Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017

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1 Draft as of The Central Bank of the Russian Federation (Bank of Russia) Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017

2 Approved by the Bank of Russia Board of Directors on 26 September 2014 The Central Bank of the Russian Federation, Moscow, 12 Neglinnaya St.

3 Contents Foreword by the Governor of the Bank of Russia... 3 I. Medium-term monetary policy objectives and goals... 6 II. Russia s economic development and monetary policy in II.1. Monetary policy implementation conditions and key measures...10 II.2. Use of monetary policy instruments...17 II.3. Exchange rate policy of the Bank of Russia...20 III. Macroeconomic development scenarios and monetary policy in IV. Monetary policy instruments in Glossary...34 Appendix...39 Statistical tables...39 Key macroeconomic indicators...41 Macroeconomic development scenarios...42

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5 Foreword by the Governor of the Bank of Russia Monetary policy of the Bank of Russia faces challenging issues on the back of current economic situation in Russia and recent developments in the Russian financial market. Geopolitical problems occurred amid the exhaustion of the traditional sources of economic growth started in the preceding years have become a serious challenge to Russia s economic policy in general and to monetary policy in particular. In the face of increased uncertainty the determination of clear guidelines for households and firms has become crucial for domestic longterm investment and economic growth. Sustainable output growth is impossible without increased labour productivity and technological modernisation. This, in turn, requires structural changes and inexpensive market funding for long-term investment to emerge. Lenders will be ready to provide long-term funding at moderate rates only in case they are sure that high inflation will not destroy their investment. Therefore maintaining low and stable inflation will become one of the key conditions for long-term money to arise. In this regard, in order to achieve the monetary policy objective of maintaining price stability stated in the Law, the Bank of Russia is going to complete the longstanding transition to the inflation targeting regime in 2015, as planned. Price stability implies achieving and maintaining steady and low rates of consumer price growth. Low inflation ensures maintaining the purchasing power of the national currency, i.e. that of wages and pensions, which is a necessary condition for raising the living standards of Russian citizens. Low inflation also creates a more predictable environment for long-term planning and economic decisionmaking. Stable prices allow households to increase their ruble savings. Savings in turn are a longterm source of investment. By ensuring growth in investment, price stability contributes to structural changes in the Russian economy in the long run. In recent years, some progress was achieved in reducing inflation, but it has accelerated significantly this year as a result of the influence of a number of unforeseen factors: worsening of the geopolitical situation that contributed to the depreciation of the ruble, imposing external trade restrictions and adverse markets conditions for certain food products. According to Bank of Russia estimates, inflation will exceed 7% by the end of the year, i.e. it will remain significantly higher than a 5% target. In this situation, it is important to continue pursuing the monetary policy aimed at slowing down consumer price growth. Our objective is to reduce inflation to 4% in the medium run. This is an ambitious goal. 3

6 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 However, we are not trying to achieve it as soon as possible and at any cost. We plan to reduce inflation to the target gradually, taking into account the potential of the Russian economy. According to our estimates, in case the imposed trade restrictions remain effective, as announced, for a period of one year, and in the absence of new negative factors, the decline in consumer price growth to 4% is possible in 2016, and with no significant slowdown of the economy. Considering the necessity of investment in order to support healthy economic growth, i.e. that is not combined with acceleration of inflation, along with the importance of borrowed funds, being the source of investment projects financing, for companies, the Bank of Russia uses non-standard tools of liquidity provision. This year loans with maturities of 3 and 12 months were supplemented with loans with maturity of one year and a half. In spring, the Bank of Russia established the tool to provide 3-year loans backed by bonds placed or loans extended in order to fund investment projects at the key rate less 1 percentage point. The Bank of Russia ensures the achievement of the inflation target primarily by affecting the price of money in the economy, i.e. interest rates. Through its operations with the banking sector, the Bank of Russia directly affects only the most short-term rates of the money market aiming to keep them close to the key rate. This impact should be sufficient for changes in the key rate to be reflected in the interest rates on bank loans and deposits that affect consumption, saving and investment decisions, and, therefore, economic activity and inflation. It is true that in Russia this mechanism is still underdeveloped. In recent years, we have been consistently improving operational framework in order to steer money market interest rates in a more efficient way. Our goal is to earn market participants confidence, to tie their expectations of interest rates dynamics to the key rate. Consequently, interest rate dynamics will become more dependent on monetary policy decisions and less subject to influence of other factors. This will strenghten the impact of Bank of Russia decisions on economy and will help the Bank of Russia achieve its goals more effectively. The Bank of Russia sets the key rate in such a way as to achieve the inflation target in the medium run. The rationale of this approach is the fact that the monetary policy affects the economy not immediately but gradually, i.e. with a lag. Therefore, when making a decision on the key rate, we rely on the forecast of economic development. Unforeseen factors may result in significant fluctuations in inflation and its deviations from the target. A symmetric range of these deviations is estimated by the Bank of Russia at 1.5 percentage points on each side. Since the monetary policy cannot affect current prices, the Bank of Russia s response to these unforeseen factors shall be determined based on an evaluation of their effect on prices in the medium run. The spreading influence of such factors on a wide range of prices, leading to higher inflation expectations and a threat of deviation from the inflation target in the medium run, is a reason for changing the key rate. An important step towards improving the efficiency of monetary policy influence on the economy will be the transition to a floating exchange rate regime. The floating exchange rate will allow the Bank of Russia to focus on steering interest rates and achieving the inflation target. At the same time the abandonment of interventions does not mean the absence of the Bank of Russia impact on the ruble exchange rate. By changing the key rate, the Bank of Russia also affects the exchange rate. In addition, the transition to the floating exchange rate does not mean that the Bank of Russia will cease monitoring the domestic foreign exchange market. In case of an emerging threat to financial stability, the Bank of Russia can buy or sell foreign currency to stabilise the situation. Another important condition for a sustained reduction in consumer price growth is to ensure lower inflation expectations. To do that, a high level of confidence in the policy conducted by the central bank is required. Credibility should be gained not only through the achievement of the goals set, but 4

