Yury MAKEYEV
Senior Researcher, Institute of Oriental Studies
Russian Academy of Sciences
Ph. D. (Economics)

Aleksander SALITSKY
Leading Fellow
Institute of World Economics & International relations
Russian Academy of Sciences,
Ph. D. (Economics)

Alexey SHAKHMATOV
Assistant Chairman of the Board, Gazprom
Ph. D. (Economics)

At the turn of the new century, PRC and India literally burst into global commodity and service markets. Russia, which continued increasing exports of raw materials and fuel, suddenly faced the problem of disposing of its foreign exchange reserves. The new situation brings up new complex issues to be addressed, which, among other things, calls for revision of certain conceptual approaches elaborated in the past two or three decades.

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The national currency exchange rate movement has an effect on both external trade and balance of payments, and national economy as a whole. A lower nominal exchange rate (other conditions being equal) favors exports, while a higher exchange rate usually results in reduced export growth rates or even export reduction. Imports grow more expensive with a lower exchange rate, etc.

At the same time, a lower exchange rate of national currency leads to higher external debt service costs denominated in national currency and greater budget expenditures. There emerges an objective conflict between interests of local producers (including exporters) and the state of public finance. Discussion of related issues might help a better understanding of the significance of the exchange rate for national economic interests.

Inflation and currency exchange rate in China and India

Not all economists, by far, consider devalorization of currency the best method of raising competitiveness of national economy and its international liquidity¹ . Of late, however, the prevailing view has been that a relatively low and stable exchange rate is beneficial, with some authors even describing it as the "most efficient instrument of industrial policy"² .

We believe that this understanding of the significance of the currency exchange rate results from the essentially expanded domain of price competition in the global market, along with increasing internationalization of production. Over the 1980s - 2000s, following economic advancement of Japan, new

¹ For discussion of these issues, see Bylinyak S.A. Emerging financial markets. M.: Oriental University, 2004. Pp. 118 - 122.

² Trade and Development Report 2004. UNCTAD, New York and Geneva, 2004. P. 104.

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industrialized countries and, especially, China, this competition has spread from homogeneous raw materials and food commodities to a very wide range of consumer technical products and equipment used in their manufacture. Correspondingly, the relative level of

Table 1

Selected economic performance indicators of India

* Average annual official rate.

Source: Reserve Bank of India (http://www.rbi.org.in/)

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domestic prices directly affected by the national currency exchange rate has had an increasing effect on protection of the domestic market, commodity export trends, direct foreign investment and, in the long run, economic growth rates.

Liberalization of international trade has been another factor increasing importance of the currency exchange rate as a competition instrument. Relatively small states primarily used the exchange rate as a means of stimulating their export sector, while the biggest developing states mostly employed it as a protective measure. It is the super-large states, which have been implementing market reforms at approximately the same time as Russia, that may demonstrate some fundamental relationships between domestic prices and the prices of national currencies on the external market, i.e. the currency exchange rates - which may be relevant for the global market and some other states.

At the turn of the century, the biggest Asian states achieved a monetary and financial stabilization. The statistics presented below covers periods between the start of the reforms and the stabilization - these may be somewhat arbitrarily referred to as periods of "devalorization" of rupee and renmingbi (Tables 1, 2).

A simple calculation based on data in Table 2 demonstrates that consumer prices in PRC were 2.42 times as high in 1994 as in 1985 (the first reform year with a high inflation - annual 6% inflation is considered the maximum in PRC). Over the same period, yuan (renmingbi) went down in value by 2.93 times. Selecting the following year, 1995, as the reference point, we get a much lesser spread, with the prices 2.83 times as high and the nominal Chinese currency exchange rate 2.84 times as low. The tie may be described as really striking - in actual fact, over a long period of domestic price

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Table 2

Selected economic performance indicators of PRC

* Average annual official rate.

Source: Zhungo tongji nianjian - 1997 (China statistics yearbook - 1997). Beijing, 1997.

restructuring, the national currency exchange rate has been lowered in exact proportion (within a hundredth) to inflation growth (1995 was the last year marked with a high inflation in PRC's history).

