The Russian election campaign and related political events have distracted the public’s attention from the fact that the country has found itself in new circumstances. Luck, which has helped Moscow to greatly consolidate its positions over the past few years, is giving way to increasingly growing problems. The general situation may be far less favorable in the new political cycle.

WORSENING GLOBAL ECONOMIC TRENDS

Food prices shot up in Russia at the end of 2007.

A combination of fundamental and short-term factors fueled the global growth in food prices. The European Union abolished subsidies for milk and dairy products, and there was an epizootic situation in China.

Climate change also contributed to the growth in food prices. There was a large-scale drought and a poor corn harvest, which means that global wheat reserves in 2008 will be at their lowest in the past 28 years, while the reserves of the world’s five leading exporters (Argentina, Australia, the EU, Canada and the United States) will be at a 34-year record low. Other factors include increased food consumption by developing countries, first of all China, and the growing popularity of biofuels.

However, there is at least one fundamental reason behind the increase in food prices that is not given enough attention – the migration of global speculative capital (“hot money”) into new markets. After the painful adjustment of the American stock market in April 2000 and the collapse of the “new economy,” money was put into exchange-traded mineral resources – oil and metals. Now these two speculative resources are giving way to food, which is no less important for human development than oil and demand for which is not very elastic in price.

The growth in food prices will deliver a terrible blow to poor countries that import food. If the present trend continues, these countries will be hit by famine, and if they do not learn to produce food for themselves to meet their requirements, the population of those countries will gradually die out. Moreover, even a modest step toward self-sufficiency in food supply would require serious efforts from these countries to improve the quality of state governance and introduce modern agricultural technologies on a large scale (which often requires a modern educational system and developed infrastructure). In order to develop their own agriculture amid the current global competition, poorer countries will need moderate protectionism; that is, at least a partial revision of the economic policy based on liberal ideology, meaning they should reject the dogmas of the Washington Consensus. For underdeveloped countries, rejecting these dogmas would mean a deep, systemic conflict with the West, since Western food producers would receive less profit. Strictly speaking, these countries cannot afford such a conflict politically – unless they enlist the support of China.

Russian imports of foodstuffs exceeded food exports by 290 percent in January-August 2007 and totaled $17 billion compared to $4.4 billion. The growth in food prices means that the foreign trade surplus is dropping more rapidly. Global speculative capital forced up the prices of Russian exports in previous years, whereas the pendulum has now started swinging in the opposite direction – speculative capital is beginning to push up the prices of Russian imports.

Since Russia is highly dependent on farm produce imports (it imports half of the milk it consumes, about half of the pork, and almost three-quarters of the beef), the worldwide growth in food prices has an automatic impact on the domestic market, boosting inflation. The price hikes hit, first of all, the poorest groups of society, who spend most of their income on food.

It is important that Russia has not yet reached even the average consumption level it had in Soviet times. Meat consumption in Russia was estimated at 73 kg per capita a year in 1989, while the norm was about 80 kg. However, meat consumption was a mere 55 kg in 2006. The same is true for the consumption of milk and dairy products: at present, Russians consume 235 kg per capita, compared with an average of 392 kg in the Soviet Union. Fish consumption stood at 12 kg per capita in 2006, compared to 20 kg in 1989.
The drop in food consumption by Russians due to price hikes might bring about serious social and political destabilization.

INFLATION GETTING OUT OF CONTROL

The above-said would not be frightening for a healthy economy with a sensible government. But Russian inflation is expected to grow to at least 11 percent in 2007 from last year’s 9 percent. Moreover, these are official figures, which are often set too low. Some specialists estimate the real growth in inflation at no less than 150 percent in 2007.

Inflation is not likely to slow in 2008: budget spending in the fourth quarter of 2007 increased by 1.07 trillion rubles (not only for the election campaign or due to corrupt sentiments, but also in order to support bank liquidity), exceeding the planned figure by 130 percent and accounting for 46 percent of all expenditures in 2007. This growth will bring back monetary inflation for the first time since Russia’s financial default of 1998. The growth rate for the domestic wholesale price for natural gas will almost double to 25 percent – in addition to a growth for electricity tariffs and utility rates.