7 Foreword by the Governor of the Bank of Russia also through understanding the pursued monetary policy. To this end, the Bank of Russia maintains active communication with the public. The specified features reflect the essence of inflation targeting regime. This monetary policy regime has been successfully used by many developed countries and emerging economies that have pursued it in the periods of high economic uncertainty. A clear understanding of the ultimate goal and flexible decision-making in response to a changing environment make inflation targeting a natural choice for a monetary policy regime in these difficult times. Foreign experience shows that the transition to inflation targeting not only helps reduce consumer price growth, but also fosters economic growth which is confirmed by numerous studies. By ensuring low and steady rates of consumer price growth under the inflation targeting regime, the Bank of Russia encourages long-term debt market development and creates favourable conditions for investment decisions. Thus, we contribute to conditions required for sustainable growth of the Russian economy. Elvira Nabiullina 5

8 I. Medium-term monetary policy objectives and goals The primary objective of the single state monetary policy is to ensure price stability which implies achieving and maintaining steady and low inflation. Price stability is required to raise and keep a high level of the living standards of Russian citizens, the latter being an ultimate objective of the state economic policy. Starting from 2015, the Bank of Russia will operate an inflation targeting regime. In view of this, the Bank of Russia has set the goal of reducing inflation to 4.0% in 2016 and subsequently maintaining it close to this rate. The permanent target of 4.0% has been set considering the specific features of the Russian economy and price dynamics in the countries that are Russia s trading partners. The target for 2015 is kept unchanged at 4.5%. According to baseline macroeconomic forecast of the Bank of Russia these targets can be achieved without posing significant risks for sustainable economic growth, even though considerably higher rates of growth in consumer prices are expected in late 2014 and early Taking into account a large share of highly volatile consumer price index components, the Bank of Russia has also specified a symmetric range of deviation from the target by 1.5 percentage points on each side. The range reflects the most likely range of inflation values owing to the impact of unforeseen factors. The inflation target is set for the consumer price index (CPI), which is measured relative to the corresponding period of the previous year. This indicator characterises a change in the prices of a basket of goods and services consumed by an average household and helps assess the magnitude of the impact of inflation on public welfare. The CPI is the most easily perceived inflation measure widely used by economic agents. Therefore, its dynamics considerably influence inflation expectations. The monetary policy affects inflation through interest rates. By conducting its monetary policy, the Bank of Russia exerts a direct impact only on the money market being the short-term segment of the financial market in order to limit its intervention in financial market pricing. The Bank of Russia uses a key rate as a benchmark for money market rates, which is set considering the prospects of achieving the inflation target and reflects the Bank of Russia s monetary policy stance. The Bank of Russia seeks to keep money market rates close to its key rate by setting the parameters of its operations. An abandonment of a regulated exchange rate of the ruble against foreign currencies is a necessary condition for the efficient steering of interest rates. By the end of 2014, the Bank of Russia will complete the transition to a floating exchange rate regime. In recent years, the Bank of Russia has been conducting foreign exchange interventions solely for the purpose of smoothing excessive exchange rate volatility without setting any fixed limits on the exchange rate level and 6