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The situation was similar in India, where the rate of rupee's nominal devalorization with respect to the leading world currency has been roughly comparable to that of domestic price increase. It appears fair to assert that in this country, too, there exists a close relationship between the currency exchange rate and the purchasing capacity of money.

Generally speaking, it can hardly be proper to refer to any "underpricing" or "overpricing" of renmingbi or rupee over a sufficiently lengthy period of economic reforms, taken as a whole, as we deal with currency units that are most closely related to the real sector and the level of domestic inflation. One can only talk of "underpricing" in the sense that the currency exchange rate movement seemed not to take into account the US inflation - however, in the periods under consideration, dollar-denominated foreign trade commodity prices showed a consistent downward trend.

One might also go somewhat farther back in history - between 1952 and 1980, consumer prices in the PRC went up by half. In the same period, the (official) exchange rate of the Chinese currency went down by almost 47%. The "market" exchange rate of yuan (calculated on the basis of exporters' costs plus 10% profit) went down by 27% between 1952 and 1980 - once again, the devaluation rate was lower than the corresponding price rise. The long-term situation with rupee was similar - the difference is it was devalued almost ten times over half the century.

Simply stated, over the entire post-war period, the renmingbi exchange rate has been devalued less than was needed to make up for the reduced domestic purchasing capacity. When you take rupee into consideration, too, it appears that the Asian currencies

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have not at all been "underpriced" - instead, it is the currencies of developed countries that have been overpriced thanks to their monetary and credit monopoly on the global market.

In other words, rupee and renmingbi are currencies that have preserved a close relationship to the situation in the 1950s - they are, so to say, "Bretton Woods currencies". In late 1950, the yuan/dollar exchange rate was 3.2 to 1; in May 1951, 2.2 to 1. Now, it stands at 8.3 to 1, being four times "depreciated". This proportion, by the way, is true for a lion's share of known divergences of the exchange rate from the correlation of currencies by their purchasing power parity (PPP). It appears that dollar has been overinflated three to five times, compared with the historically justified role of world money (numeraire) - which, however, does not prevent it from coping with functions of world currency (lower-quality money remains in circulation - it is an old law). Anyway, this gives us a somewhat clearer notion as to who is to blame for the imbalance, and where "classical" money is minted.

It appears, therefore, that interests of local producers (including exporters), the need to consolidate domestic markets, and problems with the balance of payments have for a long time forced Chinese and Indian financiers to pursue a policy of "cheap" national currencies. Domestic prices have for a long time been frozen on a lower level, compared with those of developed countries. The technical methods used in exchange rate regulation have been different - periodic currency devaluations with the exchange rate being practically fixed between these (PRC prior to 1994), or exchange rate reduction under a floating regime (India prior to 2002).

At the same time, the present existence of a developed export

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sector, the good financial standing and availability of substantial currency reserves have not, however, led to any significant rises in the exchange rate in these countries, for fear of losing external markets in price competition.

As a result, a relatively low price level has been formed at the turn of the 21st century in both PRC and India, leading to downward currency exchange trends in neighboring states (Table 3). The loss

Table 3

Average annual rates of exchange to US dollar (1995 = 100)

Source: International Financial Statistics. Wash.: IMF, 1995 - 2002.

of price competitiveness by some East Asian states is sometimes considered one of the reasons for the crises in 1997 - 1998.

The current high price competitiveness of India and China largely results from their persistent and successful fight against inflation in the 1990s. It is important that supporting the purchasing capacity of money has remained a clear priority issue in both states³ , which was

³ The Law on the People's Bank of China passed in 1995 directly specifies its chief objective as supporting the purchasing capacity of money for economic growth.

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largely taken into account in regulating currency exchange rates.

Monetary and financial stabilization in Asia and its consequences

The logic of tough fighting for price competitiveness is spreading to other countries, too.

It became clear at the turn of the new century that the biggest countries in the East are quite self-sufficient in the monetary, financial and credit sphere - in other words, the monetary and credit monopoly of the West is now a thing of the past.

It is important that, along with economic growth of the biggest Asian states and their accumulation of sizeable foreign currency reserves, many other countries start placing priority on internal growth factors, import substitution, targeted industrial policy. It should also be stressed that the accelerated economic growth of Eastern states in 2001 - 2003 was accompanied by a continuous and rather sizeable reduction in direct foreign investment and an outflow of portfolio foreign investment. There is a general tendency towards a growing economic role of the state, with the scope of privatization programs being essentially reduced. The neo-liberal theory and practice are gradually passing away.

