Designed its policy response during the Covid-19 crisis, the Russian central bank addressed the consequences and spillovers of all three shocks facing the Russian economy: the demand and supply shocks, increased asset price volatility, and a collapse of oil prices.
  |   Ksenia Yudaeva’s note: The Covid 19 pandemic led to a global macroeconomic shock of unprecedented magnitude. Сentral banks reaction was unprecedented as well in terms of size, speed and scope. E-book ‘Monetary Policy and Central Banking in the Covid Era’ released in June 2021 by Centre for Economic Policy Research (CEPR) summarises the responses by 16 central banks from both advanced and emerging economies. with the publisher's permission posts the chapter writing by Ksenia Yudaeva about the Bank of Russia experience.

Three shocks

During the Covid-19 crisis, the Russian economy confronted three problems: 1) the demand and supply consequences of the lockdowns; 2) increased asset price volatility, particularly during March 2020; 3) a collapse of oil prices in March–April 2020.

While the first two shocks were common to most countries, the third hit oil-exporting countries, including Russia. In designing its policy response, the Russian central bank tried to address the consequences and spillovers of all three shocks.

Moreover, the Bank of Russia is a mega-regulator – i.e. it is both a monetary policy institution and a supervisor and regulator of bank and non-bank financial institutions and markets. This broad mandate allowed us to develop a monetary and regulatory policy mix that addressed specific challenges at each stage of the crisis. Monetary policy and regulatory measures were complementary and mutually reinforced each other. We also cooperated with the government on some of the anti-crisis measures.

I shall briefly describe the policy mix that we used at different stages of the crisis and then describe some policy trade-offs in more detail.

Evolution of the Bank of Russia’s policy mix: rationale and priorities

At the first stage of the crisis, in March 2020, our main concerns were volatility of global financial markets and the collapse of oil prices. The Bank of Russia responded with a policy mix, which included (1) monetary policy, (2) FX policy, and (3) regulatory forbearance.

Addressing a spike in financial market volatility and an increase in risk premia, we paused monetary policy easing and introduced a temporary mechanism of additional FX sales that occurred when oil prices were below $25 per barrel. These sales topped up FX sales activated in accordance with the fiscal rule mechanics. The regulatory forbearance measures included an allowance for bank to fix the 1 March 2020 exchange rate and asset prices for regulatory purposes until 30 September 2020. As a safeguard, we also offered extra FX and ruble liquidity through stand-by swaps and repo auctions, respectively.

Addressing the problems that the Russian economy faced at that time, the Bank of Russia took support measures for small and medium-sized enterprises (SMEs) and the healthcare and pharmaceutical industry. We launched a special refinancing programme (of 500 billion rubles, or approximately $6.6 billion) for banks, which kept their small business credit portfolio above 90% of the pre-crisis level. Loans under the programme were granted for a period of one year at a rate of 4% (i.e. the policy rate minus 2 percentage points). The interest rate on these loans was later reduced to 2.25%, in parallel with our policy rate reduction. We also temporarily decreased risk weights on loans to the healthcare and pharmaceutical industry to stimulate lending.

When lockdowns were announced in Russia at the end of March, the Bank of Russia focused on preserving the smooth functioning of the financial system and on supporting lending activity. Most of our measures were of the regulatory forbearance type. We allowed banks to not reassess the financial standing of borrowers, freezing the requirement to make additional provisions for restructured loans until 30 September. This measure applied to credit to retail customers whose credit was restructured both according to the programmes, established by law, and to other banks’ programmes; credit to small businesses; and credit to large businesses which, before the pandemic, were classified in the top or second quality group.

To encourage banks to sustain lending and to compensate for potential losses incurred by credit institutions due to a temporary decrease in interest income, we also released some of the macroprudential buffers. We fully released the macroprudential buffer on mortgage loans (worth $1.7 billion) and later partly released the buffer on unsecured consumer loans (worth another $2.2 billion). Macroprudential add-ons to risk weights for new mortgages and unsecured consumer loans were also reduced.

