Moldova & IMF IMF Activities Publications Press Releases


Weekly Newspaper "Chisinau Observer"

Thursday, May 29, 2008

Johan Mathisen: "To lower inflation, one needs to dampen credit growth"

Interview with IMF's Resident Representative in Moldova

- At the moment, fighting inflation is the cornerstone of financial policy in Moldova, which was coordinated with the IMF. Nevertheless prices grow at "shock" rates. At the same time, lending interest rates increase, which, naturally, affects the local producers’ possibility to develop. Why does fighting inflation appears to be more important than industry revival?

- I understand this concern. It is very difficult to fight inflation in such environment. But if we speak from the point of view of economic activity, it is necessary to go back and to explain why inflation is bad, indeed. It is a question of balancing long-term and short-term objectives. It is necessary to find a compromise because for the short-term the decrease in interest rates might increase production . But the experience of other countries shows that practically immediately such actions lead to the growth of prices, wages and of various other costs in the economy. That means even higher inflation. Going this way would result in decreased investment inflows, lower growth and less well-being of citizens.

If we look at the level of crediting in Moldavian economy, it is rather high. Last year total crediting grew by almost 52%. At the same time, the national currency got stronger. I did not analyze the situation in Moldova since independence, but if you look at the last five years it is obvious that such growth is record-breaking. It means that there is no shortage of means for crediting business. Actually, probably one can argue that on the contrary there is too much credit in economy, and loans are too easy to get. Certainly, we are not talking here about stopping crediting, but it is necessary to just dampen growth.

- Why attract even more foreign investments if you are saying that there is enough money in the country and under favorable conditions local business can invest it itself? And then local business will develop rather than foreign business.

- Actually here the issue is not the money supply as such or resources for crediting. The idea is that, according to the experience of other countries, in particular new EU members, foreign investors by themselves or in cooperation with local businessmen bring into the country not so much money but capital, which includes knowledge, established trade links, new technology. And, consequently, foreign investments lead to faster development of economy. The overall level of investments into the Moldovan economy last year was 1/3 of GDP.

If we compare Moldova to the countries with similar situation, namely with the countries with low and average level of income, here the situation is somewhat better than in other countries. And this indicator is significant enough. Especially if we pay attention that since independence till 2004 the average total amount of investments was 18% a year. Thus, we witness a sharp change of situation and very strong growth of investments.

Today it is not a question of reducing investment growth or stopping investment – investments are necessary, both domestic as well as foreign ones. The challenge is to try to dampen domestic demand to ensure long-term and midterm sustainable economic growth. When we speak about measures which could be implemented to lower inflation, we do not necessarily refer to a distant perspective. The experience of other countries shows that if there is will and appropriate measures are taken inflation can be lowered literally in several months. Once inflation decreases and the situation is stabilized, interest rates will quickly come down.

- Did I understand you right that measures for fighting inflation lead to rapid growth of foreign investments, so that local business is slightly frozen, and foreign business gains in strength, especially if we take into account that foreigners have access to much cheaper financial resources?

- No. We probably need to try to define what investments are. Because there is some misunderstanding in the public about the difference between direct foreign investments and private investments. Foreign direct investments is a concept related to the balance of payments, these are monetary flows coming to Moldova as income - for example, when a private foreign investor buys some firm and the building where it is located. These operations are not reflected in statistics, in national accounts. It is not a direct foreign investment because the money was used to buy a building that was already there. Production extension, new buildings will be reflected as the direct foreign investments. And for the national economy it is very important that it is the level of direct foreign investments that grows, in the sense as it is reflected in national accounts.

- But local business can build or expand production if they have access to resources.

- This is not a win-lose situation. Experience of other countries shows that when foreign investors come and start to develop on territory of the country by themselves or in cooperation with local business, if they are effective in their activity it tends to increase productivity and income in the economy as a whole. Economists use such concept as "the general pie". Very often the public thinks that the economy is a kind of slicing a pie. But actually it is not absolutely accurate. Because when the economy develops, the pie grows. At the same time, if no measures are taken to fight inflation, the economy stays at the current level, it might even grow. But then the flow of foreign and local investments can decrease.

Therefore it is necessary to ensure macroeconomic stability, so that any businessman could plan his actions without the need to factor in measures to prevent the uncertainty risks. Here again we come back to the beginning: the volume of crediting grows in the country too fast and it is a concern for us. During discussions with Moldovan authorities we have come to the conclusion that they are also concerned.