The hypertrophy and instability of the financial sphere in the West, the oversupply of dollars in global economy, on one hand, and the moderate currency policy of Asian states, on the other hand, have apparently and logically resulted, at the turn of the century, in a reduced price of money (expressed by the lending rate). It becomes clear that the growing inflow of capital and the free transfer of capitals between states is no longer an indispensable condition for maintaining high economic growth. It

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is no longer needed to set a short-term objective of achieving capital account convertibility of national currency - nor is it obligatory to form an exchange rate as a result of free interaction of market forces and players.

"Conservative" concepts based on direct linkages between the currency exchange rate and the purchasing capacity of local currencies have proved to be fairly efficient in raising competitiveness of national economies and sustaining high economic growth. Preserving restrictions on foreign capital

Table 4

Currency exchange rates to US dollar

* Year-end figures

Sources: Deutsche Bundesbank; Asian Development Outlook 2004. ADB: Manila. 2004.

Average annual figures have been rounded off.

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movement has also appeared to be more productive - among other things, from the viewpoint of opposing drastic external influences and maintaining macroeconomic stability. Low inflation and moderate lending rates have become another important factor of increased competitiveness.

The monetary and financial stabilization in Asia is spreading to an increasing number of states. Price competitiveness and, especially, low inflation appear to be essential elements of investment attractiveness (Tables 4 - 5). It is easy to see that countries which are unable to cope with inflation (exceeding China's 6% inflation maximum) appear to be deprived of this source. Nevertheless, even these countries (Indonesia, Thailand)

Table 5

Direct foreign investment in Asian states, billion dollars

Source: Asian Development Outlook 2004. Manila: ADB, 2004

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demonstrate accelerated economic growth. More simply, this confirms the hypothesis that, in big countries, foreign capital is not so much a factor as an indicator of successful economic growth, and its complement⁴ .

The above data demonstrate, among other things, that countries which rather rigidly peg their national currency unit to world currency (PRC, Malaysia, Vietnam) are better able to cope with inflation - they, as a rule, also demonstrate higher economic growth.

On the whole, however, the precipitous improvement of the monetary and financial situation of Asian states once again raises the issue of priority development of the export sector and inflow of foreign direct investment (FDI), because the value of increasing foreign currency reserves no longer appears to be self-evident from the viewpoint of national interests. Instead, some countries, especially PRC, have been recently restricting inflow of foreign currency using currency and other regulation procedures.

In the new situation characterized by intensifying price competition, on one hand, and availability of excessive currency reserves in many states, on the other hand, priority development of the export sector in big countries obviously entails major additional risks, the main danger being a future loss of price competitiveness due to an excessively appreciated currency. Emphasis is therefore shifted to increasing investments in the domestic market. Characteristically, the recently resumed economic growth in the US, which has shifted its focus to stimulation of real economy, increasing investment (with the rate of saving in the US growing from 18% in 2002 to 21% in 2004) and

⁴ Borisov D.V. Trends and factors of direct foreign investment in the economy of developing states of Asia and Africa (1990 - 2002). Ph.D. (Economic Science) dissertation. M.: Institute of Asian and African Studies, Moscow State University, 2003.

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domestic demand, appears to be steadier than in Germany, whose export sector was fast developing at the turn of the century.

Global economy at the turn of the new century actually reminds us of the fundamental law of economic history, namely that growing investment is the key factor of dynamic economic growth, whereas orientation to export development, and even a fast expansion of the export sector, may only slightly raise the rates of GDP growth. Even developed countries failed to ensure economic growth without any substantial increase in the rate of saving (Tables 6, 7).

It should be noted that reduction in credit interest rate for the real sector is of great importance for increasing the rate of saving and lowering inflation. PRC and India have the real interest rate of 2 - 6%.

Table 6

Average annual rates of growth of selected economic indicators in developed countries, %

Source: Maddison A. Phases of Capitalist Development. Oxford, New York: Oxford University Press, 1982. Tables 3.2; 3.7; 5.4.

