Bank of Russia First Deputy Governor Ksenia Yudaeva’s Interview with Vedomosti Newspaper on 24 February 2014

‘A turning point in the economy may come unexpectedly’

How the Bank of Russia can contribute to economic growth, why refinancing has grown sharply and what will happen to foreign exchange policy

By Olga Kuvshinova

The transition to inflation targeting, which the Bank of Russia is carrying out as one of the largest institutional reforms, has frightened both the market and officials. The process coincided with the period of the depreciation of emerging market currencies, including the rouble, which became the leader of the fall by mid-February. Some persons (for example, Finance Minister Anton Siluanov) link the rouble’s depreciation with an abrupt decline in economic growth, which actually showed annual zero rates in January. Others (for example, experts from Sberbank CIB, the Gaidar Institute for Economic Policy and the Development Centre of the Higher School of Economics) point out that attacks on the rouble were facilitated by the central bank’s policy.

Experts criticising the central bank’s actions say it has built up refinancing volumes and created a closed circle while balancing between foreign exchange and monetary policy: banks are buying foreign currency from the central bank and simultaneously taking out rouble loans from it to purchase foreign currency again. This would not have occurred, if the exchange rate had been free, believes Bank of Russia First Deputy Governor Ksenia Yudaeva.

The Ministry of Economic Development, on the contrary, proposed slowing down the transition to a freely floating exchange rate, fearing further market destabilisation. Many countries loosened the reins gradually, maintaining interventions for the purpose of influencing the exchange rate: some advanced countries switched to the exchange rate’s free float just years after they had declared the launch of the inflation targeting regime. This regime in a half of emerging markets is still modified with the exchange rate’s float, which is managed in some or other way.

The inflation targeting regime being hotly debated today is normally equated by persons engaged in a dispute withthe rouble’s free float. But there are options in this regard. Which option does the Bank of Russia mean when it talks about the transition to inflation targeting?

When the Bank of Russia talks about the regime of inflation targeting, it talks about the entire system of institutions required for the functioning of inflation targeting, including the refinancing mechanisms, the system of decision-making and reporting, communication policy, etc. The exchange rate plays far from the first role in this list. Inflation targeting does not simply involve measures for its reduction; this is a certain regime of monetary policy implying that central banks set medium-term inflation targets, while interest rate policy is the principal instrument of achieving these targets.

We have already practically introduced a classical system of interest rates for inflation targeting. We have a key rate, the one-week repo rate, at which we either provide or absorb the main volume of liquidity. Around this rate is a corridor of fixed rates of plus or minus one percentage point: if some banks are confronted with liquidity problems and cannot resolve them using the interbank lending market, they can borrow from the Bank of Russia at any moment at these fixed rates. There are also the so-called ‘fine-tuning’ operations for terms from one to six days just in case if a considerable need arises for liquidity or, on the contrary, its absorption after one-week auctions. The ECB, for example, regularly held liquidity absorbing auctions during the periods of reserve requirement averaging.

The rules of exchange rate policy also underwent changes. And they will apparently change more. What will they be?

The current exchange rate regime, when we daily hold very active interventions, undoubtedly comes into conflict with our other institutions. We are currently in the transition period and have to balance between exchange rate and interest rate policies. We’ll be changing the parameters of the rules of our actions in the foreign exchange market during the year and we’ll be increasingly raising the exchange rate flexibility. But we’ll keep the rules in case of a financial instability threat.

Does this mean that the corridor will remain? Do the rules signify that interventions will be held automatically, like they are held now, rather than at random, by the central bank’s decision, like under the free float?

The word ‘rules’ means by definition that automatic interventions will be held. While it is better not to use rules with regard to the exchange rate from the standpoint of economic theory, we have become convinced that it is better to act by the rules in this country, at least, in the near future. But I cannot assert now what this rule will be: a closed corridor like now, an open corridor or some other system in place. We have quite serious discussions inside the Bank about what a final regime of balancing between financial stability and the normal operation of refinancing institutions should be.

Does the central bank plan to elaborate the rules by the end of 2014?

And it plans to launch them from 2015.

For some definite period?

So far, for an indefinite period. If we develop derivatives markets, then we’ll possibly eventually switch to interventions in these markets, like Mexico or Brazil did, for example. It also seems to me that two things are confused when there is talk about foreign exchange operations by central banks: interventions with the aim of influencing the exchange rate and operations with foreign currency, for example, foreign exchange swaps intended to maintain liquidity. Countries with narrow financial markets have very extensive experience in using foreign exchange swaps precisely for regulating liquidity rather than directly influencing the exchange rate. We also use them. We are aware that our operations in the money market against pledged currency, that is, foreign exchange swaps, may grow after we switch to inflation targeting because the markets are not yet sufficiently developed to allow us to hold refinancing operations without the use of foreign exchange swaps.

