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Sunday, December 2, 2007

Inflation in Russia: Too Much Money Chasing Too Few People?

by Edward Hugh: Barcelona

Over the next few years Russia is almost certainly going to face a major and serious crisis in its labor markets. According to data from the Russian Health and Social Development Ministry, between now and 2010, the country's workforce is likely to fall by almost 9 million (assuming participation rates remain unchanged, for which see below), from the presnt 74.5 million to the reduced figure of 65.5 million.

This scenario sounds becomes even more preoccupying when we begin to think about the fact that Russia is already losing over 700,000 working-age people every year, due to a lethal combination of high mortality and low birth rates. The low fertility level which exists in Russsia is almost normal and commonplace among the ECA (Europe and Central Asia) countries but the high levels of adult mortality at relatively young ages are more or less unique to Ukraine and the CIS countries, and the persistance of this phenomenon raises a number of very important questions, only some of which are economic ones.

And the problem only begins to get worse when we begin to think about the low relatively level of labor mobility and labor flexibility which exists in Russia, the relatively low-level work ethic which characterises social values in some parts of the country, and the poor quality provision which is on offer in much of the vocational and training system. The labor market development plan for 2007-10, presented recently by Health and Social Development Minister Mikhail Zurabov, is supposed to be an attempt to begin the work of addressing the huge challenge that the situation represents, but even given the best of intentions and an ability to act decisively (both of which are should not by any means be automatically assumed to be present in the world of contemporary Russia), the plan, even at the very best, can only be described as a declaration of intent, and meanwhile Russia's labor market problems remain, surviving from one day to the next in what could only be described as a state of organised chaos.

Meanwhile Mother Russia trundles on, and the economic performance has been and remains robust. Having grown by 7.9 percent (year on year) in the first half of 2007 (as compared with 6.7% y-o-y in H1 2006), Russia is more than likely to post full-year GDP growth of over 7 percent in 2007 despite some recent slowing down (of which more below). This growth in output continues to be driven - following a pattern which we are observing across central and eastern Europe - by buoyant household consumption and booming construction activity. Domestic consumption in fact increased by 9.8 percent in the first half of 2007, contributing in the process about 6.7 percentage point to the half yearly GDP growth.

Manufacturing growth has been solid in recent years, but, as we will see, it has actually started slowing notably in the second half of 2007.

Gross capital formation also continues to expand at a brisk pace - growing by 28.5 percent y-o-y during the first half of 2007 (11.2 percent in H1-2006), in the process contributing 4.4 percentage points to aggregate growth, as compared with only 1.8 percentage points during the first half of 2006.

Consumer demand has also been strong, but exports have not (comparatively) been performing well.In fact in the first half of 2006 net exports contributed minus 1.4 percentage points to GDP growth, while in the first half of 2007 the slowdown in the rate of export increase constituted an an even bigger relative drag, at minus 3.7 percentage points.

So export growth has weakened during 2006/2007 and the emergence this negative contribution of net exports to GDP growth is important, since what it indicates is that while non-oil exports are growing, they are not growing as fast as imports.

So it is the rapid acceleration of imports and Russia's comparatively weak non-energy export performance which have meant that the size of the trade surplus has been steadily declining (and remember that the data here are in "nominal" - money - terms, thus the decline in the real value of the surplus is more significant than it appears).

Booming domestic demand has been fueling import growth, while the real appreciation of the exchange rate and rising labour costs far beyond the levels of productivity increases have been eroding competitiveness in most tradable sectors in manufacturing (outside resources and metals) in so doing raising the question of just how sustainable that Russian trade surplus actually will prove to be in the mid term.

Latest Rosstat estimates indicate that industrial growth, and in particularly, manufacturing growth, slowed in the third quarter of the year. Industrial production in August and September grew by only 3.0 and 3.8 respectively, as compared to 4.1 and 5.6 percent reported for the same months a year earlier. Similarly, preliminary statistics for August and September already show manufacturing growth of only 5.5 and 4.0 percent respectively, compared to 6.2 and 5.1 percent last year. Four out of thirteen manufacturing industries reported negative growth rates in August and five in September, compared to only two last year. Just four manufacturing industries reported higher growth rates in August and September 2007 than during corresponding months of last year. The same sort of notable slowdown was also reported for extraction industries.

