ED: This article is from the series DATACRUNCH that digs into details of macroeconomic and sectorial trends. It draws on bne IntelliNews’ premium PRO news service and bne IntelliNews’ monthly country reports (see a sample here). If you are interested in these trends then sign up for a trial to PRO here.  If you would like to see this month’s Russia country report or would like more information then email sales@intellinews.com.

 

Since the collapse of the Soviet Union inflation been falling and has dropped to post-Soviet lows in the last two years. Now it’s back. The double whammy of a global pandemic and the oil price shock saw economic growth collapse and currencies across the region devalued. Now the crisis is receding inflation is surging. But what exactly is causing prices to rise and will it get worse?  

The good news is that economists say inflationary pressures probably peaked in April and they should start to fall once spring arrives. The bad news is higher inflation will probably persist for the rest of this year and into 2022. But just how fast the recovery will be will vary widely depending on how competitive each market is or how exposed a country is to things like commodity and agricultural production.  

Food: Rising food prices is one of the main drivers of inflation and is having a bigger impact than anything else. Grain is the most important of the food categories, as in addition to producing key products such as bread and pasta, the price of grain also affects the price of meat, as pigs and chickens are fed on grain. Firming grain prices sends those of a whole class of agricultural goods up.  

The rise in grain prices has been made worse after Russia introduced restrictions on the export of grain to try to keep its own prices of grain, bread and flour down at home. As Turkey and Egypt have been buying more grain than usual, removing substantial amount of Russian grain from the international market has only made inflation worse for everyone else.  

Food imports: Food price rises spread quickly to other countries thanks to trade. The upshot is the local prices for food are increasingly tied to the international price. A devaluation of the local currency leads almost immediately to rising food prices.  

Sugar can be made cheaply in Ukraine, but after devaluation the profits producers make in dollar terms fall. As they can export it and make more money they raise domestic prices to international levels to keep both their market share and their profits at the same level. As a result, sugar prices last year soared 75% in some countries and this applies to whole range of food products. The situation was made worse last year after China had to slaughter most of its pigs.  

“China has had several bouts of African swine fever and they have had to kill most of their own pigs. Chinese demand for pork has gone shooting up and that spills over in the close substitute meats like poultry and beef,” says Ikka Korhonen, the head of Bank of Finland Institute for Economies in Transition (BOFIT). “Food inflation is very contagious, as it's an international business these days.”  

Devaluation: The currencies of the big commodity exporters in the region – Russia, Kazakhstan and Azerbaijan – were obvious hurt by the collapse of oil prices last year, which fell below $25 to the barrel in April, dragging their currencies down with the tumbling prices.  

But it can take up to six months for the effect of a devaluation to make itself felt. If a department store has imported a lot of Italian shoes then it has to put up the prices if it wants to get enough money to buy some more. However, this happens slowly, because if it puts prices up faster than its competitors it will lose market share. As the shoes are already paid for and it has several months of inventory, shopkeepers will put prices up slowly and may even try and win new customers by increasing prices more slowly than their rivals, but sacrifice some of their profit margin in the hope of selling bigger volumes of shoes.  

The more competitive the market, the slower the price rises are, and in a market where there is only one shoe store the owner is free to pass the increased costs on to the consumer immediately.  

Contagion: The EBRD describes Russia as a “node” country in Eastern Europe and Kazakhstan and Azerbaijan play a similar role in Central Asia and the Caucasus respectively.  

If the ruble, tenge or manat collapses then that quickly affects the currencies of the surrounding countries after the raw material exporters cut imports and send migrant workers home.  

Trade is the most important conduit for contagion. When a crisis hits most economies immediately stop buying the most expensive imports. That reduces revenues for the trade partners and their currencies weaken as a result.  