9 Medium-term monetary policy objectives and goals the range of its fluctuations. Under the new exchange rate policy regime, the Bank of Russia will abandon its domestic foreign exchange market operations designed to influence the exchange rate, except for the cases when it is necessary to maintain financial stability. In addition to contributing to more complete control over money market rates, the transition to the floating exchange rate regime will make the economy more resilient to external shocks and help it adapt to them through changes in the exchange rate. Money market rates affect other interest rates in the economy and asset prices, as well as exchange rate dynamics, which in turn determine economic agents consumption, saving and investment decisions and finally impact inflation. The monetary policy influences the economy through several channels. An inflation response to a change in the key rate depends on the channel and may vary from several months to two years. However, the greater part of the monetary policy effect on inflation manifests itself between twelve and eighteen months. Therefore, the Bank of Russia takes its monetary policy decisions on the basis of a medium-term macroeconomic forecast and risk assessment of achieving the inflation target. The Bank of Russia will continue improving its modelling tools and internal decision-making procedures to raise the quality of economic analysis and forecasting. Anticipated medium-term deviation from the inflation target lays the ground for changing the key rate, should this deviation be of steady and continuous nature. The Bank of Russia does not respond to the temporary acceleration or deceleration of inflation induced by nonmonetary factors, which are of shortterm nature or specific for some segments of the consumer market, if inflation is expected to return to the medium-term target. At the same time, the Bank of Russia focuses on the analysis of the impact of these factors on the prices for a wider range of goods and services, and inflation expectations. The emergence of temporary factors that pose risks for achieving the medium-term inflation target is a reason for changing the key rate. While implementing its monetary policy, the Bank of Russia seeks to smooth out fluctuations of economic activity and financial indicators relative to their fundamental levels, inasmuch as this does not prevent it from achieving the inflation target. Specifically, when inflation exceeds the target, the speed of its decline to the required pace will be determined considering the need to avoid the economy s excessive cooling down. On the contrary, if inflation is below the target, the speed of its increase is determined in such a way as to avoid excessive overheating of the economy. Thus, a cyclical slowdown ceteris paribus is a reason for loosing monetary policy, while a cyclical boost - for monetary policy tightening. Economic agents expectations about future inflation dynamics, as well as those about the further movement of short-term interest rates and other economic indicators have a substantial impact on inflation. Active communication allows the Bank of Russia to increase its influence on expectations and raise the efficiency of monetary policy measures. The regular announcement of objectives and measures taken by Bank of Russia, as well as its efforts to explain the nature of inflationary processes in Russia and monetary policy results to the public contribute to better understanding of Bank of Russia s monetary policy and help to raise confidence in its actions. In addition to price stability, the Bank of Russia also ensures stable functioning and development of the banking sector, financial market and payment system. This goal and the inflation target are equally important and considered to be complementary long-term objectives. Specifically, the Bank of Russia believes that the efficient and smooth operation of the financial system is required for implementing the state macroeconomic policy, including, 7

10 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 inter alia, monetary policy. In some cases, when both goals cannot be achieved simultaneously, decisions are taken as the case may be, based on the analysis of risks and the assessment of their long-term effects. Fostering cooperation with federal authorities in tariff administration, tax policy, the management of government accounts with the Bank of Russia and communication play an important role in monetary policy implementation by the Bank of Russia. At the same time, the successful implementation of the state economic policy will largely depend on the Russian Government s measures aimed at ensuring a balanced budget and carrying out consistent structural reforms which are necessary for sustainable economic growth in the long run. 8

11 II. Russia s economic development and monetary policy in 2014 In 2014, the Bank of Russia implemented its monetary policy under challenging circumstances. Events in Ukraine and the restrictions imposed by a number of countries on the Russian economy had a negative impact on the situation in the domestic financial market and in the banking and real sectors. Amid the increase in geopolitical tensions, large-scale capital outflow from the Russian financial market and worsening expectations of economic agents in relation to economic development prospects, investment demand fell, adding further to the structural slowdown in economic growth which started roughly two years ago. As a result, the position of the Russian economy in 2014 significantly deviated from the baseline scenario described in the Guidelines for the Single State Monetary Policy in 2014 and for 2015 and Thus, instead of the previously expected GDP growth to about 2% in 2014, the Bank of Russia is forecasting a slowdown in economic growth over this period to 0.4%. At the same time, due to the specific impact of external factors on the behaviour and expectations of economic agents, inflation risks have increased considerably. Foreign exchange rate dynamics (the gradual fall in the value of the Russian ruble from late 2013 to early 2014 on the back of changes to the policy of the US Federal Reserve System (Fed) and the drastic weakening of the ruble in March 2014 amid the growing geopolitical tensions) triggered the acceleration of consumer price growth and increase in inflation and depreciation expectations of economic agents. Annual inflation increased to 7.5% in July from 6.1% in January Restrictions imposed on the imports of a number of food products led to accelerated growth in consumer prices in August. Alongside the probable impact on inflation expectations caused by changes to tariff and tax policy which are currently under discussion, this could lead to continued high inflation until the end of Faced with these conditions, the Bank of Russia undertook certain decisive measures. The key rate was raised considerably to limit inflation risks. Together with the temporary tightening of the FX intervention mechanism, this allowed the Bank of Russia to stabilise situation in the FX market and avert any significant risks posed to financial stability. In addition, the observed growth in interest rates for banks ruble deposits contributed to a recovery in the inflow of funds to ruble deposits and a fall in the dollarisation of bank deposits. The moderately tight monetary policy pursued by the Bank of Russia is establishing necessary prerequisites for the stabilisation of exchange rate and inflation expectations, together with the normalisation of households propensity to save, and is geared towards achieving the mediumterm inflation target at 4%. 9

