate demand had also continued to rise since
as salary increases (20 percent) outpaced productivity gains
(8.5 percent). Higher salaries had driven banking sector
growth, particularly retail lending, which had prompted
120-percent growth in mortgages and raised banks' consumer
loan portfolios to more than half of the banking sector's
assets.


6. (C) According to Ulyukaev, inflation peaked in May at 15.1
percent. It was, however, negligible in June and July.
Slowing inflation was the result of tighter money supply,
itself largely the result of lower capital in-flows, which
totaled only $13 billion so far in 2008, as opposed to $60
billion at this point in 2007. Ulyukaev said that falling
domestic food prices, the result of Russia's best modern
harvest and summer seasonal drops in demand had also helped
to lower inflation. Ulyukaev was optimistic that inflation
for the year would be just over 11 percent, compared to 11.9
percent at the end of 2007.


7. (C) Ulyukaev said he did not share the view that the bulk
of Russia's inflation was "imported," internal imbalances

were the main culprits. That said, the global economic
slowdown could help cool Russia's economy. The benchmark
price for Urals oil had, for instance, dropped from $127 to
$108 in recent weeks. Global food prices had also
stabilized. These trends would be beneficial for Russia
since they would slow the growth of the money supply and
would help keep price indices stable.


8. (C) Ulyukaev explained that the CBR's role in the
transition to inflation targeting centered on easing the
ruble's managed exchange rate. Previously, the CBR adjusted
its currency interventions when the value of the ruble
reached certain pre-determined limits. Over time,
speculators began predicting the upper and lower limits of
the exchange rate at which the CBR would act, causing added
volatility. Ulyukaev's description of the CBR's new approach
was that the exchange rate limits were "no longer a lane, but
rather a pool, only the swimmers don't know where the edges
are, only we do." He said this would curtail speculation and
reduce volatility.


9. (C) Ulyukaev resisted the characterization of this
approach as a managed exchange rate, calling it a
"quasi-managed exchange rate." He said this transition,
which would be completed in 2011, was the optimal route
toward a free-floating exchange rate. The gradual approach,
which assumed that a free-floating ruble would be relatively
stronger than suggested by today's exchange rates, would
allow domestic producers to adjust to the greater efficiency
that a stronger ruble would demand, since imports would be
relatively less expensive. A floating exchange rate would
also enhance monetary policy effectiveness since it would
temper capital inflows seeking to exploit what had in
practice been a one-way bet on ruble appreciation.

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Conservatives vs. Progressives: Right and Wrong
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10. (C) Agreeing with the ECMIN's portrayal of the Finance
Ministry-CBR camp as advocates of a conservative growth
model, Ulyukaev said "we are on the right side" of the debate
on economic policy, trying to engineer a "soft landing" as
the economy cooled and inflation was brought under control.
The "right" option for Russia, according to Ulyukaev, would
be to provide moderate growth and moderate inflation. He
predicted disagreements over the best mix of incentives
between the Finance Ministry and MED during the budget
discussions scheduled for August 21.


11. (C) Ulyukaev called the Ministry of Economic
Development's (MED) advocacy of "pro-growth" policies flawed.
As a case in point, he cited the MED's long-term economic
plan, which proposed reducing VAT as a means of encouraging
the private sector toward more innovation-oriented
production. Ulyukaev said that the country's taxes were not
burdensome and that reducing VAT would be inflationary,
without delivering a direct stimulus to the business
community, which was more affected by corporate taxes. VAT,
he said, "should be the GOR's last priority" since it would
only fuel higher consumption when the economy needed to cool
down.

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The Dancing Elephant--the U.S. Economy
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12. (C) In response to the Charge's questions about whether
U.S. economic developments presented concerns for Russia's
economic policy, Ulyukaev admitted that the CBR had reduced
its holdings of dollar assets "a little." Without specifying
amounts, he explained that T-Bills, GSE obligations, and bank
deposits still constituted a sizable share of the CBR's
reserves. He conceded that the change -- a reduced volume of
bank deposits -- had been a response to political pressures
that emerged when media reports lamented the CBR's
investments in Fannie Mae and Freddie Mac. He also noted
that the U.S. presidential election cycle had heightened this
sensitivity. All that said, Ulyukaev called the "flexible"
U.S. economy an "elephant that can dance" and said the GOR
was confident that it would rebound soon.

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Comment
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13. (C) Initially nervous at meeting with American
officials, Ulyukaev relaxed as he talked about the details of
Russian economic policy with a surprising degree of openness
and a great deal of technical expertise. Moreover, on
Georgia, Ulyukaev came across as voice of moderation who
understands the larger issues at play with respect to
Russia's economic future.
BEYRLE