12 min read

It could always be worse

The CBR is worried that if the US raised interest rates amid a potential series of asset bubbles, you'd see a global hit that would lower Russia's GDP in the range of 1.4-2.4% and force the CBR to raise the key rate to 9% to ward off inflation.
It could always be worse

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The Bank of Russia has released a forward-looking report on monetary and credit policy for 2022-2024 and included modeling for a potential global financial crisis in 2023 as well as a few other related scenarios for things like oil demand (if it declines), global inflation levels, and assumptions about a prolonged period of high global levels of COVID infections. The presumed causes struck me regarding the financial crisis modeled – the CBR is worried that if the US raised interest rates amid a potential series of asset bubbles, you'd see a global hit that would lower Russia's GDP in the range of 1.4-2.4% and force the CBR to raise the key rate to 9% to ward off inflation. Setting aside the Federal Reserve's role in this scenario,  a 9% hike is not nearly as large as past crisis-induced hikes and reflects the long-term decline of key rates in the economy as inflation has been 'tamed' by the demand slowdown after 2008. Also worth reflecting briefly on a few potential trends and takeaways in the baseline forecast:

Export earnings in monetary terms actually are forecasted to fall after 2022 while imports keep rising. Household consumption is expected to provide steady growth, which has an unclear relationship to expected real wages and incomes given the labor market imbalances right now. Most importantly, fixed capital investment and GDP growth line up almost perfectly. Investment growth rates at that level, however, are still on the lower end given room for growth. A rise in imports also presupposes no breakthrough for domestic brands or manufacturers, which I think is safe. Though the Bank sees inflation returning to its normal target range, this is still stagnant growth and, I think, underestimates the negative impacts of the refusal to spend at least a few % of GDP more in fiscal measures to offset the COVID shock. After all, manufacturing is already contracting again. It's a big deal to see climate risks being normalized for macroeconomic planning, particularly given the importance of hydrocarbon demand for macroeconomic stability and the assumed $50 a barrel long-term oil price on which this forecast is built. The forecasters also clearly haven't incorporated any potential variation as a result of the huge surge in natural gas prices. Natural gas in Europe is now trading significantly higher than the oil price when calculated in barrel equivalent terms:

Coal is now cheaper than natural gas. Great. The ongoing surge for the SPD in Germany has opened the door to an interesting coalition-building election that may well shift the overton window for what's possible in terms of German energy policy, investment, and intra-Eurozone energy policy as well. Too soon to tell. However, it is clear that even a relatively short-lived period of sky-high prices can induce political responses that would further affect the assumptions behind the Bank of Russia's model. Russia is desperately in need of domestic demand to power through a rocky export environment steadily piling on the complications. The full report deserves its own post, and features a bit in a longer one I'm slowly working on at the moment. These were just initial impressions skimming the main findings.


What's going on?

After a furious increase in business investment activity in the second quarter of 2021 followed by sustained higher demand, it seems that capital investment levels are set to flatten or else fall in the face of uncertainty and in the absence of state support. 2Q investment levels were 8.3% higher than 2019 figures. Machinery, cars, and appliances led the pack. We can see the surge and moderation starkly in the Rosstat data, here using 2013 as the benchmark comparison:

Orange = production of cars, machinery, and appliances for the domestic market Blue = Demand for construction materials Seafoam = imports of machinery and appliances

This chart looks like a worst case scenario for recovery in the making. The surge in demand for production creates a surge in demand for labor and other inputs, contributing to higher inflation. Some of that inflation would happen via global commodity price levels, some via competition for imports of goods that face supply bottlenecks. But if that last uptick in investment falls off for the rest of the year, then suddenly the price increases already seen largely remain in place as companies raked in huge profits where they could while capacity doesn't expand much to the ease supply bottlenecks. Inflation has eaten away what otherwise might be strong real wage gains for many and the combined slowdown in demand and investment suggests a return to stagnation. Looking at the size of the banking sector's credit portfolio per CBR data, there's slight evidence of a slowdown by July-August. More important is the fact that individual debt owed to banks has grown faster than all other categories of credit except for credit owed between financial organizations, something else to watch:

Blue = individuals Red = corporate Green = nonfinancial orgs Purple = financial orgs Light Blue = small(est) firms

We need September data before jumping to too many conclusions about trends. The Russian economy can, in fact, surprise us positively. But in the absence of real fiscal stimulus – the payments going out seem unlikely to have a large impact in the aggregate – there's no longer 'pent-up demand' waiting out there. If people could afford it, they've probably already made the purchases this year that they held off on last year or else started last year taking advantage of the mortage program. The program's extension will undoubtedly keep the housing market more buoyant, and also draw in more money that might have gone towards other sectors or savings. Of course, I don't know what happens politically when homeowners realize it's their best store of wealth if pensions struggle to keep pace with inflation or the economy becomes yet more uncertain. Next thing you know, programs to build more housing create new headaches for local government. That's all more speculative for now. Suffice it to say that the economy needs another jolt to sustain demand at high enough levels to push growth to the higher end of the Central Bank's forecasts or higher. Only state spending can provide that right now.

