© 2000 John Petroff  

 Indeed, Russian annual interest rates in 1995 have been close to 100%, down from twice that amount in the previous year. The drop is entirely attributable to the slowing inflation rate. Some countries, such as those of Latin American in particular, have learned to manage with very high rates of inflation. Nowadays, economists agree that inflation is generated by government budget deficits and monetary policies to finance these deficits, much more than by price increases in free markets. While being the cause of inflation, governments also feel that it is their duty to avoid policies that are inflationary, and thus, they try to bring stability to their currency. Although some prominent economists question that any harm comes from inflation as long as it is correctly anticipated, it is clear that in financial matters, the accuracy of financial assets valuation depends to a great extent on the selection of a discount rate that is precise and accurate. One will recall from the first section of this chapter, that nominal rates are used in valuation of financial assets.

If it is not possible to rely on an accurate discount rate, then, errors in valuation of financial asset are unavoidable. When inflation makes up nine tenths of the interest rate, and is changing from month to month, it creates such a distortion that other elements play a trivial role, and financial valuation is undermined. This explains why, in Russia, only short-term contracts are based on current ruble market interest rates; and this will continue as long as inflation is high and unpredictable. Moreover, the practice of variable or indexed rates is not used today in Russia. There are very few Russian contracts that are long-term. Those that are long-term, are currently stipulated in ruble equivalents of U.S. dollar, so that only moderate rates of inflation are present in these time payments: that of the dollar.

This is a workable alternative, but it requires an acceptable future average rate of long-run inflation of the dollar. One can suggest the long-run annual inflation rate in the United States over one century, which has been estimated (by Ibbotson, see Table T-2.1 to be in the order 3.1%. The choice of moderate inflation rate can be very acceptable to the extent that all comparative evaluations are also based on the same assumption of inflation.