By the end of April, global financial markets had steadied and financial stability risks had eased. By that time, real time data pointed to a deep fall in economic activity. The immediate inflationary pass-through effects of a ruble depreciation and the one-off spike in demand for the most popular consumer stables in March proved to be limited at that point of time. They had almost no effect on inflation expectations against the backdrop of a large drop in consumer demand. Furthermore, the pandemic and lockdowns were expected to have disinflationary effects. Therefore, the Bank of Russia found it appropriate to resume and intensify monetary policy easing: its policy rate was decreased to the historically record low level of 4.25% by the end of summer.

Banking sector liquidity was another concern of the Bank of Russia in the second quarter of 2020. This concern had both monetary policy and financial stability implications. As in many other countries, demand for cash in Russia increased dramatically during first few months of the pandemic. The volume of cash in circulation increased by 1.7 trillion rubles ($22.7 billion) in the first half of 2020. As a result, the structural liquidity surplus in the banking sector decreased substantially. The government’s intention to massively increase borrowing might have decreased structural liquidity surplus even further, albeit temporarily. Falling interest rates prompted depositors and banks to switch to shorterterm funding, while credit restructuring extended loan maturity on the asset side of the banking sector balance sheet. To address both of these problems, the Bank of Russia launched one-month and one-year repo facilities, decreased the costs of collateralised liquidity lines (used by systemic banks to comply with LCR requirements), and abolished individual ceilings for such lines for banks.

From the mid-summer of 2020, developing an exit strategy from some of the anti-crisis measures became the major task of the Bank of Russia. By that time, it had become clear that the pandemic would last longer than had been originally expected. Moreover, in many countries a second wave of the pandemic started in September. However, economies and societies adapted to the pandemic to a large extent. Global market volatility declined significantly as a result of supportive measures by major central banks and governments. A stress test conducted by the Bank of Russia showed that the Russian banking sector would be able to sustain stresses even under a severe scenario. The demand for credit restructuring was expected to increase during the potential second wave of the pandemic in Russia. Taking all this into consideration, the Bank of Russia decided to prolong beyond 30 September 2020 only those earlier regulatory forbearance measures that facilitated loan restructuring (until 1 April 2021 for large businesses and 1 July 2021 for SMEs and retail clients).

In the autumn of 2020, inflationary pressures intensified, including those related to the pass-through from the ruble depreciation. The growth of some goods prices accelerated either because of global commodity price increases or due to bad domestic crops and other supply bottlenecks. The support of the Russian government and the Bank of Russia to the economy spurred demand for many goods and services up to pre-pandemic levels, while supply was often lagging behind due to various local and global pandemic-related reasons. Although most of these effects were supply-driven rather than demand-driven, they prompted an increase in household one-year inflation expectations to 9.4% (as of September 2020). Under such circumstances, the Bank of Russia decided to assess wherever additional monetary policy accommodation was needed and took a pause in its policy rate reduction.

Later on, it became clear that the situation was changing even further. The economy adapted to the pandemic and demand continued to recover, supported by government stimulus and expenditure-switching effects from foreign travel to domestic consumption. Low deposit rates pushed consumers towards investing in financial markets and buying durables. At the same time, production and logistical bottlenecks prevented an adequate supply response. Inflation continued to increase. Therefore, the Bank of Russia started to raise interest rates in March 2021.

Policy trade-offs in emerging markets and lessons learned

During the COVID-19 pandemic, the Bank of Russia’s tactics were similar to those in other emerging markets in many respects. There were, however, very important differences. We started aggressive monetary policy easing later and stopped it at a higher interest rate level than many other central banks with similar inflation targets. Our FX operations were limited and rules-based and we have not made any asset purchases – just employed some additional liquidity operations. At the same time, we used regulatory forbearance to a larger extent than many other central banks, and we also started to exit the anti-crisis measures faster than most other central banks.

In the following section, I shall try to explain in more detail the rationale behind these policy choices and assess effectiveness of some of the measures.

  • Monetary policy easing and the effective lower bound

After a formal introduction of inflation targeting at the end of 2014, inflation in Russia was put in check. Average inflation in 2017–2019 was 3.9%, with an inflation target of 4%. This represents a significant disinflation from 8.2% in 2010–2016 and 12.7% in 2000–2010. The inflation targeting regime earned credibility among market participants – analysts’ and markets’ inflation expectations were anchored at the 4% target or slightly below. The inflation expectations of households and businesses decreased significantly, but were still relatively high, and, more importantly, unanchored.

