CIAO DATE: 6/99

Rebuilding Russia Initiative: Economics Discussion Group
Discussion Paper # 1 _*

November 2, 1998

EastWest Institute

In response to the current economic and political crisis, the EastWest Institute (EWI) has launched a new ambitious, multi-year Rebuilding Russia Program. The Program’s objective is to serve as a bridge between two groups of thought and action leaders united by a common interest in rebuilding Russia’s economy and restoring its political stability: 1) the broadest possible center of Russian policy makers, economic experts, and business leaders, and 2) concerned Western policy makers, strategic investors, and non-government thought leaders with a stake in Russia’s economic and social development.

A central part of the Rebuilding Russia Program is the Economics Discussion Group, which serves as a forum for exchange of opinions on current economic developments in Russia and plays the role of a virtual, organic task force on economic policies in Russia. The group’s analyses and policy recommendations are published as Discussion Papers and disseminated among a selected group of public and private sector leaders in Russia and the West.

In October, the EastWest Institute held its Board meeting in Moscow and conducted a series of meetings with Russian government and parliamentary leaders, economists, business people, and young leaders from all sectors of Russian society. Although speakers’ policy prescriptions and predictions varied considerably, the roots of the current economic crisis were broadly identified. There was less agreement, however, on what needs to be done to set Russia’s course toward a more socially oriented market economy.

In this first Discussion Paper, we begin to survey the main problems and related solutions identified by some of the major stakeholders in Russia’s economic and political revival: the government, parliamentary factions, domestic and Western thought and business leaders, multilateral institutions and prominent policy experts. Our aim is to find common ground, if possible, among these often disparate points of view and to stimulate a debate about Russia’s economic choices that moves beyond finger pointing for past failures towards a constructive discussion of the way forward.

 

Roots of the Crisis

1. The current ‘fiscal’ and ‘monetary’ crisis signaled, above all, the collapse of the ‘real’ economy The country’s industrial base has been steadily imploding since the last years of the Soviet era. In the current decade, manufacturing output has shrunk by more than 50%. This decline in real production has a number of causes, including inter alia:

   1. Disruption of ancient trading relationships through dismemberment of the Russian (not just Soviet) empire. Arkady Volsky, the influential Chairman of the Russian Union of Industrialists and Entrepreneurs, gave as an example the textile industry. Uzbek cotton, which had been a captive source for Russian textile mills for 250 years, is now sold at world prices to Western buyers and the mills stand idle. The trend of disengagement from previous high levels of dependence on Russia is accelerated by the devalued ruble. Moldovan agricultural exports to Russia are no longer commercially viable. (Moscow, however, tries to leverage energy supplies and control of trade outlets to retain its sphere of influence — the recent acquisition by Gazprom of 51% stake in the Moldavian national gas company points in that direction).

   2. Obsolescence of Russia’s manufacturing base . This is not only a matter of physical deterioration through lack of capital investment. It also reflects the unsuitable location and configuration of much of Russia’s industrial infrastructure in relation to both domestic and international markets. In a production-driven ‘command’ economy, it did not much matter where factories were sited. In a market economy, particularly one in which global patterns of production predominate, proximity of production to sources of supply and customers is an important consideration. On that criteria, a large part of Russia’s existing industrial base is a write-off, incapable of attracting foreign direct investment for its renovation.

   3. Unsustainable exchange rate policy. As a country relying heavily on commodity exports, Russia may have been slow to devalue the rouble in a period of falling world commodity prices (Canada and Australia provide a model of gradual devaluation that averted a major current-account setback.) The overvalued ruble was also one of the reasons for contraction of domestic production: it made it more profitable to import goods than to produce them.

2. The collapse of the ‘real’ economy was disguised for several years by various means , including:

   1. Pyramidal issuance of short-term debt by the Government. The GKO market, whose collapse triggered the current crisis, financed budget deficits averaging 8% of GDP in the past three years. Such deficits did not merely reflect ineffective tax collection, as IMF strictures seemed to suggest. Rather, they revealed the disappearance of any taxable base of viable enterprises. The speculative bubble created by spiraling short-term GKO interest rates diverted liquidity into the financial sector, starving the ‘real’ economy and hastening its demise. It also warped the development of the financial sector itself, turning the ‘banking’ system into a series of speculative enterprises more akin to hedge funds. A critical component of any market economy, independent and efficient capital intermediation, was therefore stifled at birth. The result is a substantially de-monetized economy, in which an estimated 75% of inter-enterprise transactions are via barter.

   2. Perpetuation, throughout most of Russian industry, of “soft” budgetary constraints — in fact, ‘soft’ prices, ‘soft’ taxes, ‘soft’ credits and ‘soft’ subsidies. Indeed, the provision of these subsidies and credits, and the failure at an early stage to get serious about tax collection, go a long way to explain the government’s chronic fiscal deficit. Tax collection in 1998 stood at 6% of GDP, compared to 10% in 1997. As a result, the ‘Red directors’ of the military-industrial complex have continued business as usual, largely insulated from the real pressures of a market economy. Company managers remained more concerned with preserving jobs and soft budgetary constraints than producing profits.