Remittances is another contagion channel. The money migrant workers send back home runs into billions of dollars a year. Over half of Tajikistan’s GDP and a significant portion of Albania’s income is in the form of remittances. A quarter of Ukraine’s workforce is now in Poland and slightly more is in Russia, sending home over $10bn a year, or just under 10% of GDP, although in Ukraine remittances have held up remarkably well in the last year. 

The pandemic hit remittances with a double whammy too, as travel restrictions made it impossible to leave home and at the same time the wages in the host country were worth less in dollar terms (remittances are almost always sent home as dollars), so many decided not to leave at all. On top of all this the slowing economies also meant a lot of migrants were sacked, so there were fewer jobs.  

Finally, during crises most companies suspend their investment plans, which also means less foreign direct investment (FDI) coming into the country, but in most of the CEE this is less of a problem than trade and remittances.  

Central banks are fairly powerless to fight this kind of inflation. Classically prices go up when too much cash in circulation is chasing too few goods. Central banks then increase interest rates to encourage people to save more or companies to borrow less, thus removing cash from circulation and consequently prices come down.  

However, increasing interest rates has no effect on grain shortages, the cost of cabbage or the amount of money in a Tajik labourer earns in Moscow, and so it can only affect inflation at the margins.  

Several governments have tried to impose administrative restrictions to control prices, but these don't really work and only introduce distortions into the market that rapidly become very complicated to police. Really the only thing governments can do is help the most vulnerable with targeted social support programmes and wait for the economy to rebalance. And it will: as prices rise producers are encouraged to expand production to meet the increased supply. In several countries in the region manufacturing and industrial production is already growing fast and Russian corporates made more profit in March than at any time in the last five years.  

The World Bank forecasts a strong rebound this year and 6% global growth as countries begin to recover. But just how fast each individual country recovers will depend a lot on the details of that economy.  

The three countries of Eastern Europe have very similar stories, as their economies remained closely linked. Both Russia and Ukraine had crushed inflation almost completely in 2019, bringing the rates down to post-Soviet record lows in at about 2% – on a par with a Western developed market.  

The coronavirus (COVID-19) epidemic has been a tragedy for both countries that had solved their main macroeconomic problems and could have reasonably looked forward to half a decade of growth and prosperity, but from about January inflation began to surge.

The National Bank of Ukraine (NBU) went first and hiked rates in March (50bp) and then again in April (100bp). The Central Bank of Russia (CBR) was only a few weeks behind and did the same with hikes in March (25bp) and April (50bp). As the charts show, the NBU’s more dramatic decisions are a result of its bigger problem.

Russia's inflation is thought to have peaked in March or April, but the expectation of higher inflation amongst the population is at a four-year high. Russians think that inflation is going to go to at least 11% this year – twice the current level – despite the fact that it is probably falling. CBR governor Elvira Nabiullina is afraid that if expectations become unanchored from reality (and the population is always more pessimistic than the CBR, and almost always wrong) then inflation becomes a self-fulfilling prophecy. This is probably the main reason she chose to hike earlier and harder than the analysts were expecting.

The decisive action of both the CBR and the NBU seems to be paying dividends already, as both countries saw inflation fall slightly between March and April: from 5.8% to 5.5% in Russia's case, and 8.5% to 8.4% in Ukraine's. However, ING said in a comment for bne IntelliNews that while the reduction in Russia was welcome, inflation is not anticipated fall much further, and both central banks are expected to tighten monetary policy further this year. 

The National Bank of the Republic of Belarus (NBRB) cancelled its March rate setting meeting entirely and has been ignoring the problem, but hiked rates in April by a big 75bp to 8.5%. With inflation already over 8% in the midst of the worst political crisis in two decades the outlook is poor. Inflation is currently running above the central bank’s target rate of 5%. As of March 2021, the increase in consumer prices recorded 8.5% in annual terms. The NBRB worries that the impact of food price shocks, and also the consequences of the pandemic in terms of higher costs of imported non-food products, may be more significant on inflation in Belarus.

