The notion that excess capital is flowing into Russia is a myth. The so-called problem would resolve itself if the Bank of Russia would only learn how to use its reserves to develop the real sector

In late January, high-ranking Central Bank officials began all of a sudden to talk about the need to limit the influx of foreign capital in Russia. “With the excess influx of short-term foreign capital, the Central Bank will use all restriction methods,” Konstantin Korishchenko, Deputy Chairman of the Central Bank, stated in one of his speeches. The record increase in gold and currency reserves became grounds for statements about “excess” capital influx. As of January 23, reserves totaled $82.7 billion, growing to $84.1 billion by February 4. “In the last year, the increase in gold and currency reserves amounted to $26 billion, of which nearly $9 billion were accumulated in December,” says Mikhail Zadornov, Chairman of the Duma Sub-Committee on Monetary and Credit Policy, Currency Regulation and the Central Bank. “Naturally, under these circumstances, the Central Bank has to take serious steps to tie down this money supply
First of all, Central Bank officials are worried that the current capital inflow could turn at any moment into an even greater outflow. “Late last year, Western and Russian investment banks decided that the ruble would continue to appreciate versus the dollar. Therefore they needed to raise funds abroad, import them into Russia, invest them in ruble assets, and make very decent rate of return in dollar terms thanks to ruble appreciation,” Zadornov explains. “And after a while, they could take the money back out of Russia. This transaction is quite understandable as far as business is concerned, but it damages the Russian economy.”
The stronger ruble is the second problem brought about by the rapid influx of foreign currency. “In January, ruble grew by about 5% in real terms,” Zadornov says. “Because of this, our exporters received 5% less revenue. In addition, imported goods in dollars become cheaper and more competitive compared to their Russian counterparts. If the Central Bank hadn’t bought foreign currency from exporters, ruble would have gotten even stronger and the dollar would be at 27 rubles, not 28.5 rubles as it is today.” Real appreciation of the national currency is typical for almost all economies in transition. In Eastern European countries, national currency appreciation was as high as 20%, while the ruble has become stronger by just 7.3%. Thus, the allegedly urgent need for restrictions on capital inflow is somewhat exaggerated. 
The Bank of Russia is forced to buy foreign currency from exporters, which begets the third problem, rising inflation, as the Central Bank has to print and issue large volumes of extra money unsecured by real goods to buy the foreign currency. Zadornov estimates that the money supply has increased by 50% in the last year.
Some experts point to one more potential hazard of the current capital inflow. “We have an unusual capital inflow profile, with a huge preponderance of loans and bonds and only a tiny share of direct investments,” says Oleg Solntsev. “These foreign loans don’t promote the investment growth but instead gives rise to multiple problems in ensuring the liquidity of enterprises and maintaining the stability of financial markets. At present, loans are increasing at the very high rate of up to 50% a year. They are guaranteed by export revenue but exports are growing at a far slower pace, and in the medium term export growth in value terms will become even slower. Next, obviously oil prices will go down at some point, and export revenue will decline, leaving less money to repay the loans. Interest rates are likely to rise in the West, which would increase refinancing costs. If companies want to refinance, they will have to borrow at higher interest rates. Under such circumstances, companies will likely face problems with repayment.”