When we analyze these things we operate with such concepts as supply and demand. If constant inflow of money to the economy compensates constant demand growth, then we end up with higher inflation and price growth. Let me give you an example. Let’s assume that there are 10 kinds of goods in the economy, and the price for each of them gradually grows every month. But during a certain period the price of one kind , say of fuel grows faster than the price of the others. And if there is enough money in the economy accommodate this supply, that is people are capable to pay this price, we would end up with a general increase of prices. It is much more preferable that this increase of prices is not compensated fully. It can be done only by containing the growth in money supply. That is, in order to keep a low rate of inflation it is necessary that the prices of other kinds of fuel grow more slowly than before. The only way to achieve it by monetary means is to dampen the growth of crediting, that is the possibility of having more money in circulation.

- But while we aspire to macroeconomic stability and we do not allow production to grow, mostly speculative investments come into the country. As a result, trade grows almost exclusively. They build mostly trading complexes to sell imported goods. And thus we continue to support foreign manufacturers.

- What you call “speculative investments” are actually profit driven investments, which are a common European practice. If we have a look at Europe we can see that there investors are interested first of all in the financial sector: banks, insurance companies. And trade, where it is possible to be competitive due to wholesale deliveries. Yes, the consumption level in Moldova grew very sharply last year. But growth of consumption is an obvious sign that it becomes more profitable to sell in this market, just because the economy is growing. Bu definition, GDP is the general level of production, which should be equal to the general level of income. A large share of aggregate income is used for consumption in practically all countries.

- But the gap between export and import keeps growing in our country. How effective are traditional inflation-fighting measures in Moldova, bearing in mind that most inflation is imported? Wouldn’t such monetary policy promote an even wider gap? Import grows, and consequently prices grow?

- Actually, it is the other way round. Demand very quickly grows in an open small economy, and it is followed by a sharp growth if import. And to some extent investments grow just as quickly. It is expected that this year investments will exceed $2 billion And most investments probably have a high import component. For decrease import it is necessary to try to dampen demand. For the fiscal sector, this means that it is necessary to spend less that it is earned. And from the point of view of private sector it is necessary to dampen the growth in demand. Actually there are only three ways which make it possible to achieve this. These are: increase of interest rates, increase of the level reserve requirements and stability of the exchange rate. During the last years the exchange rate in Moldova has really changed, which is good for consumers. This phenomenon can be observed in all countries in the region. From the point of view of national currency import becomes cheaper. And it is logical that import grows.

- But this way local producers are restrained by high lending rates , while private consumption of import is not restrained – a growing flow of remittances keeps coming.

- Money transferred as remittances from abroad does not influence the economy very much. If all this money is used for consumption of import then the money comes from abroad and then it goes abroad again. If the interest rate increases however, many of the people who would buy, say, an imported car, would get an additional incentive not to spend money, but rather to save it by placing the it in a high-yield deposit. And the money remains in the country then. This money will be used for the development of economy. Banks can use this money as credits. On the other hand, for enterprises it is more advantageous to use money they have, reinvest it, rather than keep it in a bank.

As experience shows, the only opportunity to lower interest rates and to achieve efficiency of economy after decrease is to lower inflation first. For example, let’s see what happened in Poland during the last 8 years. Inflation in 2000 was approximately 20%. To fight high inflation interest rates went up to 24-25%. Inflation decreased below 10% in several months, and for the last 5 years inflation did not rise above 5%. And interest rates went down too. Now they are below 10%.

- But there are also other examples. Bulgaria: growth of consumer prices – 7.8%, the refinancing rate of the Central Bank – 3.9%, Lithuania: prices growth – 5.4%, refinancing rate – 4.8%, Latvia: inflation – 9.6%, the refinancing rate – 5.8%. Why is inflation 12.5% and the rate of refinancing of NBM 15% in Moldova?

- To get an accurate picture when you compare these figures ypu need to look also at the credit growth. And then you will see that in Moldova crediting grows much more quickly than in these countries. In Moldova the volume of crediting has grown by 52%. And the overall money supply monetary by more than 40%. It is a lot. To fight inflation it is necessary to dampen growth in demand.

- This insistent policy of IMF applied to all countries very much reminds of centralized Soviet planning.

- It is very seldom that the IMF is accused that their policy reminds of the centralized system of planning. The hope that bringing down interest rates will lead to increased productivity, which would lead to lower inflation is a myth. It is related to a group of theories which work only with the supply side and has deep roots.

You see, there are many people, including top officials, who favor the decrease of interest rates when inflation is high, and not only in Moldova. And this reasoning is typical for former Soviet republics. Because attention is paid only to the supply side: supporting producers and production. Certainly, lower interest rate will fuel production, but it is necessary to take in consideration the demand side to see the full picture. With such a high level of credit growth, spending increases more than production, hence we have higher inflation! Look, the increased production cannot keep up the pace with the increased demand fuelled by the credit boom, as there is too much money chasing too few goods..

The alternative is to contain credit growth—through tighter monetary monetary policy—in order to balance money supply with available goods. This worked well in the pre-EU accession countries, why not here?.

Irina Astakhova