Speech by Bank of Russia Governor Elvira Nabiullina at the joint meeting of the State Duma financial market, budget and taxes, and economic policy committees (transcript)

Good afternoon, dear colleagues!

I would like to make a retrospect reconstruction of events which have influenced our policy and continue to do so, before we begin a detailed discussion of the Monetary Policy Guidelines.

The Russian economy has advanced considerably over the past two years. As you may remember, in autumn 2014, the national economy had to sustain a double blow from a large-scale drop in oil prices and the end-2014 peak in the external debt payments which coincided with the imposition of restrictions on access to foreign capital markets. We estimate the annualised deficit in foreign currency roughly at $200 billion. It has produced a noticeable effect on the Russian balance of payments.

During that period, the ruble made a deep plunge. Therefore, seeking to accelerate the stabilisation in the FX market and to keep inflation in check, the Bank of Russia switched to the floating exchange rate regime slightly ahead of the schedule (the preparations for the transition to the floating exchange rate regime began in 2009) by sharply rising the key rate and, eventually, all interest rates in the economy. Alongside the government’s bank recapitalisation programme and anti-crisis plan, these measures stabilised the situation. As expected, at first the inflation picked up to 17% in March 2015, but then it started to decline rapidly. Despite being rather significant, the economy’s downturn was not as deep as during the 2009 crisis. Just to remind, our deepest drop in quarterly terms was 11% then, whereas this time it was 4.5%. The economy performed better than most economists forecast. However, this shall not make us too optimistic. As you may recall, in 2008-2009, amid the resumed oil price growth the economy recovered quickly and adopted rather high growth rates. Now, it may take longer for the economy to revive, because the underlying factors shall be different compared to the factors observed before the decline in oil prices. We are well aware of all this, so today we are talking about the need to change the economic development model in Russia. At present moment, some signs of economic recovery may be seen, and a slight growth in GDP is expected by the Central Bank next year. Despite this, it is clear that processes observed across different sectors and across different regions are still highly varied and unstable.

We view the monetary policy measures implemented at that time to be of systemic nature rather than being temporary and purely anti-crisis. Up till now, these measures protect the economy against external shocks and help to identify new sources of growth. For example, the floating exchange rate became a factor balancing the interests of exporters and importers which is key for the development of import substitution processes, non-commodity exports, and also for programmes required for the technological modernisation based on best (including international) technological solutions. So far, the share of growing sectors is small, but they take hold and they in turn have enterprises that are also developing. Still we believe that the share of these sectors and their promising enterprises will increase as the Russian economy will adopt the new non-petroleum growth model.

One needs to realise that the economy model based on commodity exports and incentives to consume, including via the consumer lending, has been fully exhausted. This was seen not only in the economic recession during the crisis, but also in the gradual fading of growth rates over previous years. We observed abating growth even before the drop in oil prices. Due to this reason we assess potential growth rate roughly below 2%, in case we fail to implement structural changes. Therefore, the most important result of the economy’s two-year adaptation to new conditions seems to be the first signs of a new development model. At this juncture, the Bank of Russia’s objective is to support this process and to install stable financial conditions conducive for the emergence of internal investment sources.

I have mentioned on several occasions and I would like to outline once again our firm belief that any rapid rate cuts or channeling of excessive funds into specially selected projects are very dangerous. They may accelerate inflation, depreciate households’ revenues and savings, and cause a further increase in corporate leverage. All these factors are detrimental for economic stability and may even lead to the emergence of financial bubbles and their bursts, etc. Moreover, such policy is not only risky, but it is not conducive for a new growth model. On the contrary, it will not allow to part with the existing inefficient model. These actions may eventually bring about a short-term surge in economic indicators, which nonetheless will not mean any increase in competitiveness or economic efficiency. According to our estimates and assessment, such actions will be inevitably followed by a recession, when we will find ourselves with broken hopes and our country will lose time which might otherwise be used to install conditions for a truly qualitative and sustainable growth.

Extremely fast rate cuts not backed up by fundamental economic trends will lead to inflation spikes. This means that such cuts will make conditions for business slightly better at the expense of the population. We do not think it to be the proper price to be paid by our society. Interest rates for businesses shall be reduced not at the expense of households or price increases, but as a result of lowering inflation. This is the essence of our policy and our measures aimed at lowering the inflation.

That is why the main objective of the monetary policy is to ensure price stability and overall macroeconomic stability, deliver inflation to 4% and keep it close to that level. This objective does not mean purely quantitative parameters. First of all, we need to ensure the well-being of people, the stability of their income and the safety of their savings.