The Chilean tax

To limit capital inflows into Russia, the Central Bank plans to exercise the full rights given to it by the new edition of the Law on Currency Control. Under its provisions which will take effect mid-June, the Bank of Russia is empowered to require participants in currency deals to deposit up to 20% of the amount of a transaction for up to 12 months or up to 100% of the sum for as long as two months. Plainly speaking, if you get a hundred dollars from a foreign investor, you must lend the Central Bank twenty dollars for a year. The officials’ logic is clear. This evidently makes foreign loans more expensive, and Russian companies will borrow less in the West. As a result, the Central Bank’s current concerns about how to limit inflation and hold back the ruble exchange rate will resolve on their own.
In 1990s, many Latin American and Southeast Asian countries faced the problem of large-scale capital inflow. In 1991, Chile was the first to use interest-free funds depositing at accounts with its central bank for a fixed term as a tool to stem the influx of capital. Since then, financiers have named this scheme the “Chilean tax.” In succeeding years, the Chilean tax was used in Brazil (in 1993-1997), Columbia (in 1993-1998), Malaysia (in 1994), and Thailand (in 1995-1997). “The surveys’ findings show that in the short term, the Chilean tax indeed helps slightly reduce the total capital inflow into a country and shifts the capital profile toward longer-term instruments,” says Ksenia Yudayeva, Director for Policy Studies at the Center for Economic and Financial Research and a member of the expert board at the Carnegie Moscow Center. “However, as time goes by, the efficiency of the Chilean tax as a method to control the structure capital inflow declines. The reason for this is that investors devise new instruments, to which capital inflow control measures do not apply.”The Russian Central Bank officials need not worry about the long-term prospects for their control techniques, however. All restrictions on currency transactions will be abolished in 2007.

False targets

There seems to be nothing to worry about. If the Chilean tax will work in Russia, everything will be fine. If it fails to work, it will expire on its own in three years, having had no time to do much harm. However, the fight waged by Central Bank officials against the notorious “excess capital inflow” hides a more urgent problem, the low efficiency of the Central Bank and the Russian banking and fiscal system as a whole.
“On the whole, excess capital inflow isn’t a problem for the Russian economy, as there is a huge demand for credit and investments,” says Elena Matrosova, Director of the Center for Macroeconomic Research at BDO-Yunikon. “The increase in capital inflow due to foreign credit and loans is the result of increasing demand by Russian enterprises and credit institutions for funds to develop their businesses. These resources are really required to finance capital investment, and the demand for foreign capital in particular is linked among other things to the low efficiency of the Russian banking system.”
Other experts openly blame the Central Bank itself for the emergence of the “excess capital” problem. “The problem is not in excess capital inflow; it is in the fact that the monetary authorities see the capital inflow as a problem rather than a blessing,” says Valeri Petrov, Deputy General Director of MICEX. “By referring to the capital inflow as excess, the Ministry of Finance and the Central Bank are acknowledging their lack of professionalism, their inability to create the conditions for transforming this money into investments in fixed capital. Hence, the attempt to protect the market from capital inflow by making the artificial barriers, which appear in the Law on Currency Control drafted by the Central Bank. It’s a rather silly position.”
Even advocates of the Central Bank’s ideas realize the vulnerability of its position with respect to capital inflow. “The Bank of Russia must pursue two goals at once: not to allow a drastic rise in inflation or too much ruble appreciation,” Zadornov explains. “These goals conflict with each other and give rise to the very complex solutions the Central Bank has to find. Of course, it would be better to focus on one of these two goals but it is impossible to do so under present economic conditions.”
This explanation of the Central Bank’s problems sounds unconvincing, though. “The idea is spreading that these two problems cannot be solved at the same time,” Petrov argues. “However, the results of 2003 prove that they are not quite as acute during investment-driven economic growth. A strong national currency is indispensable for investments, and the growth of investment demand automatically leads to reduced consumption and, as a result, lowers inflation.”
In other words, it is high time for the Central Bank to forget these two goals and set itself new ones, such as organizing investment in Russia. More and more financial market players are making such suggestions. The Central Bank and the Ministry of Finance view their responsibilities too narrowly. They are virtually uninvolved in shaping the Russian financial market despite the fact that they have to power to do so and this is what others expect from them. In essence, there is no public securities market in Russia, which is part of the foundation for any financial market. There is no system of credit refinancing in Russia, although rapid growth makes it a necessity. For this reason the refinancing rate doesn’t work in Russia. This says a lot. Current Central Bank tools do not allow it to completely regulate currency circulation in the country. No matter how frightful it may be for the Central Bank, the time has come to learn how to get the money market to expand, not just shrink.

Yuri Korotetsky assisted in the writing of this article.

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