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Table 7

The rate of saving in selected developing countries, average for the period, %

Calculated from data presented by B.M.Bolotin and V.L.Sheinis⁵ .

Finally, it should be noted that the shift to development based on savings growth as the focal point of economic strategies constitutes the essence of changes in foreign theory and practice. World economic thinking is increasingly inclining to the need for heterogeneous strategies.

Russia's specifics

The start of economic growth in Russia is also related to increased investment, with the 9% average annual rate of growth between 1999 and 2003 reaching as high as 17.4% in 2000 and 12% in 2003.

⁵ Bolotin B.M., Sheinis V.L. Economy of developing countries in statistics. Pilot statistical study. 1950 - 1985. M.: Nauka, 1988. Pp. 491 - 493.

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The rate of saving, however, remains low, an average of 16.5% in the past five years.

The figures for renovation of capital equipment by industries demonstrate that absolutely all industries have been hit by curtailment of investment activity, with the ones oriented to the domestic market being the ones that were most seriously affected. Since 1980, the capital equipment renovation coefficient for industry as a whole has gone down 4.5 times, from 8.1% to 1.8%. Machine building and metalworking were among the industries showing the biggest decline (as Russian industry stopped purchasing new equipment). Improved foreign trade environment in 2000 - 2004 sharply improved the financial standing of enterprises, primarily in export-oriented sectors, enabling them to start a more active renovation of capital assets and expand production.

The lengthy period of investment famine resulted in depreciation of fixed assets of Russian industry. The mean age of operating equipment has nearly doubled over the reform period, increasing from 10.8 to 20.1 years. At the same time, the share of new equipment (staying in operation under 5 years) has gone down 4.4 times, from 29.4% to 6.7%. It appears, therefore, that the capital assets of Russian industry are currently worn out, both morally and physically. In this situation, the main advantage of manufactured products remains their price competitiveness based on relatively low energy tariffs. If the manufacturing industry is unable to renovate its capital assets in the near future, its prospects appear to be rather bleak.

It is evident that nominal revaluation of the ruble will result in reduction of subsidies which Russian economy gets from

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infrastructure sectors. This development, in the situation when the mechanism of transformation of national saving into investment is not yet working, is fraught with a substantial slowdown, if not cessation, of economic growth.

Russian economy still represents a market system in the stage of formation, with a low level of market infrastructure support. Many elements of market economy (which actually always represents a combination of monopoly and market sectors), including large concerns, are still underdeveloped. Market forces are not yet able to accelerate the process of consolidation and concentration in manufacturing industries through mergers. As a result, Russian manufacturing enterprises cede the domestic and external market to their foreign competitors. Larger enterprises might find it easier to get access to the capital market, reduce costs, optimize production processes - besides, enterprise enlargement would put an end to the often senseless competition among Russian manufacturers. In essence, what Russia needs is not so much private as corporate, mixed, joint-stock, collective and other forms of ownership acting in harmony.

Russian economy possesses a wide range of prerequisites for sustainable and dynamic development. At first sight, sufficient basis for this is provided by the high (by world standards) level of gross savings that exceeds 30% of the GDP (33.8% in 2004, 32% in 2003). Considering availability of skilled labor resources, idle or worn-out capacities, sufficient infrastructure objects, the complete transformation of aggregate national savings into investment, according to our estimates, might provide for no less than 10% rate of economic growth.

It is widely believed that existence of underestimated prices of

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products and services in infrastructure sectors turn Russian economy into an enclave that is unable to duly perceive market signals originating from the global system. Proponents of this view seem to disregard two factors. In the first place, global economy in its present form appears to be rather unbalanced, especially in its financial sector, and sort of "dichotomous", split into industrial and post-industrial segments. The industrial segment seems more dynamic and possesses a higher price competitiveness, yet its effect on Russian economy is not strongly pronounced due to the specific geographic distribution of Russia's foreign economic relations. Secondly, the structural and price parameters existing within large economic systems of the modern world (which we may arbitrarily refer to as the West and East) are absolutely different - what is more, these very differences constitute a prerequisite for the global economy's working as an organic unity. It is as absurd to require that Russia would raise its domestic energy prices to the European level as it is to complain that labor is "cheap" in Thailand or India. Another thing is that Russia's relative advantages in the energy production sector have an ambivalent effect on its manufacturing industry. On one hand, it really enjoys "hothouse conditions" in the form of relatively low tariffs. On the other hand, however, there is an apparent "suppression" of other sectors by the fuel and energy sector due to their declining competitiveness, which, among other things, results from the growing nominal currency exchange rate, high inflation, and the lack of mechanisms for redistribution of the natural resource rent to meet investment needs of sectors not directly related to the fuel and energy complex.

