06.09.23 Review

Recovery Bubble: Budget and credit activities are pushing the economy beyond its potential


The growth of the Russian economy in the first half of 2023 has been attributed to an infusion of budgetary and credit measures the scale of which does not correspond to its inherent potential and objective capabilities, according to experts from the Central Bank. This development has triggered an acceleration in consumer prices, overheating of the economy, and, in part, the devaluation of the ruble, leading the Central Bank to respond by raising the key interest rate to a prohibitive level. As a consequence, analysts effectively argue that the government has departed from the principles of conservative fiscal and credit policies, and the reaction of economic authorities to these consequences has been inadequate. Instead of limiting fiscal stimulus, the Kremlin demanded a sharp interest rate rise from the Central Bank, shifting the costs of overheating onto private economic agents—commercial credit has now become virtually inaccessible. Therefore, it is expected that there will be a sharp slowdown in growth in the near future, which will continue until the economy returns to its natural trajectory.

Analysing the dynamics of the economy in the September issue of the 'What the trends say' bulletin, the experts from the Central Bank begin by noting that, in August, the Russian economy grew again after a two-month pause (as recently reported by Re:Russia). However, when evaluating the quality of the economic boom in the first half of the year, they conclude: 'Increased demand in the economy, driven by budgetary measures in some sectors, has partially replaced lost export demand (e.g., in metallurgy) and, in other sectors, has led to an excess of production capacity, taking into account logistical constraints (e.g., in engineering). Together with the high credit impulse, this factor has led to GDP exceeding its new potential level. This answers the question of why, despite the overall recovery of GDP only reaching the pre-crisis level, the existing demand in the economy has surpassed the supply of goods and services, creating significant inflationary pressure.' In other words, the budgetary and credit stimulus has provided an artificial boost to growth, which has encountered 'constraints from the labour market, production capacity, and technologies.' Additionally, the authors note, 'a part of GDP, unrelated to the production of goods and services satisfying final consumer or investment demand, has increased.' This refers to military production, which impacts economic dynamics, stimulates employment and wage growth, but does not generate a mass of goods that the economy and citizens can consume. This further exacerbates the imbalance between demand and supply, affecting other indicators such as employment or income dynamics.

In the foreseeable future, it appears that the Russian economy is poised to enter a phase of deceleration, if not outright stagnation, with growth expected to slow significantly. According to preliminary estimates from Rosstat, as cited in the Central Bank’s bulletin, GDP dynamics in the second quarter indicate a deceleration in quarterly growth from 0.7% to 0.1%. The results of business sentiment surveys further support the notion that the peak of economic recovery has likely passed.

The main driver of production growth in the second quarter and the beginning of the third quarter remained the manufacturing sector, 'in the context of consistent expansion in demand from both the public and private sectors,' the Central Bank experts note. At the same time, public sector demand was largely associated with the needs of the military-industrial complex. A breakdown of growth in manufacturing vividly illustrates the disparity in growth rates between 'heavy' investment sectors (where defence industries are concentrated), intermediate industries, and consumer production. Sustained growth in manufacturing is hindered by maximum capacity utilisation and an intensifying labour shortage.

Output of manufacturing industry groups, 2017-2023, SA, 100% = January 2016

The overheating of the economy has resulted in high inflation. The inability of domestic production to meet demand has led to an increase in imports, which, in turn, has put pressure on the ruble and contributed to rising prices. The experts from the Central Bank highlight that, in July, the monthly price growth sharply accelerated to 12.2%, compared to 5.6% in June. Annual inflation rose from 3.25% to 4.3%, surpassing the 4% target. In August, according to preliminary data, annual inflation exceeded 5% 'against a background of continued price increases at higher rates and the exit from the base of low rates of price growth in the summer of 2022.' Additionally, robust demand has driven imports, and the deterioration of the current account balance has contributed to the weakening of the ruble, which, now compounded by the transfer of the exchange rate to prices, is creating additional inflationary risks.

'The problem of overheating can only be resolved by returning the economy to a path of sustainable and balanced economic growth,' the Deputy Chairman of the Central Bank Andrey Zabotkin warned in early June. One way to achieve such a return would be to reduce budgetary injections and restrain credit (some of the responsibility for which also lies with the budget, such as preferential mortgages). However, the regulator cannot influence budgetary constraints. Moreover, during a heated debate with the Central Bank in the first half of August, the government and the Kremlin shifted the responsibility for the situation onto the Central Bank, forcing it to sharply raise interest rates.

In other words, the government has deviated from the principles of conservative fiscal and credit policies and then shifted the costs of the resulting economic overheating onto the private sector. The increase in the key interest rate from 8.5% to 12% is, in essence, prohibitive and deprives the private sector of access to commercial credit. In effect, budgetary funds become the only investment resource at such a rate. It is worth noting that around the time when the debate between the Central Bank and the Kremlin was unfolding regarding the potential methods to cool down the economy, the resignation of Ksenia Yudaeva, Deputy Chair of the Central Bank, who was responsible for the expert and analytical justification of the Central Bank's decision to raise the key rate, became known. The analysis presented in the September edition of the Central Bank's bulletin clearly indicates that the regulator's decision regarding the interest rate lacks such justification.