The Institute for the Problems of Natural Monopolies expects demand for freight cars to steadily decline over the next 6 years. Per IPEM's forecast, demand for railfreight wagons should fall about 1% annually through 2027. Production of gondola cars is expected to fall at about the same rate – 6-7% overall – while impending writeoffs lead to a stronger market for tank cars. That's bad news for industrial capex. Existing manufacturers should be able to meet new demand by rolling out about 44,100 wagons annually. That's 22.8% fewer wagons than in 2020 and 44.6% fewer than the record set in 2019 at 79,600 wagons. This may seem arcane to many, but the rail fleet lies at the heart of Russia's domestic logistical network even with the rapid growth of truck-based delivery managed by e-commerce services. Trains are the traditional backbone for deliveries at distances of 1,000 kilometers or more. Fluctuations in the size of the available wagon fleet have had drastic political implications as recently as 2018 when shortages of wagons for wheat shipments triggered a panic from the governor of Leningradskaya oblast' over the availability of bread. The 2019 surge was partially in response to network shortages that increased inflation as firms had to bid up prices to secure wagons to ship goods. The impact of rental price changes may seem to be small in normal times, but the reaction to relatively minor movements in the price of benzine should underscore how little it takes to evoke political concern and notice among the public.

The rise in commodity prices hit wagon manufacturers the last 18 months – the cost per unit for a gondola car is 3.5 million rubles without VAT included. Last year, that was more like 2.8 million rubles signaling a 25% increase. For those who don't know (most I assume), gondola cars are open-topped wagons used for loose bulk materials. The surplus of gondola cars from the 2019 buildup is down this year because an extra 20,000 cars have been getting repair work done vs. 2020. That drives up loading costs on top of the higher cost of acquiring wagons if you're an operator intending to lease out capacity. You normally rent a wagon on a time basis with a rate set for loading services and the time the wagon is in use. If the rate was 800 rubles (I believe per day, but will follow up) for a gondola car in May, that rate's more like 1,200 rubles now. Declining demand suggests the potential for price deflation in the years ahead assuming that wagons can get to where they're needed. But that deflation and drop in orders will also mean fewer profits, fewer jobs created, and more pressure to find new revenue sources to maintain the plant capacity for the existing production base. Russian firms were ok'd to export wagons to the EU last year, a big deal mostly because the different rail gauge used in Russia affects designs and compliance with regulatory requirements, but that's not the real risk. If policymakers are confident that the Russian economy will actually grow above 2% annually in the years ahead, there should be an expansion of the freight load on the rail network. In August, RZhD's haulage was about 109 million tons, a 0.9% increase over the previous August. You'd expect more of a difference supposing growth is strong this year, but that also goes to show just how much of the wagon fleet is oriented towards serving exporting industries. If the domestic market declines in the years ahead while there's still growth for China-Europe transit and the expectation of rising coal exports, then they either have to get more use out of existing wagons, change the structure of the fleet, or import more. The rise of e-commerce is probably helping ease the problem some as they shift deliveries to central logistical points from which trucks can be used locally or regionally. Still, these stories can come back to haunt headlines when you least expect it.

The Ministry of Emergency Situations is going the extra mile to make sure the public are safe from unscrupulous businesses cutting corners when it comes to fire safety. A new legal act from the ministry is set to increase the rate at which 'raid' inspections are conducted at different businesses based upon their assessment by risk category: highest-risk businesses get a visit every year, high-risk businesses get a visit every 2 years, and businesses posing a significant risk get a visit every 3 years. A raid inspection is basically a snap inspection without warning whereas existing 'field' visits operate on a reliable schedule determined by federal and regional authorities. Businesses are preparing for problems as officials show up, storm around premises, and can threaten action. In Moscow, 91 of 542 complaints (16.8%) put forward to the city's business ombudsman concerned fire safety inspections. The Ministry is quite clearly expanding its powers to affect operations, incur legal action, and naturally create graft or else pressure business owners. The announced legal act comes just a week after the Ministry revealed plans to create regional staffs and offices without any additional budgetary expenditure, no doubt heavily influenced by this summer's fires.

