Russia's central bank governor talks to Stefanie Linhardt about how the country is reaching its inflation targets, why its international reserves have been rising, what impact low interest rates have had, and why Russia's banking sector is now in a stable position.

Elvira Nabiullina

Q: Russia is  now very close to its 4% inflation target for the year-end. Is the Russian central bank's work on inflation targeting practically done? How easy is it to maintain inflation around the target?

A: Indeed, we have virtually reached our inflation target, with inflation being only marginally above 4% [as of June]. Now, our key task is to achieve sustainability and make certain that inflation stays close to the target.

It is difficult to say which task is more difficult – to achieve low inflation or to sustain it. At this stage, the problem we are facing is to reduce and anchor inflation expectations because we will be able to achieve our goal of sustainable low inflation only if we are able to reduce them.

To anchor inflation expectations at a low level, we need to make sure that both the business community and households trust the Bank of Russia. This implies confidence in our ability to withstand any shocks and bring inflation back to the target level in the medium term no matter what happens.

Q: How strongly are inflation expectations linked to the rouble exchange rate and what other factors are having an impact?

A: There is a link between inflation expectations and the exchange rate and it remains significant, although it has weakened in recent years. Before we started inflation targeting, inflation responded to any changes in the exchange rate very rapidly and people naturally got used to that. 

Now the pass-through effect from exchange rate fluctuations into inflation has decreased. Before, we estimated it to be at 0.4, while now it is down to 0.1 to 0.12 when the rouble depreciates and even lower when the rouble appreciates.

This reduction in the pass-through elasticity has been achieved because the volatility of the exchange rate has decreased. So it is very likely that the pass-through rate [could] increase again, unless we are able to anchor inflation expectations. This brings us back to the need to anchor inflation expectations. It would reduce the impact of exchange rate fluctuations on inflation among other things.

Q: Your international reserves have been ticking up – from about $380bn at the start of 2017 to more than $410bn in July. Are you consciously moving towards replenishing your reserves?

A: Our international reserves have been growing, and three factors stand behind their growth. First, it is the positive valuation effect of the assets in which we invest our reserves.

The second factor was the repayment of foreign exchange [FX] repo that commercial banks borrowed from the Bank of Russia in 2015. At that time, the Bank of Russia introduced a new instrument to provide commercial banks with short-term foreign currency liquidity from our international reserves. This had been done in order to solve a problem of FX liquidity shortage in the market during a period of large FX debt repayments by commercial companies and banks amid their limited access to foreign lending. We set a limit at $50bn for the outstanding amount of our FX repo facility. The peak demand for FX repo was a little over $35bn. From the very beginning we said that this liquidity line would be closed by the end of 2017 and that all the money allocated under FX repo would have to be repaid. At the beginning of this year the amount of outstanding FX repo stood at $11.5bn. It has been scaled down to $1.5bn now – the $10bn went back to our reserves.

In addition to that, hard currency that the Ministry of Finance purchased under a new fiscal rule was also deposited as international reserves. This third factor has added about $5bn to our reserves since the beginning of this year.

Those are the three factors that have contributed to the increase of international reserves. The Bank of Russia did not make any FX interventions to raise the reserves.

We will not intervene in the FX market to replenish reserves until we are sure that such purchases would not undermine our efforts to sustain our inflation target and we would only consider starting replenishment if we are confident that markets are stable enough. For now, the rouble currency market remains volatile because of volatile oil prices.

Q: Related to inflation, the key interest rate you set has continuously been lowered, from 10% at the end of 2016 to 9% in June, and the central bank has indicated that there might be further cuts to the rate this year. How low can the key rate go in 2017 and where would you like to see it in the long term?

A: We see some room for further cuts to our policy rate later this year. But the speed of policy easing and the size of rate cuts will very much depend on the new data and updates on our outlook for the future. That said, our monetary policy will remain moderately tight, even though we see the potential for a further reduction of our key policy rate. And our key policy rate in real terms will remain above its neutral rate for some time.

Over time, our key policy rate will decline to its neutral level. In real terms, that would be 2.5% to 3%, and in nominal terms 6.5% to 7%.

But again, that would only be possible when we see and are confident that inflation expectations are anchored and are not responding much to any shocks. Until then, the policy rate will remain higher. Although inflation expectations have been decreasing, so far they remain unanchored and are still very sensitive to inflation fluctuations.

Q: Have the lower interest rates translated into a pick-up in lending from the Russian banks to the economy?

A: We do see that lending in the Russian economy is gradually picking up. Retail lending recovers first, followed by corporate lending – but the recovery trend remains moderate. We see a number of factors affecting that. First, the economy has been picking up. Second, the number of non-performing loans [NPLs] on banks’ balance sheets has virtually stopped growing. Finally, our efforts to lower inflation and stabilise the macroeconomic situation have started bearing fruit and now banks can offer cheaper loans at better lending terms.

Importantly, the loan quality that banks provided to the economy in 2015 and 2016 is higher than loans that had been granted prior to that.

Q: Would you say you are now content with the state of the Russian banking sector?

A: Generally speaking, the Russian banking system is stable. This has been proven by the banking system stability throughout the period of strong external shocks it had to withstand in late 2014 to early 2015. Of course, at that time the profitability of the banking sector went down and the share of overdue NPLs did go up a little, but we saw an improvement of all major indicators of the banking system last year. The banks’ profits have doubled in the first half of this year compared with the same period in 2016.

That said, there are still are some unstable, weak banks in the market.

Over the past four years we have reduced the overall number of banks by one-third. The bulk of the reduction came at the expense of small banks and some medium-sized banks. So, the banks we took out of the market last year accounted for only about 1.5% of the total assets of the Russian banking sector. That had no negative impact on the stability of the banking sector. Quite to the contrary, it had a very positive overall impact on the market discipline: banks that remained in the market improved their internal compliance rules and risk management, and that helped to improve the overall situation in the market.

Q: When we spoke at the end of 2016 you said you wanted to 'raise the efficiency of banking supervision so that it is proactive and follows the risk-based approach'. Are you satisfied that you are achieving this now?

A: Improvement is an ongoing process. It is the process of improving the quality of supervision. We did change certain elements. For instance, we have set up a risk analysis service, which is capable of doing a prompt analysis of a bank’s asset quality.

Now we are in the process of centralising banking supervision. In the past, banking supervision of non-systemically important banks has been done in regions. To perform a supervision function faster and harmonise the practices across the regions, we decided to centralise supervision. We are doing this in stages. Even more importantly, we are in the process of building the professional competencies of the individuals who perform our banking supervision. We educate them to understand complicated tools and models that different banks use. It is the process of continuous improvements, because you can never achieve perfection. We expect the bulk of changes to be completed in one-and-a-half to two years.

Elvira Nabiullina is the governor of the Bank of Russia.


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