What else, apart from the new rules of interventions, remains to be done for the transition to the inflation targeting regime planned for 2015?

So far, we are in the process of implementing communication policy approaches, which are standard for countries with inflation targeting. Some 10-20 years ago, central banks could avoid holding regular meetings of their board of directors, announcing them in advance and paying much attention to how they explained their decisions. Now regularity, early notices, specific disclosure methods and additional analytical reports have all become a norm. This occurred exactly because most countries in the world are now working in the inflation targeting regime. The Bank of Russia has also taken steps in this direction: we have announced a year-ahead schedule of board meetings, a schedule of monetary policy reports, etc. We are gradually improving our information notices and we have provided for regular press conferences by the Bank of Russia Governor, which means that we are also progressing in the area of raising the transparency of our policy and its explanations.

There are several things, which we have not implemented yet. Inflation targeting is largely centred on the fact that the Bank of Russia is independent from the executive power and primarily fulfils its goal related to inflation and economic growth inasmuch as this does not run counter to inflation targets. But still the central bank must be accountable to society. Parliament in all countries is the main body of state power where society is represented. That is why central bank governors traditionally report to parliaments regularly on their policies. In our case, we present annual reports and Guidelines for the Single State Monetary Policy. We deem it expedient to pay more attention in these reports to whether we have achieved the inflation target or not and in the latter case — why we have failed to achieve the target.

To what extent is it possible in general to control inflation, if it is largely determined by the low level of competition in commodity markets, and if services provided at administered tariffs account for almost a third of the CPI growth? How effective monetary policy methods may be in this case?

We talk much about inflation expectations and I would say that it would be desirable for us to influence the inflation expectations of tariff regulators as well. This would remove a part of the problems you are speaking about. There are problems with the absence of competition and these problems largely affect the level of prices for certain goods rather than the rates of price growth as a whole. Inflation shocks in the economies with higher monopolisation levels may possibly last longer than in competitive economies. But all the same, even if we have a monopolised economy, the rates of growth in monopoly prices are different when inflation is 15% and when inflation is 6%. Inflation always reflects the scale to show whether your prices grow at an average rate of 2%, 5% or 15%.

Central banks in advanced countries normally target inflation at the level of 2% and below. Now this policy has come under criticism, even from the IMF and a big discussion is underway about whether it is possible to keep inflation at a higher level of 4%, while maintaining confidence in the policies of central banks. In emerging markets, where large structural changes are taking place, including from the standpoint of prices for various goods, the inflation targets are after all more frequently centred around 4% rather than 2%.

And which level do we need?

So far, we believe that the long-term level is 3-4% but there are also disputes about it. We have set the goal of achieving 4% by 2016.

Russia is a raw material exporter, that is, it depends heavily on foreign currency revenues from the standpoint of both the balance of payments and the budget. The population also watches closely the exchange rate because it strongly influences the level of personal well-being. The transition to inflation targeting in raw material countries like Norway and Chile was accompanied by the support from other institutional reforms — budget and tax transformations limiting the influence of rental income on the economy. In this country, however, the budget rule failed to exist even for a year. Won’t it come out that the central bank’s reform will suffer a failure as the rest of the economy is moving in another direction?

We are one of the countries with the fear of floating and in my view this is linked with the fact that the exchange rate is considered as the main variable accurately predicting inflation rather than the fact that the population understands well the dependency of the budget and revenues in the country on raw materials and the influx of foreign currency. To a large extent, this is still the legacy of the 1990s when inflation and the exchange rate indeed normally moved in one direction and quite rapidly. The fear of floating will remain until we manage to reduce inflation and fix it at sufficiently low levels, although this fear has decreased in recent years. I normally cite the example of Australia: the Australian dollar has weakened against the US dollar since January 2013 approximately by the amount of the rouble’s depreciation. Meanwhile the situation with inflation in Australia was and remains calm and inflation is considerably lower there than in Russia and the local population pays little attention to the exchange rate. To my mind, it is inflation rather than the exchange rate that is a key issue after all.