Food prices are growing as well – not only for global, but also for purely domestic reasons.

The immediate cause of increased prices on the domestic market was the rapid growth of grain exports: in January-August 2007 they doubled to almost $1.5 billion and kept growing afterwards (Russia exported 2.4 million tons of grain in September and grain exports reached 3.1 million tons in October). Export duties are unable to hold back these sales, while commodity interventions are insufficient, too late and only play into the hands of re-wholesalers rather than producers.

The price was high for the government’s incapacity in the sphere of market regulation. Bread prices soared 20 percent in January-September, compared with 7.6 percent in the same period of 2006; macaroni prices increased by 13.8 percent (compared to 3.8 percent), and groat prices went up by 15.9 percent (11 percent).
Wholesale prices for new harvest sunflower seeds almost doubled, and even the price of sunflower oil from old harvest seeds increased by 17.2 percent, although it fell 1.2 percent in the first nine months of 2006.

The inflation wave is even hitting new sectors of the economy that saw stable prices in the first nine months of the year.

For example, retail gasoline prices grew by a mere 2.3 percent in January-September 2007, compared with a 12.2-percent increase in the same period of 2006 – primarily because the price growth potential was exhausted (similar things happened on the sugar market).

However, in the second half of October, wholesale gasoline prices soared to a point where the profitability of independent refuellers fell to a critical level. The reason was not only a growth in world oil prices, which stimulated the export of oil products, but also a drop in production due to repairs at oil refineries and the inefficient distribution of oil to refineries that were recently placed under Rosneft control.

The recent freezing of prices for six ‘socially significant’ product groups will only have a temporary and limited effect, even if the state ensures their universal availability for sale. First, because the price freeze is voluntary and non-participating monopolists can raise prices. In addition, even those who have pledged to freeze prices can engage in cross-subsidization, thus offsetting their profit shortfall with price hikes on “socially insignificant” goods. And after the price freeze agreement expires on February 1 or April 1, monopolists can drastically raise prices. So the price freeze is simply a measure to win time, which the government will not be able to make use of since an effective antimonopoly policy is in conflict with business interests and the dogmas of liberal fundamentalism.

The government has not fully understood that an underdeveloped agricultural sector and a servile dependence on external markets is behind the surge in inflation. Measures to comprehensively develop agriculture, which would combine reasonable protectionism (at least at the level of developed countries), the development of agricultural infrastructure and the lifting of artificial barriers on domestic markets, remain beyond the government’s consciousness. The most that the government can do is to take pinpoint protectionist measures to support lobbyists, not the economy.
For example, the government added fuel to the price fire by almost doubling the import duty on sugar on December 1 – as if this measure could help increase the amount of the already harvested sugar beets in Russia.

The government’s activity has caused panic buying of long-term staple goods, whose prices are regulated (in anticipation that prices will increase once the regulation period expires), and long-term storage substitute goods (primarily canned food).

The main cause of the price increases was not the price jump on global markets and not the weakness of agriculture, but the monopoly in trade. This was already evident during the undoubtedly man-made food crisis in the Kaliningrad region. Similar crises had been arranged in the past, as well – to condense the market and oust small companies from it (e.g. the ‘wine crisis’ in early 2007, caused by the introduction of the Unified State Automated Information System), or simply for the sake of a clearance sale (the salt crisis and several small sugar crises).

This time food prices jumped before imported goods purchased at higher prices or liable to higher duties entered the market, and before the government raised pensions. On the whole, prices rose not because of increased demand or costs, but merely on news about expected increases. This means that inflation was caused by a total abuses of monopoly. Fighting such abuses is not only technologically and legally difficult (Russian laws still require evidence of direct collusion, which may not take place at all), but also politically dangerous. Indeed, putting an end to monopoly overpricing would deprive businesses of funds for bribing the corrupt bureaucracy, who would thus lose this money.