In this situation, the Bank of Russia was able to conduct counter-cyclical monetary policy for the first time in modern Russian history. However, the proper sequencing of policy changes was the main challenge. We had to account for the impact of short-term inflation increases and exchange rate fluctuations on household and business expectations and behaviour. After years of high inflation, Russian households have become used to reacting to significant inflation spikes and exchange rate depreciations by increasing demand for durables and hard currency. This behaviour became much less pronounced in the recent years, due to a decline in inflation and in its sensitivity to the exchange rate. However, households’ behaviour may still be an important factor that limits monetary policy space at times of high volatility and may push up the effective lower bound for the policy rate.

The effect of fiscal policy on demand and inflation was another factor that we considered in our policy discussion. At the onset of the Covid-19 crisis, at the time of the lockdowns, fiscal measures – in particular, social transfers to households and grants to businesses, and regulatory incentives to restructure loans – proved to be more effective tools to support demand in the Russian economy than monetary policy. However, accounting for lags in monetary policy transmission, monetary policy easing had to be started as early as possible to support economic recovery at a later stage, after the removal of tight lockdowns and at the time of fiscal policy normalisation.

Therefore, the Bank of Russia’s monetary policy actions at the beginning of the pandemic were as follows. We kept the interest rate unchanged in March, to stabilise inflation expectations at a time of high market volatility. By the end of April, FX market pressures had subdued. Inflation pressures due to the ruble depreciation and the panic buying of storable consumer goods in March had subdued as well. Our assessment was that the effect on inflation expectations and household behaviour of short-term inflationary pressures was limited. Therefore, we started a monetary policy easing cycle. By the end of July, the key policy rate was decreased from 6% to 4.25%. Lending rates also decreased significantly following the decline in money market rates and long-term bond yields. This supported a fast economic recovery in the third quarter of 2020.

By the end of the third quarter, inflation pressures appeared. We considered these to be of a short-term nature. Compared to the first round in March, the second round of exchange rate depreciation triggered a more significant pass-through effect on prices against the backdrop of recovering demand. In addition, prices of some basic food products started to rise as well, largely due to increases in these prices on international markets. Household inflation expectations rose significantly. At the same time, deposit interest rates reached a record low level. As a result, households started to look for alternative means of savings: structural products, bonds and equities (including foreign ones), and investments in housing.

Under these circumstances, the Bank of Russia decided to take a pause in the policy easing cycle and wait until inflation expectations stabilised. However, economic recovery and inflationary pressures proved to be stronger than we originally expected. Therefore, our assessment as of the middle of February 2021 was that policy easing was over, and in March we increased the interest rate to 4.5%.

Overall, the important lesson from our experience is as follows. Our earlier efforts to earn policy credibility bore fruit. It was our improved credibility that allowed us to implement monetary policy easing during the Covid-19 crisis. Nonetheless, our policy space was more limited than many observers thought. Our effective lower bound for the policy rate proved to be much higher than zero because of still-high and unanchored inflation expectations of households and businesses. However, if we arrest inflation, which currently runs above our target again, and keep it close to the target for longer, this may widen our available policy space should another crisis occur

  • FX operations versus regulatory forbearance of mark-to-market

While inflation targeting is a common monetary policy regime among the major emerging market central banks, their views on FX operations differ substantially. There is a group of more ‘interventionist’ central banks that believe that FX interventions help to increase monetary policy space and provide hedges to the economy in the situation of massive capital flows. Another group believes that, although FX interventions can be used for financial stability concerns, their use should be limited and well communicated. Otherwise, the active use of such interventions could undermine the effectiveness of inflation targeting by provoking markets into thinking that the central bank tends to target the exchange rate rather than inflation. The IMF’s Integrated Policy Framework attempts to identify the conditions under which one or another policy approach is appropriate.

The Russian approach is to consider FX operations separately from the monetary policy framework. As an oil-dependent country, Russia has a fiscal rule that, to a large extent, isolates the Russian economy and markets from oil price fluctuations. According to this rule, the Bank of Russia acts as a broker for the government, converting oil and gas windfall revenues into FX when the oil price is above a certain threshold (about $43.3 per barrel in 2021) and selling an appropriate amount of FX when the oil price is below the threshold. In addition to this, at times of stress we use targeted exchange rate operations, usually in the form of FX swaps or repos, which provide FX liquidity to the banking sector. The Bank of Russia also reserves the right to amend the time schedule of FX purchases done in accordance with the fiscal rule if it is needed for financial stability purposes.