12 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 II.1. Monetary policy implementation conditions and key measures External economic conditions In January-August 2014, the smooth recovery of the global economy continued amid low, albeit steadily growing, inflationary pressure. At the same time, the situation was not uniform: GDP and inflation exhibited significantly different dynamics in various countries. In addition, in Q1 a number of negative factors (primarily, the unfavourable weather in the USA, market participants concerns about a possible debt crisis in China and measures taken by the country s authorities to contain the growth of debt burden and property prices) contributed to a significant drop in GDP growth rates in many countries. In Q2, economic growth in the USA and China picked up. However, the slowdown of the global economy in January- March was large enough, so that international organisations global economy growth forecasts were revised downwards for 2014 on the whole. In particular, the forecast published by the International Monetary Fund (IMF) for 2014 was reduced from 3.7% to 3.4%. Similarly, economic growth in the euro area continued to slow in Q2, and current business indicators do not suggest that it will accelerate in Q3. Despite steady growth in inflationary pressure in January-August 2014, inflation levels in Russia s trading partners remained low compared with average historical values due to weak economic activity. Annual inflation in OECD (Organisation for Economic Cooperation and Development) member states was 1.9% in July, slightly higher than at the start of the year (1.7%). Core inflation remained at 1.9%. However, overall price stability masked divergent trends in different countries. Inflation in the USA accelerated over the period under consideration, and in August reached 1.7% (year on year) compared with 1.5% the year before. In contrast, inflation in the euro area continued its downward trend, remaining at a level far below the European Central Bank (ECB) policy target. In August, annual consumer price growth was 0.4%, according to preliminary estimates (1.3% the year before). In this climate, the ECB reduced its policy rates twice over the period under consideration, on 11 June and 10 September, and introduced additional measures to tackle low inflation and address fragmentation. Financial conditions were easing for the majority of emerging markets in January-August Long-term interest rates and implied volatility indicators in developed economies dropped and stock market indices increased, surpassing historical highs. Against this backdrop, the capital flows to emerging markets renewed, despite the weak economic activity and the strengthening of national currencies against the US dollar from February. Accommodative stance of U.S. Fed monetary policy and additional actions of the ECB promoted low yields in international capital markets. Balance of payments In January-June 2014, the Russian Federation s balance of payments was shaped amid sharp growth in the private sector s net capital outflow compared with the same period in A significant amount of this capital outflow was offset in roughly equal shares by growth in Russia s current account surplus and fall in international reserves. Amid the on-going tension in the Middle East and steady growth in demand for oil as the global economy recovers, the average price of Urals crude in the first half of 2014 was $107.8 per barrel, 0.9% higher than in the same period the year before. Consistently high energy prices and the fall in the ruble exchange rate (the real effective exchange rate of the ruble in January- 10

13 Russia s economic development and monetary policy in 2014 June 2014 was 6.4% lower than in January- June 2013) contributed to growth in goods exports in January-June by 1.3% compared with the corresponding period in 2013, to $255.6 billion. In the second half of 2014, oil prices will have a moderating effect on commodity export dynamics. From June to August 2014, the average monthly price of Urals crude fell from $109.6 to $101.4 per barrel. At the same time, the contraction of the import of goods continued: compared with the first half of 2013, it decreased by 5.1% to $152.8 billion. Weakening business activity and the ruble depreciation had a restricting effect on imports. As a result, in January-June the trade surplus increased by 12.5% compared with the same period in 2013 to $102.8 billion. The current account surplus rose by 53.6% to $41.2 billion. The capital account deficit was $10.1 billion in the first half of 2014, reflecting the $10-billion North Korean debt written off in May for loans granted by the USSR. In July, Cuba s debt, totalling $32 billion, was also written off. The general government s foreign assets were reduced by the corresponding amount. In January-June 2014, compared with the same period the year before, the amount of balance of payments financial account operations dropped significantly, both in terms of attracting non-resident funds and in foreign investment. The Russian economy s net accepted liabilities declined to $2.2 billion in January-June 2014 from $105.3 billion in the first half of 2013 (due to a reduction in banking sector liabilities by $7.6 billion in Q2). The net acquisition of assets totalled $66.0 billion, falling by almost two times compared with the same period in 2013, with Q2 accounting for only $14.8 billion of this amount. As a result, the net outflow of private sector capital significantly accelerated to $71.7 billion ($33.5 billion in January-June ). The bulk of the capital outflow occurred in Q1, especially in March, the period of the greatest uncertainty connected with the situation in Ukraine. The figure for this month was almost $35 billion. The capital outflow was largely internal in nature; a substantial proportion of the outflow was caused by a surge in demand for foreign cash both from 1 Excluding the impact of FX swap operations with the Bank of Russia and the foreign currency account balances of credit institutions held with the Bank of Russia. 11

