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1.1.6. Short and Longer Run Challenges and Risks The fundamental risks to the countrys sustained development in the medium run lie with foreign trade factors. The common is the view that a possible downfall in prices for oil and other Russian exports would form the main source of instability in Russia. But the pre sent, extremely favorable, state of affairs on international markets forms a far greater dan ger, for high oil prices strengthen the populists positions and appetite for a greater budget expansion at the expense of oil dollars.

The sustainability of Russias economy demands for a conservative budget policy. It has become increasingly harder to advocate and pursue it when the country enjoys a co lossal positive surplus of its trade balance. The pressure on the part of proponents of budget expansion manifests itself in some softening of the budget policy on which the fi nancial agencies compromised in the 2005 budget. These measures include the increase of the projected oil price up to USD 28/barrel and comments on the readiness to spend a part of the Stabilization Fund on investment purposes.

The situation may turn yet more risky, once growth rate decelerate substantially, which cannot be excluded even under a favorable state of affairs in the foreign trade area, for the concerns of the political and legal situation in the country would hamper busi nesses investment and entrepreneurial activity. In the event growth rate begin to decline notably against the background of high oil prices, that would give an nearly immediate rise to the emergence of the populist policy and primarily a broad budget expansion. At that juncture, the eagerness to boast with good figures may form a dominating motive in the economic decision making process. That would mean the victory of short run red tape in terests over long term challenges facing the national economy. Such a scenario is not, of course, inevitable, but it cannot be ignored, for the political and intellectual elites last year have been increasingly displaying a clear inclination to the budget expansion policy.

As long as encouragement of entrepreneurial activity and, consequently, mainte nance of acceptable growth rates is concerned, the focus of attention should be put on prospects of development of the judicial and law enforcement systems. Once this particu lar system shows no signs of progress, this will form a main obstacle to businesses, both foreign and domestic ones. The latter would suffer at most, as they have no choice.

Finally, the predictability of the governments action is a fundamentally important is sue. The state should not scare or appall investors and entrepreneurs either in political area, or in the economic policy one. The first group of these fundamental problems envel ops the stability pf the constitutional system of which Mr. Putin made repetitious state ments in 2004, stable rules of the game and predictability of their modification. The other group implies the return to stable tax and regulative conditions, refusal of the currently emerging tendency to a manual regulation of large companies economic operations, securing the impossibility of employing the court of law and law enforcement agencies in competition.

Section 2. Monetary and budgetary spheres 2.1. Monetary Policy The RF Governments monetary policy drew more attention in 2004 than in the previ ous 3 to 4 years. This was basically caused by some developments that took place in the banking system in May and June, namely breaking the upper limit of seasonal movements in the consumer price index that was prevailing over the last few years, and breaking the upper limit of inflation set as a targeted value by the Central Bank and the RF Government.

At the same time, close association of inflation developments and monetary aggre gate movements normally breaks up under moderate and low inflation rates, as was clearly demonstrated by comparing their patterns in the previous year. In this case, cost push in flation (prices of raw materials) and structural changes in prices had more impact on the rate of price increases. Under such circumstances, however, the role the RF Central Bank came down to practically curb real growth of the RUR exchange rate (against the basket of currencies), create initial conditions for introduction of free RUR convertibility and monitor the situation in the banking sector, while the RF Government was entrusted with the task of controlling inflation.

In this context, the following issues are worth analyzing :

movements and factors of inflation developments ;

changes in the demand and supply in the money market ;

movements in nominal and real RUR exchange rate ;

banking system development.

We will consider these in details below.

2.1.1. Inflation Development At the beginning of 2004, monthly values of the CPI were less than the corresponding figures in 2003 (Fig. 1). The results obtained in the first half of the year allowed one to rely upon the forecast of consumer price growth in 2004 (from 8 to 10%). Since July, however, incremental growth of prices began to exceed the figures of 2003. Such movement was caused by a variety of factors, among which a rapid growth of prices of food products should be emphasized as compared to the previous year. In regard to the prices of non food products, prices of motor gasoline grew faster than those in 2003. Finally, in regard to paid services, prices of the services rendered to the general public by the passenger transport industry and preschool institutions grew faster than those in 2003.

Lets consider quarterly movements of the CPI.

Growth rates of consumer prices slowed down notably throughout the quarter 1 of 2004. In spite of the fact that in January prices of paid services for the general public were increasing at the rates comparable to those in January of the previous year, a more mod erate movement of prices of food products caused a general decline in the CPI from 2.4% (in January 2003) to 1.8% in January 2004. The figures in February were also positive enough, especially having regard to prices of paid services for the general public whose growth rates dropped by 2.5 percentage points. Growth rates (by 1 percentage point) of prices of paid services kept declining in March 2004, which resulted in that the CPI growth rates decreased down to 0.8%. At the same time, the fact that growth rates in prices of food products and non food products stopped to decline as was the case over the last few years, was a negative sign in March. Underlying inflation was 2.4% in the quarter 1.

Section 2.

Monetary and budgetary spheres 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% 2003 Fig.1. Producer Price Index Movement in Russian Federation in the Period Between 2003 and In the quarter 2, the fastest incremental price growth, 11% over the first half of (by 15.6% in 2003), continued in the category of paid services for the general public. In general, in the first half of the year, all groups of prices of paid services for the general public grew more moderately as compared to the previous year, except for the prices of services rendered by preschool institutions and cultural organizations. Food products came second by incremental growth rates of inflation with price movements coming up to the values of 2003 (8%) for the first time since the beginning of 2004. Total incremental growth in this group accounted for 6% (against 7.3% in the first half of 2003). Basic infla tion continued to slow down in the quarter 2 of the year. It accounted for 0.5% in June against 0.6% in May and 0.8% in April. Thus, unerlying inflation accounted for 1.9% in the quarter 2. Basic inflation dropped gradually as a result of monetary pressure on prices (see below). It should be noted that inflation rates were equal to the corresponding values of 2003 only in April and June. Taking into account that the CPI grew at a slower rates dur ing the rest of the months of the first half of the year than in the previous year, there were reasons to suggest that consumer prices would grow up within the expected limit of 10%.