The Monetary Policy Guidelines contain survey findings demonstrating that in terms of its significance, inflation is still ahead of other issues worrying Russian citizens. High inflation is also harmful for the competitiveness of Russian business, and domestic goods and services. You may find more numbers on this issue in the materials given to you.

Today, the annual inflation stands at 6.1%, its delivery to the 4% target by the end of the next year and its staying at the level are possible. Only after this target is achieved and after citizens get assured that prices grow slowly, we may count on a sustainable decrease in inflation expectations among households and businesses. These expectations are yet rather high, though they tend to go down following the actual inflation. But it is too early to say that expectations have lowered to the level matching our 4% inflation target. Monetary policy shall remain moderately tight to ensure a decline in inflation. The reduction in inflation from 6 to 4% makes a much shorter distance compared to the distance from 17 to 6.1% already covered by us, nonetheless this is a challenge. Today, we do our best not to make mistakes or to act in haste, and also not to be too optimistic in our forecasting.

We cut the key rate very smoothly and gradually, and we do it only when it is called for by steady economic trends, but not by short-term factors, no matter how positive they might be, because for us the stability and predictability of financial conditions are as important as the level of rates. It is extremely important to avoid another (much worse) situation necessitating opposite measures, i.e. increase in the key rate, as it will exacerbate uncertainty for business. We believe it is important to have the rate-cutting process ongoing, consistent and rational.

Moderately tight monetary policy does not mean that nominal interest rates may not decrease. We have seen it happen this year when we lowered rates. And we will continue doing the same next year, whenever our baseline scenario materialises. However, real interest rates will remain positive. This will protect household and corporate savings against depreciation and will preserve incentives for ruble savings. It will stimulate companies to raise efficiency when selecting projects for implementation.

Let us have a look at our forecast.

The baseline scenario of our forecast is mainly built on the same assumptions as the forecast prepared by the government. The two forecasts are prepared independently, but this year they are very similar in their assumptions and in the underlying trends considered for three coming years.

We expect that domestic and external conditions will remain rather complicated for Russia’s economy. We do not think that the economy will be significantly transformed or its capacity will grow markedly during this period. The reason is that economic capacity may only grow as a result of structural measures, whose positive effect is usually built up during several years and does not feed through at once but only with a certain time lag. We are aware of these specifics and take them into account when preparing our forecasts.

This being the case, we still believe that, once implemented, certain government measures may improve the situation. If we observe more specific measures, we will adjust our forecasts accordingly. This is our standard approach. If it happens, economy may grow faster, than we assume now, and this growth will not cause inflationary pressure, as it will be based on the increase in labour productivity and production efficiency.

Today, economic growth is mainly hampered by structural factors. Why are we so sure about it? In fact, we have stated this more than once. Our statements are supported by economic indicators, e.g., even during economic recession unemployment in Russia (adjusted by part-time employment) remained stable. At the same time, we are extremely concerned that wages demonstrate a faster growth than labour productivity. All this creates inflationary effects. Specifically, insufficient labour mobility, low competition in goods and services markets lower the economy’s flexibility and its ability to raise labour productivity. The progress in lowering inflation is held back by the following features of our economy: income inequality, high share of food products and essential goods in the structure of consumption, and unpegged inflation expectations. On top of this, the low diversification of economy enhances its sensitivity to external shocks.

When global markets face such events it is crucial to take conservative approach to domestic planning. We expect persistently sluggish global economy growth and assume that sanctions will remain and will limit Russian borrowers’ access to global markets. Oil prices will remain an important externality. Our economy still largely depends on oil prices. We consider several forecast scenarios.

Our baseline scenario assumes that oil prices will remain at $40 per barrel for the following three years, while economic growth will gradually increase. We believe the growth will be balanced with smoothly recovering consumer and investment demand and better consumer and producer sentiment. However, overall GDP growth rate is bound to be low: less than 1% next year and 1.5-2% in 2018 and 2019. If we take additional structural measures, a slightly higher growth rate is possible in 2018 and 2019, depending on the nature of measures.

Regarding the balance of payments dynamics, which we traditionally mention in the Guidelines, we expect the current account balance surplus to decrease over time. We can already observe this trend. Export growth will remain moderate, not least because we predict conservative oil prices, and because economy structure will by inertia retain a large share of oil and gas exports, and imports will be slightly recovering along with the pick-up of internal demand. Even now, we see the recovery of investment imports and we hope it will feed through to production growth. At the same time, capital outflows will remain low at about $25 billion for the whole forecast period, and this year we expect a figure less than $20 billion. This will be mostly determined by a gradual decline in corporate external debt repayments and by the real sector’s constrained demand for foreign assets. The trend will be supported by positive real interest rates what will keep ruble savings appealing. We expect that under said circumstances banks will repay their debt under FX refinancing operations by the end of 2017. Let us remember that we introduced this instrument in late 2014 to facilitate corporate external debt repayments when the access to external markets was blocked. We believe that the developments will be favourable and banks will repay their debt to the Central Bank.