14 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 households and in the banking sector: in Q1 alone residents investments in foreign currency totalled about $20 billion. International reserves included in the balance of payments fell by $37.7 billion in January-June Taking into account the currency and market revaluations, as well as other changes, compared with the start of the year the Russian Federation s international reserves dropped by $31.3 billion to $478.3 billion as of 1 July Domestic conditions: economic growth and inflation In 2014, the Russian economy saw lower economic growth rates than those forecasted in the baseline scenario in the Guidelines for the Single State Monetary Policy in 2014 and for 2015 and 2016 (2%). In Q1 and Q2 2014, GDP growth rates were 0.9% and 0.8% respectively compared with the corresponding period the year before. The heightened uncertainty over the Russian economy s growth prospects led to a fall in investment demand alongside a significant increase in capital outflow from the domestic financial market. Fixed capital investment in January-August 2014 dropped compared with the corresponding period in 2013 by 2.5% (by 0.4% in January- August 2013). In the first half of 2014, the contribution of gross capital formation to GDP growth was negative, according to estimates. The contraction of investment demand decreased construction volumes (except residential construction) and suppressed output in manufacturing investment-oriented industries. At the same time, the impact of the fall in the ruble exchange rate from the end of 2013 to early 2014 and changes in the external economic climate on aggregate demand components varied. The growth in uncertainty and ruble depreciation led to a temporary fall in households propensity to organised savings and a rise in demand for durable goods, which supported an increase in the output of goods to satisfy consumer demand in March-May. Household demand for real estate also saw growth. Overall, household final consumption expenditure continued to be a main source of economic growth, however the growth rates of this expenditure dropped amid the slowdown in real incomes and retail lending. In January- August 2014, household consumer spending rose by 2.0% (5.4% in January-August 2013). The ruble depreciation led to an increase in the ruble profitability of exports and exports price competitiveness. The rise in prices for imported products and limited demand reduced import quantities, which, amid growing exports, ensured positive contribution to the Russian economic growth from net exports of goods and services. In the first half of 2014, GDP growth was mainly supported by an increase in gross value added in manufacturing, as well as in mediatory services sector (operations with real estate, financial services), while the contribution of construction, transport, and wholesale trade was small or negative. At the same time, in 2014, as during several previous years, structural factors continued to have a restraining effect on economic growth. The weakening of economic activity was accompanied by a long-term trend of reducing labour supply as a result of demographic factors. In August 2014, the unemployment rate reached its record lows: 4.8% (5.1% seasonally-adjusted). In the first half of the year, there were observed other signs of a growing labour force deficit (part-time employment fell and the number of hours worked per one employee increased) which, given the high production capacity utilisation, points to limited opportunities for non-inflationary growth without increasing labour productivity and modernisation of production. 12

15 Russia s economic development and monetary policy in 2014 According to estimates, this year GDP can increase by 0.4% (it grew by 1.3% in 2013). The slowdown in economic growth in the first half of 2014 was largely structural in nature. The negative output gap amid the low potential output level was comparatively small ( %). As a result, the downward pressure on inflation from aggregate demand was small, and consumer price growth rates remained at an increased level. These dynamics were shaped by a number of factors. The ruble depreciation caused accelerated growth in prices for a wide range of goods and services. However, it is important to understand the reasons underlying the ruble depreciation. To a large degree, it was due to external factors: the curtailment of the Fed s quantitative easing measures and growing uncertainty coupled by the geopolitical tension. Against this backdrop, the increase in the Bank of Russia s key rate contributed to the stabilisation of the FX market and a decrease in inflation expectations and inflationary pressure. Besides exchange rate dynamics, there were other temporary pro-inflationary factors observed in certain food markets. These included low crop yields for certain types of vegetables in 2013, the increase in global prices for certain types of food products and agricultural raw materials, and measures designed to protect Russian markets from inferior imported agricultural products. The annual growth rate of food prices reached 9.8% in June, compared with 6.5% in January. Consumer prices growth in June reached its highest value since the start of the year: 7.8% relative to the corresponding period the year before. In July 2014, annual inflation fell to 7.5%, which was largely caused by the fact that the planned increase of administered prices and tariffs for utility services was smaller than in There was a distinct slowdown in the growth of housing and utility services prices (their contribution to the year-on-year inflation dropped to 0.6 percentage points; in July 2013, it was 1 percentage point). However, in July 13