CHANGES IN CAPITAL MOVEMENT

The mortgage crisis in the United States, which has also hit the UK and shaken the global financial system, was not accidental. It reflects the end of the economic recovery stage in developed countries achieved by easing financial policy. Now the time has come to toughen this policy, appreciate the national currency, raise the cost of borrowing, and return capital from risky markets (including Russia) to developed ones.

It is important that the mortgage crisis only acted as a catalyst and accelerated the reduction of capital inflow into Russia, which began long before the subprime lending crunch. The inflow of private capital into Russia began to grow in March 2007 when its net volume reached $17.4 billion. The growth continued to $18.8 billion in April and accelerated to $29.1 billion in May. But the net inflow of private capital dropped to only $4.8 billion already in June (before businesses went on holiday).

The massive inflow of private capital into Russia ended in the second quarter, although statistically it hit a record high, giving rise to new yet unfounded hopes. Private capital outflow again exceeded inflow in the third quarter by $9.4 billion – a record for the entire Putin presidency.

The changes in capital movement are even more evident if we analyze the gross inflow and outflow by month (we do not consider here the movement of ‘shadow capital’ which is totally illegal and invisible to the state – see Table 1). Capital outflow and inflow were a respective $3.5 billion and $3.7 billion in January 2007. Capital outflow grew to $11.1 billion in February and stabilized at that level for three months ($10.8 billion in March and $11.3 billion in April). At the same time, gross capital inflow during the same months grew rapidly: to $13.4 billion in February, $27.1 billion in March and $28.1 billion in April. May was a record month for capital inflow when gross capital outflow fell by half to $6.4 billion, while capital inflow jumped to $38 billion. However, the trend reversed in June as capital outflow grew to $14.3 billion, while inflow fell to $15.2 billion.

CAPITALIZATION – THE END OF THE “LAST FREEBIE”

The practice is widespread among Russian businesses to adjust accounting reports by reporting expenditures as investment. This measure inflates profits and hides losses, while increasing capitalization and improving a business’s image. This, in turn, helps the business to borrow more money (or place shares) in order to cover reliably concealed running losses.

Worsening global financial trends caused by the mortgage crunch in the U.S. and higher food prices are putting an end to this business practice.

The flow of money from the West has almost stopped and the scale of ruble borrowings has shrunk dramatically. The average interest rate on loans given to mid-sized and large businesses has increased from 10 to 13-14 percent, which is a disaster for businesses that used to cover their growing losses by borrowing money against capitalization growth.

The situation is aggravated further by a possible crisis in private foreign debt, which has been growing quickly since 2002. Whereas private debt grew by 7.5 percent (from $29.2 billion to $31.4 billion) in 2000 and by 10.6 percent in 2001, it increased by 36.4 percent in 2002, by 66.7 percent in 2003, by 35 percent in 2004, by 62.1 percent in 2005 and by 49.1 percent in 2006. Private foreign debt grew by 31.4 percent to $343 billion in the first half of 2007. The share of private debt in Russia’s overall foreign debt jumped from 20.9 to 89.1 percent.

A large part of private borrowings abroad – at least since 2005 – is used to service and renew loans. Loan allocations peak in the fourth quarter of a year, causing an accelerated growth in private foreign debt at that time of the year. For example, foreign debt in Russia’s private sector grew by 20.2 percent in the fourth quarter of 2005, while the growth for the whole year was 62.1 percent. The growth was even more impressive in the fourth quarter of 2006, making almost half of the yearly figure – 21.4 and 49.1 percent respectively.

Businesses were no longer able to refinance and increase their foreign debt for free in 2007. Therefore, the most natural way to go is through the practice already underway of taking insolvent debtors into the ownership of creditors. However, banks do not want to recognize the loans they have provided as hopeless (this would hurt their reputation and financial standing). Their silence will ensure that there will be no scandals, yet it will not solve the problem, but only postpone it: banks will not be able to improve the management of companies that come under their control and ensure their financial recovery. Russian businesses are built to exist if the cost of borrowing is about 10 percent, and most of them will not survive a growth of this cost.

Shifting the burden of corporations that hide their losses onto their creditors will only postpone a general crisis and increase its dimensions, and bring the banking system into it. At the same time, the number of Russian businesses bought with foreign capital has fallen to a point where there will be no shock-absorbing effects.

