Statement by Bank of Russia Governor Elvira Nabiullina in follow-up of Board of Directors meeting on 15 June 2015


Good afternoon!

Today the Bank of Russia Board of Directors decided to reduce the key rate from 12.5% to 11.5% p.a.

I would like to dwell on the reasons for our decision.

I will start with the situation in the financial sphere.

Now we can say with a great deal of confidence that the situation in financial markets, primarily in the FX market, is coming back to normal to some extent. Inflation expectations have declined considerably against the maximum values early this year and the inflow of household funds to bank deposits, primarily those denominated in rubles, has resumed.

The overall situation is developing in line with our forecasts. However, the latest estimates show recent slower decline in inflation expectations. And though the current inflation is diving, the stabilisation of inflation expectations at the current high levels can retard its further decline. And ongoing inflation slowdown is possible only in case of lower inflation expectations.

Given high inflation expectations, current financial stabilisation can be sensitive to abrupt changes in the monetary policy.

Now some words about the economic dynamics.

Amid declining investment demand that persists for the second year and contraction in consumption that has started this year, a decline in economic activity is observed. According to preliminary estimates, in 2015 Q1, GDP fell by slightly less than 2% year-on-year, that is in line with the forecast published in the Monetary Policy Report in March. However, we believe that unlike the inflation peak, the trough of the economic recession is not yet passed.

Structural restrictions, including demographic ones, and persistent decline in oil prices show that the economic downturn is mostly of structural nature. Nevertheless, some indicators confirm that the nature of output contraction is cyclical to some extent.

Lower oil and other commodity prices have increased uncertainty about the prospects of the Russian economy discouraging investments. At the same time, low consumer demand temporary limits the possibilities of import substitution, especially in production of relatively expensive goods.

Possibilities for substituting external lending resources with domestic ones are still limited. Lending conditions, especially banks’ requirements to borrowers’ creditworthiness, remain tough. Meanwhile, debt burden of many borrowers has increased largely due to the relatively high share of lending in foreign currency in Russia. These factors hamper investment activity, which is already low. At the same time, investments are supported by anti-recessionary measures taken by the government. The decline in the investment demand is yet less considerable than expected.

However, consumer demand shrinks more dramatically than we have forecast, seriously impacted by the limited growth of nominal wages in both public and private sectors. Households started saving more valuating their wealth more carefully.

Thus, domestic demand does not support economic growth. As for the external demand, due to the ruble depreciation, drop in imports, and a certain increase in oil prices this year against the minimum level, net exports were the only factor giving a positive contribution to GDP.

Lower decline in investments and positive contribution of net exports have allowed us to revise upwards our GDP forecast for this year, i.e. decrease the estimated decline to 3.2% compared with our forecast in March.

Amid the economic downturn, certain growth in unemployment has been observed, currently its seasonally adjusted indicator stands at 5.6%. Meanwhile, the labour market traditionally adjusts to the new economic situation through lower real wages and less working hours rather than through higher unemployment. Nevertheless, the ongoing demand contraction will result in higher unemployment rate that, according to our estimates, will rise to 6.5% by the year-end.

The federal budget that is estimated to have a deficit of 3.7% of GDP this year, generally encourages the economy. This impact was especially significant in Q1 when considerable advance payments for defense procurement were made. However, due to the policy to decrease public expenditures, the positive impact of the budget on the economic growth will be insignificant in the next few years. Nevertheless, such policy enhances macroeconomic stability in both short and medium term.

Some words about the situation with the balance of payments.

It has turned out to be less tense than expected. This was facilitated, among other things, by rather fast leap in oil prices to the level exceeding US$60 per barrel. Besides, it should be mentioned, that the peak of external debt payments that was in 2015 Q1 was passed rather easily, due to, inter alia, the efficient mechanism of FX refinancing in the central bank. Following the initial stabilisation in the oil, FX and financial markets, corporate and household demand for foreign currency weakened considerably. The situation with the FX liquidity improved significantly. Currently the market completely satisfies demand for FX liquidity. Therefore, we first raised the interest rates on our operations to the levels close to the market ones, and then suspended the increase in volumes of FX refinancing. The stabilised situation in the markets enabled the Bank of Russia to start replenishing the international reserves. Later, I will give more details on this issue.