16 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 inflation decreased more slowly than had been forecasted, which called for a further increase in the Bank of Russia s key rate. In August, annual growth in consumer prices again accelerated to 7.6%, which was to some degree due to the import restrictions on a number of food goods. Amid accelerating price growth for certain food items included in the calculation of core inflation and price growth rates for non-food goods that remained at elevated levels, core inflation rose to 8.0% in August. According to estimates, by the end of 2014, inflation will exceed 7%. The Bank of Russia s monetary policy can ensure that it will reach the 4% target in the medium term despite the increase in inflation in the second half of 2014, as this change is linked to temporary factors. Financial conditions Interest rates In 2014, the Bank of Russia implemented its monetary policy by steering short-term money market rates: over the entire period overnight interbank lending rates were predominantly within the Bank of Russia interest rate corridor (the key rate ±1 percentage point). On the whole, money market rate dynamics were primarily shaped by changes in rates for Bank of Russia operations: after each increase in the Bank of Russia key rate (in March, April and July) there was a corresponding rise in money market rates. With the persisting structural liquidity deficit, money market rates in January- July 2014 were predominantly in the upper half of the Bank of Russia s interest rate corridor. In August-September 2014, the average level of overnight interbank lending rates was close 14

17 Russia s economic development and monetary policy in 2014 to the Bank of Russia key rate, which was conditioned by a change in the situation in the FX swap operations segment. The Bank of Russia s monetary policy decisions impacted government and corporate bond yields. Other factors also affected the situation in the bond market; these factors were primarily linked to the uncertainty of the external economic situation: the dynamics of crossborder capital flows, announcements about the introduction of sectoral sanctions against Russia, geopolitical risks, and revision of sovereign and corporate credit ratings. In 2014, growth in rates was also observed in the bank lending and deposit operations segment, linked both to the increase in the Bank of Russia key rate and restricted access and higher cost of foreign lending, as well as growing credit risks associated with a potential rise in overdue loans. As such, the change in rates for operations with various maturities differed. In July 2014, the long-term household deposit rate was 7.8% p.a., 41 basis points higher compared with December 2013; and short-term deposit rate was 6.2% p.a., remaining almost unchanged compared with the end of Lending rates in 2014 grew faster than deposit rates. In January-July 2014, rates for short-term loans to non-financial organisations increased by 132 basis points, and for longterm loans by 128 basis points (to 10.7% and 11.9% p.a. respectively). Bank lending Amid the fall in economic growth rates and the increase in the debt burden on borrowers, banks raised their requirements to the financial standing of borrowers and the quality of collateral. Coupled with the increase in interest rates and weakened demand for loans as a result of the downturn in economic growth, this caused a slowdown in the growth of banks loan portfolios. At the same time, tighter requirements to borrowers helped keep in check the impairment of loan portfolios. The share of overdue debt in total loans provided to non-financial organisations was 4.5% as of 1 September 2014 (compared with 4.2% at the start of the year). The corresponding indicator in the household lending segment rose from 4.4% to 5.6%. In 2014, the slowdown in consumer lending growth rates witnessed in previous years continued, due to the macro-prudential measures implemented by the Bank of Russia to contain growth in unsecured consumer lending and to the revaluation of household lending risks by banks. This slowdown was in part offset by accelerated growth in mortgage lending, but household lending growth mainly slowed to 18.2% as of 1 September 2014, which is 10.5 percentage points lower than the corresponding indicator at the start of In the non-financial organisation lending segment, Q1 saw a small increase in annual lending growth rates, but this was predominantly down to the expansion of lending to nonresident organisations and the revaluation of foreign currency loans. In Q2, the growth in lending to non-financial organisations slowed somewhat. Money supply and its sources Decrease in credit growth within the economy, which is the main source of money supply, led to a slowdown in the growth of 15

18 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 monetary aggregates. In addition to this, another contributing factor was change in the external sector balance, which was manifested as a reduction in the Bank of Russia s net foreign assets as a result of foreign exchange interventions in January-April 2014 not offset by growth in credit institutions net foreign assets. Moreover, in 2014, balances in budget accounts with the Bank of Russia grew faster than in the previous year, as a result of which net claims of banking system on the general government reduced. Consequently, on 1 August 2014, the annual growth rate of broad money (M2X aggregate) was 9.0% versus 15.7% on 1 January 2014 and 17.5% on 1 August The slowdown of money supply growth rates was accompanied by a change in its structure. Amid economic uncertainty and the nominal depreciation of the ruble at the start of 2014, one could observe an outflow of depositors funds from banks and deposits transfer from ruble into foreign currency. As a result, the dollarisation of household deposits, included in money supply, rose from 19.4% on 1 January 2014 to 23.8% on 1 April 2014, and the dollarisation of corporate deposits over the same period increased from 22.2% to 28.0%. From April, the inflow of depositors funds to Russian banks recovered, with the growth in funds in ruble deposits exceeding the growth in funds in foreign currency deposits, which contributed to a steady decline in the level of deposit dollarisation. Under these circumstances, the annual growth in the M2 aggregate fell from 14.6% on 1 January 2014 to 6.2% on 1 August 2014, dropping to its lowest value since Exchange rate In the period from January to July 2014, the ruble depreciated against major world currencies, and in some periods ruble exchange rate dynamics were affected both by factors common to all emerging market currencies and by specific factors linked to the growing geopolitical risks to Russia. In Q1 2014, the increasing uncertainty over developments in the situation in Ukraine and its effects for the Russian economy, the imposition of sanctions against Russia by a number of countries and the subsequent decrease in Russia s sovereign credit rating by Standard & Poor s led to the 16