Now is not the best time to step up the regulatory burden on businesses, but this is a development that responds to a clear political and public need. The drive to lower the number of workplace accidents since 2014, for instance, has notably been quite successful. Public tragedies in Kazan in 2015 and Kemerovo in 2018 reinforced the failure to adequately maintain necessary standards, though I suspect no one has grappled with how conflicting regulatory requirements and excessively complicated permitting encourage these practices. I recall going to a talk with a US businessman at EUSP in 2015 who was involved in property investment and management, and he noted that something like over 140 documents had to be approved in the proper order to authorize a project. If any were filed out of that order, you had to start at square one. It was cheaper to pay the fine for failing to comply with various requirements than to actually comply with them. That was St. Petersburg. One can only imagine attempts to wring out more money from the process in places truly lacking in revenues. It's the constantly shapeshifting relationship between the state and business that's the problem. The Ministry is setting itself up to be able to collect a lot more money in the years ahead.

As part of the ongoing anti-inflation and pro-investment campaign, Yuriy Borisov has signed off on plans to review how to help the scrap, ferrous, and non-ferrous metal sector. Specifically, the aim is to improve the management and collection of scrap, reduce illegal preparation and procurements, and ideally stimulate production of scrap metals to increase production by up to 50% for domestic consumers in the metallurgical sector, construction, et al. MinPromTorg, MinFin, and MinEkonomiki signed off on his letter laying out some basic timelines. From the end of January 2022, there'll be regular monitoring of the production, consumption, export, and prices of scrap metals. By the end of March, there'll be a system worked out at the sector level to systematically account for scrap metal use as well as measures to stimulate more costly extraction of 'hard-to-get' scrap or the production of scrap in more remote regions. By the end of December 2022, the government will launch directives for companies with state participation to make use of the sectoral accounting system.

One can easily mock the plan insofar as it goes to show how scared Moscow is of domestic inflation levels tracking with global trends. There is a profound and obsessive fear of global markets dictating domestic political contexts. What I find more important to explore is the fact that these measures are actually, in theory, a decent idea. What causes inflation frustrates economists, pundits, and households to this day, but the idea that it's a phenomenon abstracted from the supply of money in a contemporary context has its roots in the late 60s/70s. The United States managed inflation during WWII through the active management of supply and demand rather than monetary policy. The British government did so as well. These wartime planning systems lasted a while before being hollowed out by technocrats reinterpreting Keynesian economics through their classical economic priors, robbing it of a crucial use and insight – states can develop administrative capacities to manage markets that poorly manage themselves not just by setting regulations, but by directing resources. The problem in the Russian case is institutional and contextual. Pursuing these types of management measures while also pursuing austerity and constantly generating new sources of state or non-state capture and intervention doesn't really resolve the problem. If Mishustin and his team are really 'fool-proofing' Putinism, then they're still in the process of building state capacity. But that capacity clearly will serve personalist ends, especially when implemented to head off public discontent. Poorly administered and politicized market interventions in Russia tend to shunt the problem they solve onto other sectors fighting over resources that are artificially scarce. This will be an interesting test case of different modes of inflation management in the few years ahead.


Odds and Ends

New COVID cases came to 18,856 while deaths were reported at 799. Still waiting for the case decline to be reflected in death totals. The demographic hit from the crisis is immense. The birth rate for the first half of the year registered a 20-year low at 678,100 births. Population loss and deaths set 15-year records. Net population changes are following suit even with a recovery in migrant flows:

Brown = natural growth Orange = migration growth Red = general growth

Russian businesses are now looking to charter trains and visit Uzbekistan to vaccinate potential workers whose transit into Russia would be paid for. Yandex is participating in a pilot project coordinated with the Ministry of Construction to start with 10,000 laborers for logistical jobs at distribution centers and more to see how it goes. Rospotrebnadzor's Anna Popova has now admitted a 4th wave would happen during the fall, but the expectation is that higher levels of lethality rather than crazy increases in infection rates would take place. Still waiting for the case decline to be observed in the deaths data.

Another small note from yesterday as I missed it, Russia announced it would not support an extension of the OSCE border and observer mission at the Donetsk and Gukovo checkpoints on the border in Donbas. The announcement was most likely a direct response to Ukrainian president Volodomyr Zelensky's visit to the White House.


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