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Section 2. Monetary and Budgetary Spheres 2.1. Monetary and Credit Policy The major development in the Russian monetary and credit policy in the year of 2006 was an explicit inflation slowdown, which has reached its historical peak;

for the first time in the RF history consumer price index did not exceed 10 per cent.

Though that indicator is conventional, a decrease of that indicator to the level lower than 10 per cent is considered worldwide as a major event and an explicit factor of successful monetary and credit policy of the government. One should note, that at the beginning of the year nobody could forecast such a result, only at the second half of the year the inflation has slowed down and made 9 per cent as of December January results. Herewith, we'll try to analyze the grounds of those developments, review the trends and interrelations in the national monetary market, the inflation processes in general and outline major developments in the RF monetary and credit sphere in the year of 2006.

2.1.1. Monetary Market In 2006 a considerable growth of gold and foreign currency reserves was ob served in the RF (See Fig. 1). The basic factors of growth were the peak prices for the major Russian export commodities, primarily oil prices. Reduction of reserves (as per results of the month) was noticed only in August and was caused by pre scheduled repayment of the external government debt to the Paris Club of credi tors in the amount exceeding USD 23 bln. By the end of the year the volume of gold and foreign currency reserves has reached an absolute record in the history of Russia, USD 303.7 bln (+66.7 per cent within 2006).

3000 2500 2000 Monetary base in narrow definition (bln rubles) Hard currency reserves (bln dollars) Source: RF Central Bank Fig. 1. Changes in Monetary Base and Gold and Foreign Currency Reserves in Years 2005Цbln rubles bln dollars 2-8.06.30.12.065-12.01.4-10.08.6-12.10.8-15.12.24-30.11.15-21.12.17-23.02.10-16.03.21-27.04.12-18.05.23-29.06.14-20.07.25-31.08.15-21.09.17-23.11.27.01-2.02.31.03-6.04.27.10-2.11.Section Monetary and budgetary spheres However, in order to restrain the accelerated stabilization of exchange rate of the national currency, the Bank of Russia was compelled to buy the foreign cur rency flowing into the country, thereby increasing money supply. Let us take a closer look at the money supply dynamics.

In 2006 the monetary base (in a broad sense1) increased by RUR 1.2 bln and reached RUR 4.1 bln (+41.4 per cent). It should be reminded, that as of results of the year of 2005, that indicator has grown only by 22.4 per cent. The monetary base volume in broad definition as of 1 January 2006 was RUR 2.9 trillion (See Ta ble 1). The cash in circulation volume, including the cash balances of credit institu tions, as of January 1, 2007 was RUR 3.06 trillion (+39.5 per cent as compared with January1, 2006), the correspondent accounts of credit institutions with the Bank of Russia made RUR 638.1 bln (+25.5 per cent), mandatory reserves - RUR 221.1 bln (+ 37 per cent), credit organizationsТ deposits with the Bank of Russia - RUR 98.bln (times 12.6), the value of the Bank of RussiaТs bonds held by credit institu tions - RUR 102.2 bln (growth 2.1 fold), the reserve funds under foreign currency operations, deposited with the RF Central Bank made RUR 0 bln2 (reduced for RUR 8.8 bln). In 2006 the growth of cash in circulation (by 39.5 per cent at the back ground of increased mandatory reserves (by 37 per cent) have resulted in exten sion of the monetary base in narrow definition (cash + mandatory reserves)3 by 38.9 per cent (See Fig.1). At the same time, the gold and foreign currency reserves of the RF Central Bank also grew within a year by 66.7 per cent and amounted, as of January 1, 2007 to USD 303.7 bln. A greater portion of the national liquidity in flow was accumulated in the RF Stabilization Fund, which volume as of January 1, 2007 amounted to RUR 1,237 bln. (USD 42.3 bln, 5.7 per cent of GDP).

Monetary supply M2 in national terms has grown in 2006 by 48.8 per cent and made as of January 1, 2007 RUR 8,995.8 bln, or 33.8 per cent of GDP (as of Janu ary1, 2006 the monetary indicator М2 was equal to RUR 6,045.6 bln (28 per cent of GDP).

Monetary base in broad definition reflects the Bank of Russia monetary and credit liabilities in na tional currency, which serve as a basis of money supply growth. The RF monetary base in a broad definition, in addition to the cash in circulation issued by the Bank of Russia, and the residuals on the accounts of mandatory reserves of the funds in the national currency attracted by credit institutions and deposited with the Bank of Russia, includes the funds in corresponding accounts with credit institutions and bank deposits, placed with the Bank of Russia, reserve funds for foreign currency operations, as well as other ;liabilities of the Bank of Russia under operations with credit organiza tions in national currency of the Russian Federation.