The classical regularities of the effect produced by exchange rate fluctuations on the country's foreign trade are not that

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pronounced in Russia. The reasons are well known - these include an extensive use of settlements and savings in foreign currency, a high vulnerability of the economic situation to external raw materials and fuel market trends and, finally, excessively high inflation, which, in the long run, appears to be the key factor of the declining price competitiveness of domestic manufacturers. The share of machinery and equipment in overall exports is steadily decreasing (Table 8).

The rise in the ruble's nominal rate of exchange to dollar, accompanied by the considerable domestic price rise, in view of

Table 8

RF export structure, %

* Eleven months.

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the above comments on the expanding sphere of price competition in the global economy and the sharply reduced inflation we found in most Asian states, gives rise to reasonable concerns.

Russia's manufacturing industry actually plays a very limited role in global price competition, and the effect of the currency exchange rate on producer competitiveness, as a rule, is hard to estimate. The only exception is production of consumer commodities (durable goods, in particular), whose share in retail sales on the domestic market is calculated by the VNIKI research institute. This indicator has been declining in recent years.

x x x

Russia is not the only country that has faced the problem of excessive foreign currency reserves "overhanging" the exchange rate. It should be noted that Asia, where the situation is similar, does not demonstrate any significant revaluation trends despite pressure from the IMF - which, in combination with low inflation in Asia and high inflation in Russia, means a very substantial loss of price competitiveness for Russia in recent years.

In general terms, the problem resulting from Russia's increased foreign currency reserves (including the stabilization fund) and their "overhang" over the exchange rate, should be formulated as the need to raise the savings ratio, while simultaneously maintaining at least the existing level of price competitiveness. We believe that the focal point here would be a sharp reduction of inflation.

A "book-keeping" solution (based on the well-known formula which specifies that the difference between savings and investments should match the assets side of the current account

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balance sheet), i.e. a further rise of the nominal exchange rate, appears to be inadvisable for a variety of reasons.

In physical terms, Russia's exports of raw materials and fuel in 2004 increased by around a quarter. The increment of foreign currency reserves is practically obtained using extensive methods and, quite probably, at the expense of deteriorating quality of reserves and deposits. Therefore, a partial way out would seem to be the gradual reduction of physical volumes of raw materials and fuel exports.

The negative effect produced by the rising nominal exchange rate, accompanied with high inflation, is getting accumulated, thus constituting a "deferred negative factor", which is going to drastically aggravate the situation if the global business environment changes. As import growth rates are only slightly behind the rates of export growth, the currency reserves may be "eaten up" rather fast.

The need to sterilize the currency inflow in reserves is a forced palliative measure that is not, however, justified from the macroeconomic point of view. It is a direct consequence of the lacking investment mechanism, which actually is the main flaw of Russia's economic system.

The monetization of Russia's economy (35 - 30%) is on the level of Myanmar, its financial sphere, by world standards, is non-functional and almost uncompetitive, the interest rate is too high, the medium-term and long-term credit resources are extremely insufficient. This gives us reason to assert that the overabundance of currency reserves in Russia is of a relative nature, resulting from an artificial suppression of money supply. In a sense, Russia has no inflation in its classical

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definition, i.e. there is no cash overflow of circulation channels.

Theoretically, currency reserves may be regarded as security for establishment of a globally competitive credit sector and a source of funds for encouraging investments. Therefore, establishment of a state or mixed investment mechanism with a simultaneous reduction of inflation and lowering of the lending rate appears to be the key objective in the near term.

Existence of a budget surplus does not appear to match present-day practice, either, while the size of budget expenses, as share of GDP, remains too low even by Asian standards. There may be no direct link between budget deficit and inflation - provided you use correct methods of fighting inflation.