Meanwhile those sectors servicing the domestic market (such as construction and the retail trade) continued to boom. The highest rates of output growth were reported in construction (23.5 percent) and the retail trade (15 percent) The rate of aggregate output growth of the base industries and sectors (often used as a proxy for GDP growth) amounted to 8.6 percent in the first nine months of 2007 compared to only 5.7 percent in the corresponding period of 2006.

Thus given that Russia in now an economy which may be considered (after years of taking up outstanding capacity slack, see more below) to be an economy which is growing close to potential, benefiting in part from high energy prices and large capital inflows. In this situation Russia faces two main challenges: inflationary pressures and an overly rapid appreciation of the exchange rate. Both of these represent serious problems in the Russian case since they are liable to produce a steady turn around in the trade balance and expose a Russian economy dependent on an inward flow of funds to the vagaries of world energy prices and the risk appetite of overseas investors.

As can be seen in the chart, the value of the rouble has been rising slowly but steadily over the last couple of years, the big problem which could face the Russian authorities would be if any move to ease currency management procedures were to lead to a large and rapid appreciation in the rouble, and if this were then to be associated with an equally sudden inward surge of funds, funds which would in all probability generate a further surge in domestic demand, domestic demand which, given the critical state of Russia's workforce and labour market, could not be met internally, and hence my cryptic adaptation of the standard inflation definition in the title of this post, since what we would actually have would be too much money chasing too few people.

Apart from the sudden inward surge of funds which we have witnessed in the second half of 2007 (see below) the most notable monetary development in 2007 is that other surge, the inflation one, which outside and beyond Russia, we have also been witnessing across much of the EU10 as a region.

Russia's Inflation Bug

At one point Russian inflation did seem to have been coming gradually under control, and remained this way into the first quarter of 2007. Since then, however, it has steadily been gaining and sustaining momentum, and the problem has only deteriorated with each new monthly reading as the year has advanced. In fact inflation reached a cumulative total of 9.3 percent over the first ten months of 2007, with the rate accelerating to 10.8 percent in October, the highest level recorded since February 2006. This was up from the 9.4 percent registered in September and a month on month increase of 1.6 percent.

The Russian authorities now appear to be resigned to the idea that by year's end inflation will be running around around 11 percent (Dec-on-Dec) as compared to 9 percent for Dec-on-Dec registered in 2006. And this inflation is, of course, moving on down the line and entering industrial producer prices.

A Manufacturing Slowdown and a Wage Surge?

At first sight the downward trend we are currently observing in Russian manufacturing growth - at at time when domestic demand and construction are accelerating - seems strange. The most probable explanation is that the slowdown is associated with challenges to Russia's tradable sectors (outside resources and metals). Those parts of the manufacturing sector that service domestic demand and encounter limited competition from imports should, after all, be able to continue to thrive in the midst of Russia’s booming domestic market. But the ongoing appreciation of the ruble and the tightening we are seeing in the Russian labour market (as workers, for one reason or another, disappear from the workforce) are evidently serving to drive up unit labor costs, in a way which suggests that wages are growing much more rapidly than productivity. And without commensurate increases in productivity, real ruble appreciation and large wage rises make achieving export competitiveness in manufacturing sectors (outside resource-extraction and metals) an ever more challenging process.

According to Rosstat, average real wages and disposable income increased by 16.2 and 12.9 percent, respectively during the first nine months of the year (see chart above). Increases in real wages continue to be well above the GDP growth rate - and surely the productivity growth rate - in most sectors of the economy. Almost all sectors of the economy are now reporting increases in nominal wages well above 20 percent across 2007. The average monthly dollar wage has been steadily increasing over the years (see chart above) and increased to 497 dollars (or by 31 percent over the same period in 2006) in the first nine months of 2007 as the rouble continued to appreciate against the US dollar. Current trends suggest that the average monthly dollar wage may exceed USD 520 by the end of this year.

A comparatively warm winter last year, an increasing demand for labor in the principal economic sectors and a declining working-age population have all contributed to produce a significant and lasting reduction in unemployment. The average unemployment rate (using the ILO definition) fell to 6.3 percent in the first three quarters of the year, compared to an average of 7.3 percent registered during the corresponding period of 2006. By September 2007 the unemployment rate had decreased to 6 percent (see chart below).

Part II of this post continues here.