Starting as of July1, 2006, the requirements for mandatory reserves and usage of special accounts for transactions with foreign currency were abolished.

Monetary base in a narrow definition is a monetary instrument (an indicator of monetary supply volume), which is fully controlled by the RF Central Bank. The Monetary base in narrow definition includes the cash in circulation, issued by the Bank of Russia (and the balance on the accounts of credit organizations), balances on the accounts of mandatory reserves of the funds in the national currency attracted by credit institutions in national currency, deposited with the Bank of Russia.

RUSSIAN ECONOMY IN trends and outlooks Table Changes in Monetary Base in Broad Definition in 2006 (RUR bln) 01.01.2006 01.04.2006 01.07.2006 01.10.2006 01.01.Monetary base (in broad defini 2 914,10 2 721,00 3 285,90 3 484,20 4 121,tion) including:

Cash in circulation with regard to 2 195,40 2 061,20 2 386,60 2 565,40 3 062,balances in credit organizations Correspondence accounts of credit organizations of the Bank 508,6 320 430,9 443,7 638,of Russia Mandatory reserves 161,4 172,1 190,2 205,8 221,Deposits of credit organizations in 7,2 44,2 108 109,6 98,the Bank of Russia Securities of the Bank of Russia in 32,8 115,2 164,2 159,6 102,credit organizations Reserve funds in foreign cur rency, deposited with the Bank of 8,8 8,3 6,1 0,1 Russia Source: RF Central Bank Therefore, as of results of the year of 2006, a more expressed growth of monetary supply was observed as compared with 2005. At the same time, in the year of 2006 active liquidity sterilization was occurring in regard to foreign currency in Stabilization Fund, which volume as of the end of the year has exceeded the amount of USD 89 bln. It should be noted, that there were some changes in the structure of monetary base growth in broad definition within the year of 2006. Thus, as of the year results, the rate of growth of cash in circulation was lower than the growth rates of monetary base in general, whereas in 2005 the rate of growth of cash in circulation was higher by 40 per cent than the growth rate of monetary base. Therefore, the above mentioned positive trend reflected a lower role of cash in the national economy. Moreover, the amount of deposits in the RF Central Bank has been considerably increased due to the raised interest rates on the Bank of Russia deposit operations. In the preceding year the RF Central Bank has been raising the interest rate four times (with the aim to increase the role of deposit op erations in monetary and credit policy). At the same time, to increase liquidity ster ilization, the Bank of Russia was actively offering its securities for sale.

To assess the success of efforts taken by monetary and financial institutions with the aim to increase liquidity sterilization, an analysis is made of correlation be tween money demand and supply4. The dynamics of demand for money demand and supply is shown in Fig.2.

Mt We assess the demand for money equation of the type = a0 + a1Yt + a2pt + a3t + t, GDPt where Mt - money supply М2, GDPt - nominal GDP, value, t Y - GDP volume in prices of 1995, рt - consumer price index, t - time. The assessment was based on the quarterly data of the years 1999 - 2006 with no regard to seasonal data. The resulting residual values can be interpreted as excess of money supply, as the left par of equation shows the actual money supply and with the help of indica tors of the right part the demand for money can be estimated.

Section Monetary and budgetary spheres Source: RF Central Bank, IET estimates Fig. 2. Dynamics of Demand for Money and Money Supply (Money Aggregate M2) in Q III One can note, that within 2006 money supply was exceeding the demand for money, which can cause excessive inflation pressure in 2007, caused by a delayed impact of changes in the money supply over the inflation processes. In our esti mates, the lag of the monetary supply changes impact over consumer price index is one two calendar quarters5.

It should be also noted, that despite the increased monetary supply, the money multiplier in the RF remains at a low level as compared with the countries of Eastern Europe, where, as a rule, its index value considerably exceeds 3. Against this background, the index value of 2.9, achieved by late 2006, appears very insig nificant (See Fig. 3). Since mid 2002, the multiplier is characterized by an upgrad ing trend, reflecting the gradual development of the RF banking sphere. Till mid 2004 the multiplierТ value was varying within the range of 2.15 - 2.45.

Therefore, basing on the obtained results of the estimates, the increased money supply, caused by the extensive purchases of foreign currency by the RF Central Bank, was exceeding the demand for money in 2006.Under those condi tions, there is a high probability, that further slow down of the inflation rate will be rather difficult. Let us review the inflation processes in more detail and try to detect non monetary inflation factors in the RF.