But the economy in Australia is also quite different. The country has a chronic current account deficit, while capital inflow largely comes from loans in Australian dollars as the reserve currency. In this country, however, as soon as the current account surplus declines slightly, everyone immediately starts to calculate who will win and who will lose, in which direction the economy will develop and how many percentage points this will add to inflation.

Inflation in our country has been gradually decreasing since the late 1990s after all. This trend stalled in 2007; moreover, this occurred amid the rouble’s continued appreciation both in real and nominal terms. This was followed by the rouble’s steep fall in 2008 — early 2009 but this trend did not cause inflation to move to a higher path; instead, it moved to a lower path. Therefore, if we just look at statistical figures, we can see that inflation has declined substantially over the past 15 years, including after the 2008 crisis.

This is simply because the demand fell very strongly during the crisis.

This is not only the case. There were also other reasons. I can tell you how inflation changed during various periods of 2000-2013. First, this process was based exactly on the appreciation of the real effective exchange rate caused by the growth in oil prices. The Bank of Russia tried to slow the corresponding nominal appreciation and printed quite a lot of money in exchange for foreign currency it purchased to add to its reserves. A part of this money was used in the economy effectively through the growth of its monetisation, while the other part contributed to the persistence of fairly high inflation. As a result, the rouble real exchange rate appreciated due to inflation rather than the nominal exchange rate. In subsequent years, however, this process came to a halt: capital inflow declined, oil prices stopped to grow and the grounds for the rapid appreciation of the real effective exchange rate disappeared. Inflation decreased quite substantially: its level of 6-7% in recent years is unprecedentedly low compared with the pre-crisis levels.

But this only confirms that inflation in this country is a sort of a derivative from the rouble exchange rate, while the latter is a derivative from the current account balance.

This confirms that inflation is increasingly a derivative from the monetary policy rather than from the exchange rate policy or the exchange rate proper. And this is the policy, which the Bank of Russia has been implementing consistently in recent years.

Interest rate as a target

There are a lot of conspiracy theories about what exactly happened to the rouble in January but all of them are unanimous that the devaluation was carried out by the authorities deliberately. However, if we look at the refinancing volumes, all of these theories can be immediately credited: banks’ debt to the central bank grew 3.3 times compared with February 2013, with most of this growth registered in the second half of the year. It turns out that the central bank was selling foreign currency with one hand and supplying banks withroubles with the other hand so that they could use them to purchase foreign currency. Why did this take place?

I am reading various foreign sources, which constantly write about the problems of emerging markets, a strong depreciation of their currencies and capital flight. But these sources, first of all, make no mention of any conspiracy specifically in Russia and, secondly, Russia itself is mentioned in far from every article. This is because Russia is not just the only country overtaken by this process. It is within the framework of some general global process and does not stand out anyhow against the background of other countries and is not any noticeable exception like, for example, Argentine, which stuck to its exchange rate but was forced as a result to devalue it by 18% over a week, or like Turkey, which suddenly raised its interest rates by almost 5 percentage points at once. All these exceptions are being actively discussed by the foreign media. So, even if there is some conspiracy, this is a world-wide conspiracy and against all emerging markets at once. (Laughing)

Now about refinancing. I would look at another indicator — money market rates. They did not change as a whole over the year. This means that the liquidity situation in the market was about the same throughout the entire period from the standpoint of the cost of money.

As we are switching to inflation targeting, the interbank market rate is our primary operational benchmark. And it is very important that the interest rate in the interbank market should not deviate strongly from the Bank of Russia’s key rate. Interbank market rates in the countries where the banking system is not segmented are very close to the key rate. If something happens in the banking system and it demonstrates several clearly identified parts, interest rates in each of these parts may vary. Russia’s specific feature has always been its fragmented and segmented banking market and therefore our market rate differs from the key rate. But as soon as we introduced an interest rate corridor, this rate stays after all 99.9% of the time within this corridor.

Meanwhile, several other processes are influencing our liquidity. First of all, there is a sufficiently large share of cash in the economy and a part of liquidity goes into cash money growth. Secondly, our budget expenditures are allocated unevenly during the year. And thirdly, central bank interventions are yet another important factor, which indeed strongly influenced liquidity last year. But this is what actually takes place: we primarily watch the rate and if we hold interventions, we absorb liquidity from the market as we sell foreign currency. And we must then return all this absorbed liquidity to the market so that the rate stays at the same level. Otherwise, market rates will deviate considerably from the key rate. Last year, almost 1 trillion roubles were withdrawn from the market through central bank interventions and this amount was substituted with repo operations and auctions for liquidity provision against non-marketable assets, as well as fixed-rate operations, including foreign exchange swaps.