There are also some methods of improving the situation, which require full consideration. One of these is early payment of foreign debts, which, by the way, has been practiced by India since 2001. It should be noted that, in India, the central bank, along with repaying the debt, was issuing inexpensive (4 - 5%) rupee-denominated bills of exchange to be placed in banks - for "off-loaded" budgets of future years. This was an explicit anti-inflationary measure. Characteristically, the practice of early payment of foreign debts was continued by Indian business entities, too.

It is known that, in PRC, large amounts from currency reserves (over $45 billion) were directed in 2004 to recapitalization of state banks. Energetic efforts are taken in the country to oppose speculative asset inflation, be it real estate or stock market. Companies operating abroad are actively financed by state banks at preferential rates.

It would be advisable to discuss the possibility of partial public financing of acquisition of foreign assets by domestic companies

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that demonstrate tax compliance. These assets might include commodity reserves, the stock of partners in their sphere of business, enterprises in the fuel and energy sector, tourist sites, etc.

It does not appear anachronistic to provide government subsidies (or preferential credits from development banks that are still to be established) for acquisition of equipment from foreign companies maintaining cooperation links with Russian producers.

It is clear that benefits for the private sector should only be provided in exchange for explicit (possibly public) pledges to maintain stable prices or reduce them.

The fight against inflation requires an extensive usage of political propaganda instruments, broad publicity. For instance, the Indian Ministry of consumer affairs, food and public distribution conducts a weekly monitoring of wholesale prices for 27 basic goods, which account for 22.3% of the cost of the commodity "basket" of 441 items, included in the consolidated wholesale price index. A daily monitoring of retail prices for 12 first-necessity commodities is also conducted. In the event of a sharp price rise, the matter is taken to the government's Committee on prices for administrative action.

Indian statistics allow making accurate estimates of the effect produced by external and internal factors on the level of domestic prices, as well as the effect of the sharpest price fluctuations (price shocks) on the overall situation. The prices of agricultural produce are closely monitored by the Indian government⁶ , which subsidizes purchase prices for rice and wheat. In the second half of the 1990s, this policy resulted, in particular, in an almost twofold

⁶ Price control was initially introduced in 1963-1964, soon covering 75% of all commodities, with special attention being given to food products.

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increase of state reserves from their usual size, which allowed exporting part of the wheat reserves.

It is usually believed that state subsidies raise inflation, reducing competitiveness of the economy. One cannot help noticing, however, that stabilization of agricultural prices in 1999 - 2002 enabled India to "freeze" inflation for a long period - practically for the first time in decades. The remaining administrative regulation of electricity tariffs, prices of oil, petroleum products, nitrogenous fertilizers, many medicines must be also acting as an anti-inflation "anchor". The fixed exchange rate may serve as a kind of anchor, too.

A further increase of the ruble's nominal exchange rate, therefore, entails obvious risks. In order to relieve the pressure of the reserves on the current and future exchange rate, it would be necessary to take a political decision, designating the currency reserves as an investment resource, which the state is going to energetically utilize. The objective of fighting inflation and reducing the lending rate should be proclaimed in the same energetic manner. It may be advisable to facilitate attainment of these goals by more or less rigidly fixing the ruble to the world currency.

The possibility of temporarily making certain budget expenditures in foreign currency may be discussed.

The state is going to gain by declaring a gradual transfer from extensive growth to development. Economic growth is necessary, yet insufficient in itself, because development also presupposes fighting poverty, implementing public investment programs, establishing large national concerns.

Russia today has necessary external and internal prerequisites

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for a targeted industrial and investment policy. Certainly, this does not mean abandoning the objective of financial stabilization, with the focal point here being the fight against excessive price increases. One should use all available means to suppress the negative effect produced by rising tariffs.

Today Russia possesses objective conditions for a sufficiently tough control over the movement and activity of both national and foreign capital. This kind of control, when skillfully exercised, is able to ensure inflow (return) of long-term cheap capital, resources and technologies. We should note that, from the viewpoint of correspondence to Russia's level of development, Asian capital in a number of instances appears more preferable, because it demonstrates a higher propensity to work in real economy. It does not certainly rule out the need to attract it to the sphere of financial and information services, where competitive advantages of, say, India look very convincing.

RA