   3. An abundance of exportable natural resources, for which world prices remained relatively high in the early years of the transition. The collapse of world commodity prices (especially for oil and gas) in 1998 deprived the government of its single largest source of hard currency reserves: 70% of reserves in 1997 derived from oil and gas exports. Faced with a deteriorating balance of payments, some members of the government espoused modest devaluation as early as March ’98, but were overruled by the IMF and a primary focus upon a strict anti-inflationary monetary policy. The Asian crisis then raised the ‘risk premium’ demanded by international investors and domestic debt service rapidly became unsustainable (35% of government revenues went to interest payments on internal debt in 1998).

3. The collapse of the real economy was hastened by the failure of ‘privatization. ’ The ‘commanding heights’ of the Soviet economy are still under state ownership. Large tracts of industry remain under the control of ‘red directors’ who only grudgingly acknowledge ‘market reforms.’ Where ‘privatization’ has occurred, it has occasioned massive asset stripping by a new, politically powerful class of national and regional ‘oligarchs’. Most of these had no interest in or aptitude for industrial management, and made no serious attempt at industrial investment or restructuring. Instead, they siphoned cash from their enterprises (‘tunnelling’ in Czech parlance) for transfer abroad. Estimates of capital flight vary from $80 billion to $300 billion.

4. Corruption is pervasive . While it is fashionable to lament the absence in Russia of the ‘rule of law’ (i.e. as a means of protecting property rights, enforcing contracts, assuring the rights of minority investors, etc.), there is a sense that this reflects not only institutional immaturity but a fundamentally different sense of the societal role of law and the justice system in Russian history and culture. Russians are conditioned to view ‘law’ less as a source of protection for individual rights than as an instrument of state power, exerted from above (see section III below for further comment on ‘rule of law’ in Russian society and culture). To that extent, an immature and dysfunctional legal system may be regarded by some as enlarging, rather than limiting the scope for individual action. In addition, there is a growing sense that the post-communist legal order was seriously weakened when Yeltsin forcibly crushed his Parliamentary opposition in 1993. Although portrayed sympathetically in the Western press at the time, it is widely seen by Russians as having undermined the constitutional order and, at least until the State Duma’s recent reassertion of power in rejecting the nomination of Chernomyrdin, as having delivered largely unchecked power into the hands of the Executive. In Russia as elsewhere, this proved a prelude to widespread official corruption.

5. The August 17^th ‘default’ was ill-considered and deeply damaging. Across the political spectrum, there is broad consensus that the Kirienko government’s Aug. 17th decisions to simultaneously devalue the ruble, restructure the GKO’s and freeze external commercial debt service were a national disaster that has severely damaged the country’s credibility in international capital markets. It will take years to rebuild investors’ lost confidence. In the meantime, any Russian government’s space for fiscal maneuver has been drastically limited.

 

Policy Prescriptions

The following policy measures were recommended by a variety of Russian economists, business leaders and politicians with whom we met in Moscow:

1. Monetize the real economy . There is a broad consensus among the political elite that, in the current emergency, the first task of government and the Central Bank must be to ‘prime the pump’ of the ‘real’ economy (as distinguished from the speculative, purely ‘financial’ economy which has prevailed over the past few years). Sergei Glaziev, one of the principal advisors of DPM Maslyukov, called for injection of ‘liquidity’ directly into the productive sector, in order to provide working capital and re-start activities capable of generating profits (which in turn will produce tax revenues). To prevent inflation, he urged that the velocity of money be reduced by offering state guarantees for saving deposits and creating new opportunities to save (for example, gold coins). According to others, the lost public confidence in the banking system will channel any monetary emission into a higher inflation as households and firms “escape from money” and increase, rather than reduce money velocity. It is also far from certain that a liquidity injection through an unreformed banking system and corrupt public administration will end up in the coffers of enterprises and not in overseas bank accounts.

2. Reform the tax code . The government was driven to the short-term debt markets because it was unable to collect enough taxes to cover its budget deficit. The tax system is narrowly based with punitive tax levels and numerous, conflicting tax regulations. These have encouraged ‘grey market’ economic activity outside the tax net, and have precipitated capital flight. There are calls for dramatic simplification of the tax code, most frequently a ‘flat tax’, coupled with a steep reduction in the rate of taxation. These are aimed not only at reducing the burden on enterprises but encouraging the repatriation of flight capital. Proposals for tax amnesty are also aimed at allowing ‘black’ and flight capital to recirculate. The largest impediment to enhanced tax collections, however, is the economy’s primary reliance on barter transactions, making it impossible to raise cash from economic activity conducted mainly ‘in kind’

3. Re-start the government securities markets . Former DPM Alexander Shokhin proposed an urgent agreement between the Government and State Duma on a national economic recovery plan, which would call inter alia for a 2-3 month hiatus in servicing the national debt, a ‘breathing space’ in which the government can catch up on wage and pension arrears (a top priority of nearly all with whom we met). The government securities market should thereafter be revived on the strength of promises to return to fiscal and monetary discipline in 1999.