During the Covid-19 crisis, the main financial stability concern was the destabilising effect of the exceptionally low oil prices that were observed in March and April 2020. The fiscal rule helps to stabilise the real exchange rate when oil prices fluctuate. However, it works with a certain lag and it is less efficient at very low oil prices, when non-budgetrelated oil revenues decline significantly. Oil prices fell abruptly, reaching extremely low levels in March and April 2020. Thus, the Bank of Russia had to pre-emptively stop FX purchases and start FX sales in March using the formula that replicated the fiscal rule given the observed levels of oil prices.

Overall gross FX sales from March to December totalled $23 billion, a small amount in comparison with the amounts of FX interventions which the Bank of Russia had carried out during the 2008–2009 and 2014 crises.

Our assessment prior to the Covid-19 crisis was that the Russian banking sector had ample FX liquidity. Therefore, in March we decided not to launch additional FX liquidity instruments, such as repos. At the same time, for precautionary purposes we decided to increase the limit of our stand-by FX swap operations from $3 billion to $5 billion. However, this instrument was not in demand by banks, in contrast to the previous crises, when FX liquidity had been a problem. This can be explained by the substantial dedollarisation of the Russian economy and the banking sector and a light foreign debt payment schedule. The rapid stabilisation of global liquidity conditions was also a factor.

Overall, the key difference between the Bank of Russia FX operations and those of other emerging market central banks during the Covid-19 crisis is that the FX operations in Russia were relatively small and addressed the effects of oil price volatility rather than capital flow volatility. What can explain the success of the Russian approach? There are several hypotheses. First, the oil price volatility that we target is correlated with capital flows to Russia anyway. Second, Russian foreign debt is low by international standards, so the size of capital outflows is relatively modest. (In March, a sell-off of government securities by foreign investors totalled $3.5 billion, equal to 10% of the total holdings of non-residents.) Finally, regulatory forbearance measures that the Bank of Russia implemented in March 2020 prevented an asset fire sale by Russian financial institutions and even prompted them to purchase assets from foreigners at low price levels, thus stabilising the Russian financial markets. At the time of extreme volatility, the Bank of Russia allowed financial institutions not to mark assets on their balance sheets to market prices, but to use pre-stress fixed asset prices instead. In March 2020, a regulatory forbearance measure allowed banks and other financial institutions to use the ruble exchange rate and asset prices as of 1 March 2020. This decreased the sensitivity of bank balance sheets to market fluctuations and created additional capacity for banks to buy assets at low prices.

  • Asset purchases versus liquidity provision and special liquidity facilities

In contrast to many other emerging market central banks, the Bank of Russia decided that asset purchases were not justified during the Covid-19 crisis. Our reasoning was as follows. Inflation targeting in Russia was relatively new, so unconventional policy could have damaged the credibility of our monetary policy. Moreover, the Bank of Russia did not perform asset purchases as regular monetary policy operations. In our operational procedures, we used repo operations instead. Therefore, asset purchases could have confused the markets, undermining our credibility and provoking suspicion of fiscal dominance. Besides, due to the low level of government debt and cautious monetary policy at the onset of the Covid-19 crisis, the Russian bond yield curve, while moving up, still did not become outrageously steep by historical standards. Markets functioned smoothly, supported by the regulatory forbearance measures described above. The yield curve went down quickly once the period of extreme volatility ended. Therefore, asset purchases by the Bank of Russia were not justified for financial stability concerns. In Russia, extra Covid-19-related government debt issuance was purchased by local banks that were interested in floating-rate bonds for interest rate hedging.

Instead of asset purchases, the Bank of Russia provided special liquidity instruments to address the potential vulnerability of banks’ liquidity amidst the increased volatility of government borrowing and spending and as demand for cash increased in the Russian economy. We launched monthly and annual repo auctions with a starting interest rate equal to our policy rate plus 0.10 percentage points and policy rate plus 0. 25 percentage points, respectively. While initially the market suspected that these liquidity lines would be used for de-facto central bank financing of government debt, the actual use of these facilities was rather low and narrowly concentrated during the period of a temporary liquidity gap, when the government accumulated significant liquidity on its account at the central bank, not being technically ready to quickly spend it on budget appropriations. In addition, we decreased the costs of access to uncollateralised liquidity lines from 0.5% to 0.15% and abolished individual limits on these lines for banks.