19 Russia s economic development and monetary policy in 2014 ruble depreciation against the majority of world currencies. In Q2 2014, as the situation started to stabilise in the domestic FX market, the ruble strengthened its position, after which its exchange rate volatility remained moderate until the end of the period under consideration. On 1 August 2014, the value of the dual currency basket was rubles, up by 6.9% compared with the start of the year. In June 2014, the ruble nominal effective exchange rate against the currencies of Russia s main trading partners fell by 1% compared with December II.2. Use of monetary policy instruments The Bank of Russia implements its monetary policy by steering interest rates. At the same time, looking forward to limit its impact on market pricing mechanisms, the central bank exerts a direct influence only on the most shortterm segment: overnight money market rates. Other interest rates in the economy, including bank lending and deposit rates, bond yields and other financial market rates, are shaped by market mechanisms, however a change in money market rates can have a major impact on the dynamics of other rates. This ensures the transmission of monetary policy decisions on the economy as a whole. The process of implementing monetary policy consists of two stages. The first is setting money market rates consistent with inflation targets, based on macroeconomic forecasts. The Bank of Russia sets the key rate as a benchmark for money market rates. The second is establishment of a system of instruments and conduct of operations in a way that ensures money market rates being close to the key rate. The core of the Bank of Russia s system of instruments is the interest rate corridor, which limits the range of market rate fluctuations around the key rate. The bounds of this corridor are set by the interest rates on one-day standing facility liquidity provision and absorption operations. The key rate representing the centre of the corridor is the interest rate on the Bank of Russia s one-week auction-based operations. By providing or absorbing liquidity at auctions at a rate close to the key rate, the Bank of Russia strives to ensure that money market rates are 17

20 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 close to the centre of the interest rate corridor. The amount of auction-based operations is determined by the forecast of liquidity supply and demand. The key indicator of the Bank of Russia s monetary policy stance is the key rate level. The Bank of Russia does not loosen or tighten its policy by changing the volume of its operations. The choice of monetary policy instrument is based on the banking sector liquidity situation. In January-August 2014, the banking sector structural liquidity growth deficit continued. As expected, one of the key channels of liquidity drain during this period was an increase in general government account balances with the Bank of Russia, which was in part offset by an increase in Federal Treasury funds held in deposits with credit institutions, while an inflow of liquidity came from the withdrawal of cash from circulation. Amid the sharp depreciation of the Russian currency in March 2014, the Bank of Russia sold immense volumes of foreign currency in the domestic FX market within the existing exchange rate policy framework in order to support financial stability. In January- July 2014, the total volume of these operations reached 1.5 trillion rubles; they totalled 1 trillion rubles in March alone. Sudden growth in demand for refinancing in March, stipulated by these foreign exchange interventions, led to an increase in the credit institutions outstanding amount of refinancing operations by 1.1 trillion rubles. According to Bank of Russia estimates at the start of the year, this level was not expected until October By the start of September 2014, this debt had reached 5.2 trillion rubles. The increase in the amount of funds provided offset the outflow of liquidity through the foreign exchange channel and did not indicate a loosening of the Bank of Russia s monetary policy. These operations mainly changed the structure of the Bank of Russia s assets, bringing about a rise in the share of banking sector outstanding amount on refinancing operations and a decline in the share of foreign currency assets. The bulk of demand for refinancing was satisfied through one-week repo operations, supplemented by fine-tuning repo auctions if required. This instrument was introduced by the Bank of Russia in February 2014 at the same time as the daily one-day repo auctions were 18