Your opponents blame you exactly for loans against non-marketable assets as they say these loans have unbalanced the entire system and the central bank has therefore created ideal conditions for the foreign exchange market speculation against the rouble.

These persons apparently believe that the Bank of Russia should not switch to inflation targeting. This is indeed some kind of novation: some time ago the Bank of Russia targeted the exchange rate in one way or another, while interest rates lived their own life, which was quite instable. Now that we are switching to inflation targeting, our interest rates have become fairly stable and predictable, while the exchange rate correspondingly lives by market laws to a greater extent. But so far we are in the process of the transition to inflation targeting and are acting by the rules of current currency interventions. There would not have been such an abrupt increase in refinancing volumes, if we had targeted solely the interest rate and had not carried out foreign exchange operations.

So, there were options.

Yes, there was a choice. If we had not offset liquidity absorption because of interventions, liquidity would have declined and interest rates would have increased and we would have maintained the exchange rate rather than the interest rate, somehow adjusting all the other factors — both liquidity and the rate — to it. This process would have been similar to that in Ukraine where interest rates were very high despite the stable exchange rate. But as we are switching to inflation targeting, it is the interest rate that has become our goal.

And why wouldn’t it be possible to use foreign exchange swaps more actively for refinancing, providing liquidity against the pledge of purchased currency?

We provide swaps at fixed rates. And they begin to be actively used in the period of growing demand for liquidity. It has been proposed to introduce auction swaps at the key rate or even use swaps on equal terms with other security in repo operations. This possibility may be considered after we switch to a floating exchange rate and give up regular interventions. Also, if the scale of interventions falls considerably and interventions cease to be regular, and if we manage to agree with the Ministry of Finance on reducing the calendar effects of the ministry’s operations on liquidity, the growth rates of market collateral will possibly suffice to meet the demand for liquidity.

Bank of Russia Governor Elvira Nabiullina has already stated that despite all the criticism the central bank will continue operations against the pledge of non-marketable assets so that collaterals can be released for the interbank market. And how critical is the situation with collaterals? We heard the figure of 70% for collateralutilisation.

Marketable assets are growing rapidly enough and this growth is also facilitated by our operations. Collateral utilisation now stands at about 60% and normally peaks in December roughly at 65% and in some days it possibly reached 70%.

You are going to revive unsecured operations, aren’t you?

We consider them as a crisis instrument and keep it in our stock but we have no practical plans for its use in the near future. We believe after all that we need to continue improving such instruments as operations against the pledge of non-marketable assets. Our bond market and, correspondingly, marketable assets should grow. Finally, we also have a possibility to work with foreign exchange swaps.

And what about extending the list of securities?

We are extending it but this cannot be done endlessly. It is very important not to cross the threshold when the entire lending or bond market activity is solely intended for assets that can be transferred to the Bank of Russia as collateral. After all, we would like the markets of these assets, as well as the interbank market to work. Nevertheless, we are extending the Lombard List to add reliable assets when they emerge. Now we have started to include mortgage assets in the list of securities used as collateral. Then, possibly, there will be project bonds. The law on securitisation will apparently add interesting collaterals to us. We are trying to find a possibility to accept pools of small business loans as collateral: we need to establish criteria and rules, which is not the simplest thing. Our economy is large and generates quite a lot of collaterals.

And what about derivatives? Specialists emphasize that foreign exchange risk hedging instruments must be available to allow for successful inflation targeting by the central bank.

The markets of both currency and interest rate derivatives are also growing in our country. Business is using these instruments ever more frequently. We’ll now give regular statistics on these markets in our monetary policy reports. The turnover of the market of currency futures and options has risen by 42.2% since September and now stands at about 1.8 trillion roubles. In percentage terms, this amount is, of course, smaller than in many other countries but we’ll take efforts to develop this market. The market of exchange-traded interest rate derivatives is also developing but is quite small so far: it accounts for less than 0.01% of the turnover of interbank loan transactions. Unfortunately, this market is still confronted with problems of legal nature. I hope that the problems will be resolved and the supreme judicial authorities will issue corresponding explanations, making it possible to neutralise legal risks.

Isn’t it dangerous, on the other hand, to develop derivatives, if we recall that they were the cause of the crisis that began in 2007?