THE PROSPECTS OF THE BANK LIQUIDITY CRISIS

A falling foreign trade surplus, coupled with a drop in capital inflow, sharply cuts the inflow of hard currency, which forces the government to spasmodically toughen its financial policy – precisely at a time when the economy begins to badly need easier policies. This will hit the banking system first of all.

In particular, the government made a decision which testified to the depth of the liquidity problem – a decision on an unscheduled allotment from the 2007 budget of 180 billion rubles “for development,” but it was actually used to provide liquidity to Russia’s three largest banks (two of them – Sberbank and VTB – recently raised considerable resources in IPOs).

Correspondent accounts at Moscow banks fell to a record low in late October compared to the past nine months of 247.7 billion rubles, while interbank rates rose again (to 8-8.5 percent for first-tier banks and 8.5-9 percent for second-tier banks). Russian banks continue to experience a shortage of ruble liquidity as they build up their accounts at foreign banks. Their funds at foreign banks rose by 37.8 billion rubles in September, while loans and deposits for non-resident banks increased by 210 billion rubles. At the same time, banks had reduced their funds at correspondent accounts in other banks by 30 percent to 80.5 billion rubles by the end of September. Several banks reduced blank limits and many banks got rid of them entirely.

Banks withdrew 320 billion rubles from securities in September. According to expert estimates, Russian banks had built a pyramid scheme on the bond market by buying bonds, investing them in repos and obtaining funds for purchasing new bonds. Now, this pyramid is falling to pieces.

Debts to banks increased by 644 billion rubles to 12.9 trillion rubles in September, as banks gave more loans to businesses and other banks. This partially reflects the general desire to reduce investment risks, giving preference to loans (as opposed to securities).

THE END OF STABILITY?

Russians have unfounded social expectations in a situation like this that are not related to the actual state of the economy.

According to the Levada analytical center, 58 percent of Russians believe that President Vladimir Putin does have a plan, highly publicized by the United Russia party, that would “make Russia a strong, rich and prosperous country” (although only 6 percent think that they know what this plan is) and expect that it will be successfully implemented, rather than face upcoming difficulties.
The key question for the present stage in Russia’s economic development is whether the government can close the gap in the financial balance of businesses and gradually cool down the overheated economy, reorganizing it and improving the quality of corporate governance.

The national budget and the Central Bank have accumulated enough funds to solve this problem, yet the government will not cope with it due to the following factors:

• shortsightedness (the government is not even aware of and has not set such a task);
• a lack of specialists;
• bureaucratic disunity (the Finance Ministry had to replenish the liquidity of state banks from the national budget, probably because the Bank of Russia refused to violate its corporate policy for the sake of the common cause).

The government will keep the general situation “within the bounds of decency” until the presidential election and it will keep promptly addressing individual problems as they become more acute. At the same time, the government will not be aware that these problems are manifestations of a gradually escalating general structural crisis of the economy. Therefore, it will not so much solve these problems as only make them less acute, thus postponing their manifestations on a larger scale for later.

Due to general irresponsibility, poor coordination and management, and fear of opening oneself up to attacks from hostile political clans, decisions will be delayed with unjustified material costs.

The policy of ineffective and delayed neutralization of individual manifestations of the general structural crisis will continue until the presidential election, after which there will be a new government and Central Bank management. However, due to the nature of the present corruption-oriented state, their effectiveness will not improve.

After the election, since everyone will be absorbed in political problems and the start of summer vacation, the government will manage to maintain stability until the end of July 2008 (when market participants will see dangers and take the lead), but later the danger that the structural crisis may evolve into an open crisis for the Russian economy will become real. This danger will manifest itself in:

• some companies will stop servicing debt;
• a divestiture of assets (above all, non-core assets), which will fuel a drop on the stock market and push down property prices;
• a serious crisis in bank liquidity.

Inflation will step up as the state tries to ease these problems by allocating poorly controlled funds and the ruble could weaken.
But this will happen after the next president is appointed (under the guise of presidential elections).