4. Political mobilization of the ‘new middle class’ . Russia’s biggest asset is the entrepreneurial spirit and personal energy of its young and highly educated millions. One positive effect of the current crisis is to reinforce their sense of self-reliance. Nevertheless, many members of this new middle class, particularly those in the financial and service sectors, are losing their jobs. How they react to renewed insecurity and enforced idleness will be a key to the development of the political situation in Russia. Estimates of their numbers range from 7 to 10 million. If they turn their energy and entrepreneurial abilities toward political organization, a new ‘middle’ force may arise that could help shape a truly reformist government. Beyond politics, this entrepreneurial class must be allowed not only to survive but to grow: only 12% of Russian GDP currently is produced by small and medium-sized enterprises (SME’s), compared with 20-25% in most advanced industrial societies. Strengthening of the SME sector is especially critical if real industrial restructuring is to begin: the capacity of the SME sector to create jobs and absorb labor shed from state enterprises (not to mention the creation of taxable profits) has been repeatedly demonstrated in Central European transition economies.

 

EWI Staff Analysis and Commentary

1. Some in Russia claim that the current crisis demonstrates the ‘failure of market reforms’ and others say that ‘only capitalism as practiced in Russia could make Soviet communism look good’. The truth, which must now be communicated to the Russian people by any government bent on creating a market economy, is that only the most superficial ‘market reforms’ have so far been attempted in Russia. In that context, the state’s failures (for example) to implement meaningful tax and bankruptcy reform are only symptomatic of its general unwillingness to challenge vested interests in the military-industrial complex and to set loose the social dislocations which inevitably accompany large scale economic restructuring. The root of the problem is therefore lack of political will rather than institutional weakness, insufficient regard for the ‘rule of law’ or similar deficiencies (though these are all critical issues to be addressed as Russia moves forward). As indicated at the outset, the key to the outcome of the current crisis will be whether a government with the political will and ability to implement real reform can emerge from the prevailing instability. The striking reluctance of the Primakov team to articulate any economic recovery plan speaks volumes about their own sense of insecurity and impermanence, although astute observers cautioned not to underestimate Primakov’s personal staying power or his appetite for power (including the Presidency).

2. Cutting across the different economic proposals is the question of fundamental institutional weakness in Russia. Lack of transparent and enforceable “rules of the game” negate even the most coherent reform program. Russia’s fundamental problem may therefore be sociological rather than ‘economic’ or ‘political’ — a historically determined set of social institutions, cultural norms, moral attitudes, and conventional practices that appear to impede (or at least significantly complicate) a socio-economic transformation of the type undertaken in Central Europe. Citizenship norms are second to communal norms when determining individual behavior. ‘Public servants’ do not serve the public, but see government service as an opportunity to pursue short-term personal gains. For this and many other reasons, Russians do not trust or respect the state as a regulator of economic activity.

   A recent survey of society’s tax culture, recounted in the October 8th EWI Russian Regional Report, found that the overwhelming majority of taxpayers perceive the tax system as a structure standing above the law, creating its own rules of conduct for others and controlling the execution of those rules arbitrarily. 83% of taxpayers felt that tax collectors can cause problems for any entrepreneur they choose to harass. Another 81% of respondents asserted that the complete payment of all taxes by an enterprise would cause the firm to go bankrupt. The public therefore believes it is morally and economically acceptable (even imperative) to violate tax legislation on a massive scale. This attitude reveals the weak institutional base for any sensible economic reforms, especially when orchestrated by the state. It will take more than the “right” economic policy blue print to rebuild Russia: it will require actually building institutions and sponsoring social practices than can make that blueprint work in reality.

3. In the short term all energies must focus on regaining macro-economic stability. The daunting long term challenge is to re-invent a micro-economy which can not only supply domestic needs but compete internationally. Doing so will require large scale restructuring of Russian industry. As indicated above, prospects for the rehabilitation of large parts of the existing industrial infrastructure are negligible. Even if Russian plants were operating at peak efficiency, and were in ideal locations to serve their targeted markets, their competitiveness would be in doubt as a result of a global over-supply of the low and medium-tech industrial assets which Russia possesses. The role of low-tech, low-cost ‘maquilladora’ to Western Europe has already been claimed by Central and Eastern Europe. Russia therefore contemplates a choice: either to invest in a 21^st century economy, leveraging its deep national resources of intellect, mathematical and engineering talent and skill, rapid acceptance of the most advanced information technologies, etc., or (in the words of more than one Russian commentator) "to become Nigeria", in the sense of being primarily dependent upon the export of natural resources (the prices of which are, in current markets, severely depressed). Even if energetically pursued, the first path will take time. For the immediate future, therefore, Russia’s self-sufficiency will depend to an uncomfortable degree on international commodity prices.

 

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Endnotes

*: This Discussion paper was prepared by an EWI team led by Rick Petree and including Rado Petkov, Robert Orttung, Allen Collinsworth and Dan Mucha. We invite your response and insights on the Russian economic crisis, including criticisms or disagreement with what you read here. Please address your questions and comments to Rado Petkov at 212-824-4133, rpetkov@iews.org. For analysis on how the economic crisis affects Russian regions, please see the EWI Russian Regional Report at www.iews.org. Back.