The safest thing is not to have any financial market at all. But in this case, there won’t be any development either. Meanwhile, rapid and effective development is demonstrated by the countries with well-developed financial markets, including the markets of risk hedging instruments. When there are risks, you should be able to calculate and manage them rather than simply try to avoid them. No doubt, you need to see to it that no bubbles emerge in this market, as well as in all other markets. It is necessary to regulate it and set up the processes of information collection and dissemination, which also helps reduce risks.

The need for investment growth

The central bank’s key rate has stayed at one level for 18 months, while the rates of economic growth have fallen from 4.3% to 1.3% over this period. It turns out that there is no relation between the rate and the real sector or, on the contrary, the rate is high and has slowed the economy.

I want to draw your attention to the fact that this assertion is quite the opposite to what you spoke before about liquidity — when we were actually criticised for keeping the rate too low from the standpoint of maintaining the exchange rate. Now it turns out that the rate is too high. There is no perfection in life. (Laughing)

There isn’t any uniformity either: there are a lot of various critical remarks addressed to the central bank.

Let us return again to the fundamentals of monetary policy. Central banks normally use their interest rate policy to stimulate economic growth in case of cyclical crises, that is, when the fall in economic growth rates is caused by the factors of demand rather than the factors of supply and is accompanied by a considerable deterioration in the labour market and when there is a real threat of a sharp inflation slowdown or deflation. In these cases, the goals of central banks for economic growth and inflation coincide and they have stimuli to increase inflation and so they ease their policies and this has an effect on demand and economic growth.

Growth rates have indeed slowed down considerably in the Russian economy over the past year, while the situation in the labour market remained quite stable and even continued to improve until recently. I specially met with labour market specialists to discuss whether this little deterioration observed lately is a return to normal after the market was almost overheated or this is a real deterioration. They are inclined to believe that this is rather a return to a normal situation. That is to say that we don’t see any serious problems in the labour market. And we see inflation that at least is not falling: it stayed almost unchanged from the same period a year earlier and increased on an annual basis compared with the start of autumn; core inflation is not decreasing. Meanwhile, output has slowed down considerably. This means that apparently we are dealing with a structural slowdown. In this case, it may be counterproductive to try to influence economic growth through the Bank of Russia’s policy: we’ll fail to influence economic growth but will propel inflation.

And the same situation can be observed in a very broad range of countries: Brazil where recession has already possibly begun, Mexico and South Africa. In Russia, the slowdown was prompted by several factors, according to our estimates. The factor of external demand has ceased to be a stimulus for growth in domestic demand, oil prices are stable, while the prices for some other export commodities have declined. The economy has reached the pre-crisis levels and, correspondingly, the factor of recovery growth no longer works. We need investment growth. In the current situation, investors apparently lack sufficient understanding about where and how they can invest.

So the rates and the cost of loans do not impede investments today and there are other factors that impede this process.

In the situation like now, the rates and the cost of money are obviously not the main factor. Moreover, banks have cut interest rates lately but this has not caused any upsurge in lending activity. This means that the problem is more complex. When the Bank of Russia’s rate is 5.5% and the final rate for the borrower is 15%, it is obvious that the 9.5%, which is found in between, is explained by quite a broad range of other non-monetary problems. The fact that the situation in the labour market is calm indicates that demography and the labour market specifics in general are one of the factors restricting economic growth: the possibilities for growth through the creation of new jobs have now been used up. We need to move workforce from bad to good workplaces and this process is rather more complex than just utilising freely available workforce.

Judging from forecast downgrades, the central bank does not expect any positive changes.

Our GDP growth forecast for 2014 was about 2% and is now 1.5-1.8%. The forecast deterioration is largely related to poor results last year. Nevertheless, we expect growth acceleration compared with 2013 for a number of reasons: the end of the cycle of inventory contraction and the improvement of the external sector. The contribution of consumption will be falling, according to our estimates. Our forecast for the next two to three years has remained unchanged: the economy will reach a growth of about 2%. We estimate quite conservatively the situation with structural reforms and reforms for improving the investment climate. Incidentally, we consider the policy of reducing inflation and switching to inflation targeting as our contribution to the implementation of institutional reforms. Low inflation and more predictable and understandable policy is what the Bank of Russia can do to raise the attractiveness of our country for investment.

Doesn’t the unfinished nature of other institutional reforms impede you in this process?

It does not impede us strongly but it rather prevents economic growth rates from returning quicker to some higher and accustomed levels. But this also gives the hope that the government can influence the situation. The implementation of institutional reforms can help change the situation quite radically and quickly. I have a solid experience in forecasting and I can say that a trend reversal can be rarely predicted and may occur quite unexpectedly.

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