Ref: УSome Approaches to Economic IndicatorsТ Estimates", published by IET, the CPI N 89P, М.:

IET, 2005.

RUSSIAN ECONOMY IN trends and outlooks Source: RF Central Bank, IET estimates.

Fig. 3. Money Multiplier in the RF in 1999Ц2.1.2. Inflation Processes Early 2006 saw dramatic acceleration in the rate of inflation (Fig. 4). As a re sult, there were serious doubts that by the results of the year the consumer price index in 2006 will not exceed the target value of 8.5 per cent. However, later a slow down of inflation took place and the target value was upgraded to 9 per cent. As of the year results, CPI made 9 per cent. It should be noted that for the first time in the RF newest history the rates of consumer prices growth was restrained at the level less than 10 per cent. We are going to take a closer look at the dynamics of inflation rates throughout the year.

In the category of foodstuff prices have grown by 8.7 per cent (as compared with 9.6 per cent in 2005) (See Table 2). Throughout the year, from January to De cember, the upward trend in the foodstuff price growth was caused by increased prices for granulated sugar (+14.9 per cent), grits and beans (+12.1 per cent), bread and bakery products (+ 11.1 per cent), vegetables and fruit (+10.3 per cent) and alcohol (+10.1 per cent). Within twelve months of 2006 the highest growth was traditionally observed in the category of commercial services (by 13.9 per cent, versus 21 per cent in 2005); thus, in pre school education (+28.5 per cent), as well as by housing utilities (+17.9 per cent). As concerns non food products, their prices went up within twelve months by 6 per cent on average (versus 4 per cent within twelve months of 2005). Within January December the utmost growth of prices took place in construction materials (+11.5 per cent) and motor petrol (+10.9 per cent). The basic CPI growth for consumer goods in general made in 2006 7.8 per cent (as compared with 8.3 per cent in the relevant period of preced Section Monetary and budgetary spheres ing year). Therefore, as of 2006 year results, the basic reasons of the expressed inflation were the accelerated growth of prices for commercial public services, construction materials, motor petrol and a number of foodstuffs.

Source: Rosstat.

Fig.4. Dynamics of CPI in RF in 2004ЦThe data of Table 2 shows, that one of basic factors of inflation throughout 2003Ц2006 was the growth of housing utilities tariffs, which have grown practically 1.5 fold within January 2003 - December 2006. Pre school education takes the second place in terms of input in the accelerated inflation, the cost of their services went up by 137.6 per cent; they are followed by culture services (+98.7 per cent) and public transportation (+77.4 per cent). An accelerated upward trend was ob served in the prices for motor petrol (+96.9 per cent), meat and poultry (+63.6 per cent), bread and bakery products (+74.1 per cent).

An analysis and dynamics of prices and tariffs for services of natural re sources monopolies (electricity, gas, cargo transportation) in 2002Ц2006 demon strates that within the period under review the highest growth rates were noticed in prices for gas and cargo transportation. As opposed to that, electricity tariffs have only slightly exceeded the growth rate of CPI.

It should be reminded, that in 2007 the RF Central Bank is planning to reduce the inflation to the level of 8 per cent. This target looks quite realistic, what is con firmed by the results of IET model forecast for 2007, where the CPI index is as sessed at 8Ц8.5 per cent.

RUSSIAN ECONOMY IN trends and outlooks Table Yearly Price Growth Rates as per Types of Goods and Services in 2003Ц2006 (% per year) 2003 2004 2005 2006 2003ЦCPI 12,0 11,7 10,9 9,0 51,Foodstuffs 10,2 12,3 9,6 8,7 47,Bread and bakery products 30,4 16,7 3,0 11,1 74,Grits and beans 17,0 11,6 0,2 12,1 46,Pasta products 14,0 14,6 1,9 4,7 39,Milk and dairy products 13,1 12,8 10,5 8,7 53,Meat and poultry 8,9 19,6 18,6 5,9 63,Fish and sea food 9,9 11,5 12,7 7,8 48,Non food products 9,2 7,4 6,4 6,0 32,Motor petrol 16,8 31,3 15,8 10,9 96,Commercial services to population 22,3 17,7 21,0 13,9 98,Housing utilities 28,7 23,5 32,7 17,9 148,Public transportation 13,7 18,0 15,8 14,2 77,Culture organizations services 21,8 19,9 17,7 15,6 98,Pre school education 15,1 21,6 32,1 28,5 137,Source: Rosstat.

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