However, from the beginning of July consumer prices began to grow at faster rates than in 2003. For example, in the period between July and September 2004 they increased by 1.7% (by 0.6% over the quarter 3 of 2003). The CPI in 2004 was beyond the corre sponding value in 2003 in each month of the quarter. By the end of the quarter, prices of food products grew up by 7.2% since the beginning of the year (against 6.1% in 2003). In the period between July and August 2004, seasonal decline in prices of fruits and vegeta bles went slower as compared to the previous year. As early as in August, when growth rates in prices of food products were positive as opposed to July, price growth since the beginning of the year exceeded the values of the two last years. Prices of non food prod ucts grew by 5.5% by the end of September (by 6.6% in 2003). Prices in all sub groups of non food products increased at more moderate rates in 2004 as compared to the previous years. Incremental growth of tariffs on paid services for the general public accounted for Jan Oct Feb Sep Dec July Mar Nov Aug May June April RUSSIAN ECONOMY in trends and outlooks 14.3% by the end of the quarter 3 (by 19.7% over the corresponding period of 2003). In this sub group, incremental growth of services of preschool organizations exceeded the corresponding figures of the previous year (by 6.9 percentage points). The reference in dex of consumer prices increased by 6.8% since the beginning of the year.

Thus, it is fair to say that according to the figures of the quarter 3, there was no tradi tional seasonal growth impairment of consumer prices in August thru September, let alone any decrease. In spite of a positive movements of monetary factors (incremental growth of the narrow monetary base accounted for 5.1% over 9 months in 2004 against 26.1% over 9 months in 2003) which encouraged restriction of underlying inflation, a record price rise of industrial products by industrial manufacturers as well as substantial price growth of motor gasoline and a series of vital food products imposed additional inflationary impact on the economy.

Rate of price increases stabilized at 1.1% monthly in the quarter 4 (in 2003, such in flation rate was recorded only in December, while the CPI equaled to 1% in October and November). Prices of food products grew up more rapidly (+4.7%). Prices of food prod ucts get up by 12.3% from the beginning of the year (against 10.2% in 2003). It should be noted that prices of red meat and poultry meat grew up dramatically: by 19.6% in 2004, while they didnt exceed 8.9% in 2003. Paid services for the general public came second in terms of growth rates which accounted for 3% in the quarter 4 of 2004 against 17.7% in 2004 (22.3% in 2003). Prices of passenger transportation services (+18% in 2004 against +13.7% in 2003) and services of preschool institutions (+21.6% in 2004 against 15.1% in 2003) grew at faster rates in this group as compared to 2003. Finally, prices of non food products grew by 1.8% in the period between October and December 2004, while in they grew up by a total of 7.4% (by 9.2% in 2003). Prices of motor gasoline dropped in De cember (by 1.7%). However, prices of motor gasoline grew by a total of 31.3% in (as compared to 16.8% in 2003).

Going to the analysis of factors which governed the growth in consumer prices in 2004, it should be noted that cost push inflation became the main cause that maintained fast growth rates of the CPI, i.e. price rice of manufacturers products, prices of final prod ucts grew at faster rates in the majority of industries in 2004 as opposed to the previous years (Fig. 2). In addition, it is seen from the Figure below that prices of products of food industry and light industry grew at extremely fast rates in 2003, which effected retail prices of the products of these industries in 2004.

In 2004, prices of the products of fuel industry and iron and steel industry (over 60% annually) grew at fastest rates, which is mostly associated with the price rise of corre sponding products in the world markets. Hence, one can say that the internal market of oil and ferrous metals in Russia has gradually been integrating into (due to transparency of such industries and a larger share of exported products) the world market, and fluctua tions of world prices also have an effect on the internal market. Consequently, high rates of price growth were also recorded in industries consuming the products manufactured by fuel industry and iron and steel industry, i.e. chemical industry, petrochemical industry and machine industry.

Section 2.

Monetary and budgetary spheres 70% 60% 2002 50% 40% 30% 20% 10% 0% Fig. 2. Incremental Growth of Prices of Manufacturers Products in Various Industries in the Period Between 2002 and Hence, according to the figures of 2004, the CPI in Russia accounted for 11.7%, which is slightly beyond the figure (12%) of the previous year. The underlying inflation was 10.5% in 2004 (11.2% in 2003). The industrial manufacturers price index reached 28.3% (13.1% in 2003). The latter creates preconditions for further growth or retarded decline of inflation in 2005 (for details on the inflation forecast for 2005 please refer to section Mac roeconomic Forecast for 2005 below).

2.1.2. Money Supply in the Economy In 2004, the gold and foreign exchange reserves of the Russian Federation were built up steadily. This was mainly caused by record breaking prices of basic Russian export goods, primarily oil. At the same time, incremental growth of the reserves was moderate enough until September when they grew substantially as a result of the USD exchange rate fall in the global financial markets, as well as stabilized situation in the Russian capital mar ket. By the end of the year, the gold and foreign exchange reserves reached $124.5 billion thus increasing by 61.9% (+$47,6 billion) during the year.

Such growth of the gold and foreign exchange reserves was apparently accom panied by printing of currency by the RF Central Bank in making transactions in the foreign exchange market. However, annual accumulation of the gold and foreign ex change reserves by the Bank of Russia and consequently monetary base growth was not steady (Fig.3).

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