We also consider alternative macroeconomic scenarios: a risk scenario assuming that oil prices fall to $25 per barrel in 2017, and an optimistic scenario assuming that oil prices will increase to $55 per barrel. Currently, we view the risk scenario as highly unlikely; however, we believe that it is necessary to take such scenario into account to get properly prepared.

If the risk scenario with low oil prices materialises, we expect GDP to decline both in 2017 and 2018. The inflation slowdown to the 4% target will occur a little later, in 2018. If necessary, the Bank of Russia will take additional actions along with monetary policy measures to ensure financial stability. Under this scenario, we are ready to carry out interventions and expand FX refinancing, if required.

Under the optimistic scenario, the economic recovery will begin sooner. However, I would like to emphasise that even if oil prices reach $55 per barrel, we will simply achieve the potential growth rate of 2% within a shorter period of time. Without structural measures there will be no increase in growth, and it will take us less time to reach the limit that exists according to our estimates. In this case, inflation will decline faster and it is important not to allow the oil price growth to discourage structural changes and further fiscal consolidation.

No matter which scenario evolves, Russia and the Russian economy will face the same challenges – to change the development model, reduce the dependence on externalities and create internal growth potential. Under all scenarios, the Bank of Russia will pursue a consistent policy and our efforts will be directed towards ensuring internal stability: low inflation, stable financial sector, and predictable financial conditions. We have all necessary monetary tools and they are described in detail in the Guidelines.

You are currently discussing the budget in the State Duma and I would like to highlight that our monetary policy and fiscal policy, developed in cooperation with the government, aim for ensuring macroeconomic stability. There is a relationship between fiscal policy and monetary policy, and I would like to briefly describe it. Both policies influence internal demand, but their influence should not cause an increase in demand-side inflationary pressure. All else equal, a tighter fiscal policy may be balanced by a softer monetary policy, and vice versa.

Second, inflation and economy dynamics depend not only on the total budget spending or deficit, but also on the spending structure, and rates of indexation of administered tariffs and payments. If growth in the natural monopolies’ tariffs exceeds price growth, we will have to conduct a tighter monetary policy to prevent impact on inflation. However, if, as the government believes, the growth of administered tariffs is slower than inflation, it will be possible to soften monetary policy. The same applies to the indexation of budget allowances. It is evident that the structure of spending is of great importance, because there are areas of spending posing fewer inflation risks, these are production and investment growth, as compared to consumption expenditure. If there is no production growth, they might result in increased inflation and there will be no real improvement in living standards, so it is crucial to prioritise spendings.

The third direction of influence of fiscal policy is financial markets. The government is one of the major agents in the economy and in the financial market, and one can see its influence on the monetary policy right now. We saw the beginning of reserve funds spending, with liquidity coming to the financial system via budget channels. It results in the structural surplus in the banking sector. The Bank of Russia can predict and manage this situation. However, the Bank is forced to use different instruments: we carry out liquidity absorbing operations instead of liquidity providing ones and we resort to deposit auctions and, possibly, to issuing our own securities. At the moment, we practically face liquidity surplus, which will remain and deepen during several next years.

Moreover, the financing of budget deficit in the years to come will increase sovereign debt. It might have an impact on longer-term and private sector borrowing rates. It is important to monitor the implications for the financial market. It is clear that the draft budget for the next year stipulates a double increase in government borrowings. We should be careful and keep control of the developments. We believe it is important to adopt a three-year budget plan, to gradually carry out fiscal consolidation and to make fiscal policy predictable both for market participants and for the Central Bank. We think that it is essential to begin the discussion of the future budget rule and we know that the government has already started it. The Bank’s instruments only influence the nominal rate and we have abandoned the practice of a managed exchange rate in favour of a more efficient floating exchange rate regime. Once adopted, the budget rule will help to limit the volatility of real exchange rate and, therefore, its influence on the competitiveness of Russian business. A correct budget rule will make it possible to accumulate reserves and to prevent the appreciation of real exchange rate amid increasing oil prices, and vice versa. We believe it is essential in the long term and it will shape monetary policy stance.

The two most important conditions for a sustainable economic growth are structural transformations and macroeconomic stability. We are ready to conduct policy that will ensure stable macroeconomic conditions, allow companies and households to accumulate savings and invest them in the Russian economy with confidence and without fear that these investments and efforts will be devaluated by high inflation or debt or financial crisis. The objective of the Central Bank is to ensure price and financial stability and, therefore, to contribute to the growth and development of our economy.

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