21 Russia s economic development and monetary policy in 2014 abandoned. These operations are only employed in order to offset short-term substantial changes in banking sector liquidity, which means that they are irregular in nature. On average, over the period under consideration, credit institutions outstanding amount due to the Bank of Russia on repo auctions was 2.6 trillion rubles, with its maximum reaching 3.3 trillion rubles. Seeking to satisfy banking sector growing demand for refinancing operations in view of the limited marketable collateral, the Bank of Russia was forced to employ more extensively operations involving other types of assets. It increased the supply and the frequency of auctions to provide 3-month loans secured by non-marketable assets. As a result, on 1 September 2014, credit institutions outstanding amount on this type of operation reached 2.0 trillion rubles, which made it possible to keep outstanding amounts on repos at a level which allowed the Bank of Russia to steer money market rates. To reduce the effect of the growing volume of refinancing operations on the gap between the maturity of assets and liabilities in credit institutions balance sheets, in July 2014, as in the previous year, the Bank of Russia held a 12-month loan auction. In June 2014, the maximum term of standing facilities to provide funds (loans secured by non-marketable assets, guarantees or gold) was increased from 365 to 549 days. This measure will allow credit institutions, if necessary, to reduce the share of the Bank of Russia s short-term operations in their liabilities. The supply of funds at Bank of Russia auctions was sufficient to satisfy credit institutions demand for liquidity. This was confirmed by the low volume of fixed-term refinancing operations, mainly presented by FX swap operations. Amid the increase in banking sector demand for liquidity and the continuing problems with certain credit institutions collateral shortage, money market rates were mostly in the upper half of the Bank of Russia s interest rate corridor. On average, the spread between the money market rate (MIACR) and the Bank of Russia key rate was 0.55 percentage points over the period under consideration. Short periods where money market rates exceeded the bounds of the Bank of Russia interest rate corridor in certain months did not pose any significant risks to the 19

22 Guidelines for the Single State Monetary Policy in 2015 and for 2016 and 2017 transmission mechanism of monetary policy and were provoked by a short-term increase in demand for liquidity, in particular from certain credit institutions. To improve the Russian economy s access to long-term funding sources, in the first half of 2014, the Bank of Russia introduced a mechanism to refinance loans for investment projects 2 with terms up to 3 years. The collateral for this type of operation includes claims on loans for investment project financing selected in line with the procedure set out by the Government of the Russian Federation, as well as bonds which are placed to fund investment projects and which are included in the Bank of Russia Lombard List. From July 2014, the rate on these operations was set at the Bank of Russia key rate less 1 percentage point (7% p.a.). This programme is not included in the Bank of Russia s monetary policy instruments framework. The provision of funds to participant banks at an interest rate below the Bank of Russia key rate for longer terms than under standard instruments offers 2 Press release dated 25 April 2014 On Refinancing Investment Project Loans and dated 29 May 2014 On Supplementing Refinancing Mechanism for Investment Project Loans. additional incentives to finance investment projects, thereby fostering the development of this segment of the credit market. II.3. Exchange rate policy of the Bank of Russia In January-August 2014, the Bank of Russia continued its exchange rate policy within the managed floating exchange rate by not setting fixed limits on the ruble exchange rate or target values for its changes. As in 2013, the Bank of Russia used the ruble value of the dual currency basket as an operational benchmark (0.55 US dollars and 0.45 euros); the range of its permitted values was set by the floating operational band. The width of the band was 7 rubles until 18 August 2014; and on that day, the Bank of Russia symmetrically expanded the operational band to 9 rubles. The exchange rate policy mechanism allowed the Bank of Russia to buy and sell foreign currency, while the value of the dual currency basket remained within the operational band; this band had a designated neutral range where no foreign exchange interventions aimed 20

23 Russia s economic development and monetary policy in 2014 at smoothing out volatility in the ruble exchange rate were carried out. The operational band borders were automatically adjusted whenever the Bank of Russia s cumulative operations reached the required amount (for the purposes of which, the amount of target purchases and sales of foreign currency were not taken into account). With the prevalence of the ruble depreciating trends against the main global currencies, in 2014, the Bank of Russia carried out largescale foreign exchange interventions aimed at smoothing fluctuations in the ruble exchange rate. In January-July 2014, net sales of foreign currency by the Bank of Russia amounted to $40.9 billion, of which $11.3 billion were sold on 3 March 2014, when there was a sharp increase in demand for foreign currency. As a result, during the period under review, the lower and upper borders of the operational band were adjusted by more than 3 rubles to and rubles respectively. The restrictions enforced by certain countries on access to foreign financial markets for a number of Russian organisations were an additional factor in the increased tension in the domestic FX market and contributed to deterioration in the banking sector s ability to manage short-term foreign exchange liquidity. To mitigate these negative effects, from 17 September 2014, the Bank of Russia introduced USD/RUB buy/sell FX swaps. This new instrument enabled the Bank of Russia to conclude overnight FX swap deals with today/ tomorrow and tomorrow/day-after-tomorrow settlements in the corresponding trading segment at the Moscow Exchange. Taking into account the auxiliary nature of these operations, the Bank of Russia limited the volume of deals with today/tomorrow and tomorrow/dayafter-tomorrow settlements to 1 and 2 billion US dollars respectively. The interest rates on these operations were fixed at 7.00% p.a. for the ruble leg and at 1.50% p.a. for the foreign currency leg. The supply of foreign currency by the Bank of Russia is temporary and is aimed at reducing the risk of disturbing the stable functioning of the domestic financial market. In the period from 20 February to 20 June 2014, the Bank of Russia also adjusted the volume of operations in the domestic FX market in connection with the transfer of foreign 21

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