In Central Asia, Kazakhstan has been one of the winners, as it has managed to contain inflation quickly, although it remains a little on the high side. Inflation was 5.6% at the start of 2020 and peaked at 7.5% in December. Firm action by the National Bank of Kazakhstan (NBK) has brought the rate down quickly but it remained at a still elevated 7% in March. After holding the key rate at 9% at its April meeting, the central bank took a neutral line, but with hawkish notes.

Uzbekistan’s Central Bank earlier this month said it was keeping its main rate unchanged at 14%. The decision was made “to ensure a balance between reducing inflation and supporting economic activity in the context of economic recovery, as well as maintaining the slowing dynamics of inflation and inflation expectations against the background of risks of rising food prices in foreign markets”. Inflation by year-end in the most populous country of the region is expected to slow to 9.0-10.0%. In April of this year annual inflation stood at 10.7%, but at its April meeting the central bank kept its key rate at 14%, hoping seasonal disinflation in the summer would be enough to keep prices in check. 

Kyrgyzstan has been one of the big losers, with inflation having surged 10 whole percentage points, and is now a problem at over 10%. Inflation rates took off almost immediately after the pandemic broke out and they are now stuck high levels, undoing all the gains made in 2019 when inflation was around 3%. The country is stuck in its worst economic crisis for many years, receiving food aid from Kazakhstan last week. In late April, the key rate was raised 100 bp to 6.5% as the central bank stepped into the breach and aggressively fought back against the price rises. 

Tajikistan saw inflation fall heavily during last summer as the economy slowed, but prices took off in October as inflation surged across the region to end the year at 10%, where it remains stuck. At the end of April the benchmark rate was hiked by a whopping 100bp to 12%. The month saw food prices grow 13.3% year on year.

Oil producer Azerbaijan is vulnerable to oil price shocks, but is maybe the most successful of all the countries in the region at keeping inflation stable, below 4%. Inflation started 2020 at only 2.7% and prices barely changed throughout the crisis year. As the pandemic began to recede, March saw a very mild increase to only 3.9%. The country stabilised the local currency (the pegged Azerbaijani manat) by tapping its sovereign wealth fund (SWF).

Georgia was doing very well in its fight against inflation, having brought the rate down to between 4% and 5% in 2019, but from December that year inflation began to surge, reaching 7%. As 2020 got under way, the lockdown caused prices to tumble in the first quarter due to low demand and consumption. Inflation dropped to a low of 2.4% in December 2020. But as the pandemic restrictions were eased this year, the release of pent-up demand saw inflation spike to 7.2%. The central bank, which has conducted a series of FX sales, has its work cut out to bring inflation back under control, but like most of its Central Asian peers also hiked rates by a big 100bp at its April meeting, citing a rather bleak inflationary outlook for inflation caused by overlapping domestic and external factors.

Moldova seems to have escaped almost entirely from the regional inflation surge. It ended 2019 with its highest rate of inflation in several years at 7.5%, but as the crisis crushed economic activity, by December 2020 inflation was a mere 0.4%. As this year gets under way it seems that Moldova is not enjoying any sort of economic bounce-back and as its economy remains moribund inflation rose only marginally in March to 1.5%.  

This was a modest recovery after consumer price inflation reached a record low of 0.2% in January amid a combination of low global energy prices and subdued demand. Moldova’s GDP plunged by roughly 7% in 2020 and the support provided by the government to the real sector and households was particularly thin. The scarce bank lending during the pandemic period also contributed to the significant demand-side shock.

The inflation would have been even lower – possibly negative – if it were not for the rise in the price of some agricultural inputs driven by the poor harvest in 2020. 

Some inflationary pressures are generated by the weakening local currency, though in the context of low inflation compared with the BNM’s 5% target. The weakening of the Moldovan currency is driven by several factors, including the drop in exports, the seasonal decline in migrant remittances and the lack of grants or loans from Moldova’s foreign partners. As inflation is not really a problem for Moldova the central bank left its rates at a modest 2.65% at the April meeting.