Positive trends of the first six months include rather fast inflation stabilisation. Annual inflation peaked in Q1 and started weakening from April. Monthly price growth fell from 3.9% in January to 0.4-0.5% in April-May. Weekly inflation stabilised at 0.1% in May, and in the week from 2 to 8 June stood at zero for the first time this year. According to Bank of Russia estimates, as of 8 June, the annual inflation was 15.6%.

The current and annual inflation declines faster than we expected early this year, due to a number of reasons.

First, faster than expected decline in consumer demand.

Second, our assumption regarding the accelerated exchange rate pass-through to domestic prices has been confirmed. Global practice shows that it often goes in line with periods of increased volatility in the FX market. Such increased price sensitivity to the exchange rate was symmetrical: in the first months of this year inflation showed rapid and strong response to ruble depreciation followed by comparable impact of appreciation that started in late February on price dynamics. I would like to emphasise once again, that considerable impact of the exchange rate on inflation is typical of countries that have recently taken up the policy of a floating exchange rate and inflation targeting. In future, as the economy adjusts to the floating exchange rate, price response to exchange rate fluctuations will gradually weaken.

Third. Prices have completed adjusting to external trade restrictions imposed in August 2014. This factor does not exert any additional pressure on inflation anymore.

Finally, as I have mentioned earlier, inflation expectations declined dramatically resulting from lower current inflation. They decreased considerably faster than during the previous price jumps.

Sizeable decline in inflationary pressure triggered revision of our medium-term forecast. According to our revised estimates, annual inflation will be about 11% in December 2015. In June 2016, annual inflation will fall below 7% to come close to the 4% target in 2017.

Let’s dwell upon the key parameters of our new medium-term macroeconomic forecast that will be published today in the Monetary Policy Report.

The main issue from the forecast perspective is sustainability of oil price growth. Due to the change in the commodity market structure, emergence of new suppliers and changes in the behavioural pattern of the old ones, oil price dynamics became even less predictable. Accordingly, we decided to work out two scenarios of developments both of which are equally possible. The first one can be referred to as consensus forecast and the second as conservative forecast. The first one provides for gradual oil price recovery to US$80 per barrel in 2018. It is very close to the price built in our baseline forecast in March and current expectations of market participants and analysts. The second scenario is based on the assumption that we will not observe such an upward trend in the medium term and the oil price will fluctuate at the level of US$60 per barrel through the entire forecast period. Meanwhile, it can be more volatile than in previous years.

Besides, we continue considering the scenario where the oil price falls and remains at the level of US$40 per barrel during three years. This is a stress variant providing for a longer and deeper drop in economic activity.

Let’s return to our main scenarios. According to the first scenario, annual economic growth rates will become positive already in mid-2016 resulting in output growth of about 0.7%. In 2017-2018, the domestic demand will continue recovering; we expect revival of both investments and consumption. GDP growth rates will go up, but will remain moderate – about 1.7-2.4%. This is because in the medium term the structural restrictions will persist and restrict economic growth. Here belong primarily unfavourable demographic trends and investment climate. Economic recovery can be faster and more sustainable in case structural reforms are carried our more actively.

The recovery of the economic activity will result in gradual decline in unemployment to 5.6-5.8% in 2018.

The second scenario provides for the lack of substantial support from external economic conditions. Economic recovery will be backed only by domestic sources. As a result it will take more time. Output will continue to contract in 2016 and the economy will recover slower in the next two years.

This scenario provides for higher inflation risks as the output gap is less due to the lower potential growth. It will restrict the possibility of monetary policy easing in comparison with the first version.

Some words about the balance of payments forecast. As the economy adjusts to the new external conditions, the demand for imports will decline more dramatically than for domestic goods. As a result, net exports will make the main positive contribution to the GDP dynamics in 2015. As domestic investment and consumer demand recovers, the purchase of imported items will resume growth and the contribution of net exports will decline.

In our forecast we assume that financial sanctions against Russia will persist. The need to repay external debts will be the main source of capital outflow. In 2015-2018, it will gradually decline from about US$90 billion to US$55-65 billion per year depending on the scenario.

