Lifting interest rates to have an adverse effect on investment activity

On April 25, 2014, the Bank of Russia desided to lift by 0.5 p. p. the key interest rate to 7.5% from 7% p. a., as well as the entire spectrum of interest rates on instruments designed provide and absorb liquidity.

As a result, the interest rate band's upper and lower values created by rates on overnight operations of liquidity provision and absorption have been moved up to 8.5% and 6.5% p. а. respectively. Additionally, the Bank of Russia has announced introduction of a new mechanism of refinancing credit institutions which allows for providing banks with long-term loans with a maturity up to 3 years. As security for such loans banks will use receivables on loans issued to finance investment projects guaranteed by the Russian Federation.

The regulator made the decision to lift interest rates on the basis of current evaluations of the dynamics of consumer prices which increased 7.2% on an annualized basis as of April 21, 2014. The Central Bank 's measures basically comply with the practice of inflation targeting, considering the target 5% growth in consumer prices in 2014 with an acceptable +/- 1.5 p. p. deviation from the target level. However, the decision made was in many ways surprising for economic agents, because when the Bank of Russia previously lifted the key interest rate to 7%, it reported that the lift was temporal.

It's important to note that serious concerns arise about the macroeconomic effect of lifted interest rates amid slow business activity in the Russian economy. For instance, according to the Ministry of Economic Development Russia preliminary data, in Q1 2014 GDP will grow at a rate of 0.8% comparing to the corresponding period of previous year. Decline in output and manufacturing industries, and the service industry is also reflected by the movement pattern of the cumulative business index which is calculated by HSBC: in March 2014, the index dropped to 47.8 points against 50.2 points in the preceding month . It is only in May 2009 that the output saw such a substantial fall, as shown by the HSBC's data.

Lifting interest rates on instruments of liquidity provision and absorption may result in further weakening of economic agents' business activity, thereby having an adverse effect on the parameters of both consumer and investment activity.

Additionally, given the current macroeconomic trends, the new instrument of credit refinancing may be found to see a weak demand. Amid ongoing slowdown in investment activity and high level of uncertainty about Russian economy's development prospects, investments risks may be found to be too high and overweighting the fact that banks may obtain refinancing while crediting investment projects.

In our opinion, considering the current macroeconomic situation and external political tensions, the Bank of Russia's assessment of the ratio of risks of further economic slowdown and inflation risks gives rise to questions.

Anna Kiyutsevskaya, Pn.D. in Economics, a senior researcher