  • Communication policy

The Bank of Russia considers communication to be an important monetary policy and financial stability tool. As far as monetary policy is concerned, the goal of our communication policy is to subdue market reactions to interest rate announcements and thereby smooth yield curve changes. Therefore, while making decisions on interest rates, we also signal our views on future policy to the markets. At the same time, we try to avoid an interpretation of our signals as commitments. We believe that such commitments can be counterproductive at a time of high volatility, and may even increase volatility of the yield curve. As far as financial stability is concerned, out main task is to improve market confidence. We modified our communication policy, making it more focused and intense in April and May 2020. The Governor of the Bank of Russia held regular weekly press conferences, where she provided our up-to-date assessment of the situation in the economy and in the financial system. She announced new support policy measures when it was necessary and shared monitoring data on the implementation of earlier measures, including on credit restructuring. The conferences were also accompanied by the publication of a weekly analytical review, The Financial Pulse, which contained all relevant information in a succinct format. These conferences played an important role in preserving the confidence of the market.

To better and more quickly assess the situation in the Russian economy, in addition to statistical data, we started using our new in-house index of financial flows to and from various industries based on real-time payment data. We have also been using the results of weekly company surveys conducted by our regional offices. This has helped to improve confidence in central bank policies as well as economic trends in general, and has had a positive impact on market stabilisation.

Conclusions and challenges ahead

To sum up, Russia’s policy response to the Covid-19 crisis and the financial sector reaction to it was different from previous crises. During 2008 and 2014 crises, monetary policy space and policy choices of the Bank of Russia were limited because of high household inflation expectations and the failure of a number of weak banks. Inflation targeting and a strengthening of the financial system through better supervision and the clean-up of the banking system of weak banks laid a foundation for a different policy response in 2020 in comparison to previous crises. The Bank of Russia was able to act countercyclically during the Covid-19 crisis and ease monetary policy. We complemented this by stimulating banks to restructure loans and increase their credit activity through regulatory forbearance and the release of macroprudential buffers.

In combination with the government support to the economy, our policy mix sustained credit activity, preventing a credit crunch. In the second half of the year, credit activity rebounded in all key market segments. The government’s mortgage rate subsidy programme supported fast growth of new mortgages. Thanks to the programme and overall low interest rates, the weighted average mortgage rate decreased by 1.7 percentage points to a record low of 7.3% since the beginning of 2020. Corporate credit grew by 9.9% last year, while SME credit grew by more than 20%.

The Covid-19 crisis showed that the policy framework set up in the last five to seven years in Russia was a key precondition for the ability to conduct counter-cyclical policies in 2020. This framework includes inflation targeting, a floating exchange rate and a welldeveloped set of financial stability instruments, as well as general measures to strengthen local financial markets. Budget policy should also get its due credit: Russia has one of the lowest government debt levels in the world and a budget rule that largely isolates the economy from oil price fluctuations. However, formidable new challenges lie ahead.

The recent acceleration in inflation has shown that rapid recovery of demand boosted by monetary and fiscal support can lead to a quick build-up of inflationary pressures and a sustained rise in inflation expectations. Supply disruptions and constraints facilitate this process. Thus, we need to find a proper balance between containment of price stability risks and the need to support further economic recovery when setting monetary policy in the near future.

The trade-off between financial stability and regulatory policies poses another challenge. We still need to ensure that the financial sector keeps operating smoothly and financing economic recovery. We have already started gradual withdrawal from temporary regulatory forbearance measures. We need to properly account for this effect in our monetary policy decisions and release some regulatory macroprudential buffers to support credit. In essence, we need to carefully balance short-term and long-term goals.

All of this means that the proper design of exit strategy and tactics is the key challenge for central banks and financial sector regulators in 2021.

Author’s note: I thank Alexander Morozov, Elizaveta Danilova, Alexei Zabotkin and Elvira Nabiullina for their comments and suggestions.