According to estimates, by late 2015, corporate external debt payments with consideration of possibilities of refinancing and intercompany debts will amount to about US$40 billion out of US$70 billion this year. Repayments are estimated to further decrease to about US$ 40 billion in 2016 and US$20 billion in 2017.

According to our estimates, expected export revenues and accumulated foreign currency assets of companies and banks will largely cover private sector demand for foreign currency to repay external debts. This will result in lower demand for Bank of Russia operations to provide FX liquidity.

These operations played an important part in stabilising the situation in the FX market. Although by their nature these are special purpose instruments. They should be used as the economy adjusts to the new external conditions. As the situation improves in line with our forecast, we will curtail these operations in order not to substitute for market mechanisms. However, we realise that it should be done gradually and predictably.

Besides, reverse transactions to provide FX liquidity can be further used by the Bank of Russia in stress situations.

In the coming years, the Russian economy will operate amid increased uncertainty over the external conditions. Accordingly, we decided to launch operations to replenish the international reserves. Currently, they meet universal adequacy criteria, though they have shrunk considerably over the past year. However, we believe that in order to smooth prolonged external shocks and ensure financial stability it is more comfortable for us to have higher foreign currency reserves. Optimally, reserves should be sufficient to cover sizeable capital outflows for 2-3 years plus conventional reserve adequacy level. According to our calculations, such level is estimated at about US$500 billion.

I would like to emphasise once again that operations in the FX market to replenish international reserves are compatible with the policy of inflation targeting as these operations are not aimed at maintaining the ruble exchange rate at a certain level. Moreover, they do not decrease the efficiency of the interest rate channel of the monetary policy. We sterilise their impact on the ruble liquidity: volumes of Bank of Russia operations to manage the banking system liquidity are adjusted by the value of interventions.

We realise that reserve accumulation even in small daily amounts ultimately impacts the balance of payments and the exchange rate. Yet, our calculations show that incremental reserve replenishment at the declared rates does not contradict our objective to bring down inflation to 4% as we consider all factors impacting consumer price dynamics in our decision-making.

Some words about the decision we have taken today and the potential for further reduction in the interest rates. Normalisation of the situation in financial markets and the outlined development of inflation dynamics should not result in complacency. We should be sensible about possible developments, and act prudently and gradually. We often hear calls for the Bank of Russia to take more aggressive actions in reducing the key rate. However, the attempt to achieve quick results may only destabilise the situation, trigger economic imbalances and their accumulation.

Thus, a slowdown in lending growth is conditioned by objective supply- and demand-side factors.

Furthermore, dramatic reduction in the interest rates may result in lower attractiveness of ruble deposits. It may result both in dollarisation of household and corporate deposits and enhanced capital outflow, higher volatility in financial markets, and excessively depreciated national currency.

Domestic savings are the most important, and in case of almost closed foreign markets, so to say, the only source of domestic investment.

Besides, destabilisation in the FX market feasible in case of dramatic reduction in the key rate may have a negative impact on inflation expectations. As I have mentioned, whether the trend for reduction in inflation expectations persists and develops is paramount for inflation slowdown both this year and in the medium term. Yet, stabilisation of inflation expectations at the increased level is one of the main risks for implementing our baseline macroeconomic forecast.

We should also take account of other considerable risks of inflationary character, primarily, a risk of unfavourable external economic developments. Besides, deviation of inflation from out forecast may result from revision of administered price and tariff growth rates scheduled for 2016-2017 and fiscal policy easing.

As inflation and inflation expectations further decline in line with our forecast, we will continue reducing the key rate. However, it should be clear that we have already gone a considerable part of this path and the potential for reduction in the key rate is definitely less in the next few months than it used to be early this year given the aforementioned risks.

I would like to repeat that as the main difficulties are overcome, the development of the Russian economy will depend on whether domestic sources of growth are found. Better investment climate and higher productivity are crucial here. We should create favourable conditions for these processes to develop without reducing incentives for economic adjustment. Price stability is one of the key elements of predictable and attractive environment for investment planning and production activity.

Our further steps will be determined by the objective to create monetary conditions contributing to the achievement of sustainably low inflation. Yet, we will regulate the pace of inflation decline to the 4% target based on the predicted economic dynamics and the need to maintain financial stability.

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