CIAO
From the CIAO Atlas Map of Europe 

email icon Email this citation

CIAO DATE: 6/99

Rebuilding Russia Initiative: Economics Discussion Group
Discussion Paper # 2 *

December 10, 1998

EastWest Institute

As part of the Rebuilding Russia Initiative of the EastWest Institute (EWI), the Economics Discussion Group 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 includes prominent Russian and Western policy makers, economic experts, and business leaders, united by a common interest in rebuilding Russia’s economy and restoring its political stability. The Discussion 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. The current paper discusses the latest economic program of the Russian government and offers policy recommendations on enterprise restructuring, tax policies, and banking sector reform.

 

I. The Government’s Economic Program: Worthy Ends, Uncertain Means

The long–awaited economic program of the Russian government and Central Bank was published on November 15th. It articulates the main principles of the Primakov government’s economic policy and describes plans to strengthen the state’s role in "shaping and developing the market and its social orientation". The overarching goal of the program can be summarized as “transition of the market economy to socially oriented economic growth.” 1

Earlier drafts of the economic program, leaked as trial balloons, were widely criticized for the interventionism exemplified in proposals for capital and price controls, national industrial policies, and lax monetary and fiscal regimes. The program published on November 15th appears to heed elements of that criticism, and articulates general policies capable of attracting guarded support from Western observers. The "devil is always in the detail," however, and the program is notably short on detail.

One policy nevertheless appears to be definitive: the section on "Creating the conditions for the stable functioning of the economy" pledges to "hold inflation in 1999 to a level of not more than 30 per cent." The government and Central Bank propose to achieve this by "rigorous control of the prices for the output of natural monopolies, refusal to allow abrupt movements in the floating ruble rate, and increasing the supply of goods to cover the demand of those able to pay." The efficacy of those policies, however, is doubtful:

  1. Administrative control of energy prices will have little direct effect on inflation since domestic energy deliveries are rarely paid for in cash—when they are paid for at all. Moreover, controlling energy prices may exacerbate the fiscal deficit, with adverse effects on currency stability, inflation and renewed access to the embargoed IMF facility. Under current rules, energy suppliers are permitted to offset receivables (“arrears”) for energy delivered to the state sector against their tax liabilities, and artificial restraints on energy prices will simply prolong the availability of such offsets. To the extent that enhancement of tax revenues is a prerequisite for restoration of fiscal equilibrium, controlling energy prices is therefore likely to prove counter–productive. Moreover, it will continue to cosset insolvent enterprises whose disappearance or restructuring is, independently, an important objective (see Section II.1 below).

  2. Capacity to manage the ruble float depends inter alia on the country’s foreign reserves. Given the state of foreign investment sentiment toward Russia, the collapse of the domestic banking system, and the uncertainty surrounding future IMF or other international financial institution transfers to Russia, such reserves must largely be earned in international trade. Russia is almost entirely devoid of internationally competitive products for export, apart from natural resources (and even those are believed to be produced and transported on a non–economic basis). Export–led hard currency reserve growth therefore depends on comprehensive industrial restructuring and enterprise level reforms, which will in the best case take much longer to achieve than the time frame relevant to the government’s economic program.

  3. Targeted measures to “enhance industrial production,” possibly including elaboration of a wide range of existing soft subsidies and credits, may simply prolong the death agony of Soviet industry. Most industrial enterprises in Russia remain production–driven facilities exempt from market disciplines including the need to sell output to real customers for cash, or to show a profit. The Primakov plan’s emphasis on industrial production, as an end in itself, therefore may hark back to Gosplan. Any plan aimed at increasing industrial output should approach that goal as dependent upon a larger process of market reform based on: (i) wholesale industrial reorganization, involving inter alia acknowledging the insolvency and irremediable dysfunctionality of large parts of the existing industrial base; (ii) restructuring and renovation of a minority of existing enterprises which may be viable in a market economy, and (iii) improving the marketability of the output, with particular emphasis on export markets.

The other main sections of the Russian government’s economic program address:

  • Normalizing the population’s living conditions. Measures to improve the availability of essential foodstuffs and medicines include reduced import duties and price controls, debt relief for domestic producers of such items and compensation to poor citizens for price increases. The need for such measures is underlined by the fact that the financial crisis has pushed 30% of the Russian population below the poverty line (a monthly subsistence wage of Rbs 522). The federal government is unable to finance such measures on more than a temporary basis, however, and their continuance will likely occasion monetary ‘emissions’ with inflationary consequences. Again, the real economy must start working to provide for employment and pay salaries that will allow people to feed themselves.

  • Restoration and development of the real sector. This part of the November 15th program addresses a fundamental problem of the Russian economy: the collapse of domestic production due to lack of enterprise restructuring and inefficient corporate management. The section rightly emphasizes the need for tax reform aimed at broadening the tax base, lowering the tax burden on producers, and decreasing the general level of indebtedness (the latter being a major propellant of the barter economy). The government plans to lower VAT rates from the current 20% to 15% in 1999 (with 1% going to finance agriculture and the coal industry), reduce profit tax from 35% to 30%, and decrease the employers’ social security contribution from 39.5% to 32%. Mutual settlements are intended to reduce inter–enterprise arrears (again, aimed inter alia at dismantling the barter system and re–monetizing the economy).

    The program gives short shrift to streamlining and accelerating bankruptcy procedures, which (as discussed in Section II.1 below) is a crucial element in corporate restructuring. The program mentions bankruptcy as only one of three ways of dealing with insolvent enterprises. The other two are 1) official rescue, and 2) "transfer of a controlling block of shares of the debtors to state ownership, to be followed by the transfer into management in trust or re–privatization." There is a real danger that, under current Russian conditions, the latter two approaches will predominate, perpetuating corporate irresponsibility and enterprise drift.

    The program offers little detail in support of the Primakov government’s promises to aid small and medium–size enterprise (SME) development, another indispensable element in Russia’s economic recovery program. The experience of successful transition in Central Europe demonstrates the critical importance of an entrepreneurial groundswell based on SME start–ups, especially in the service and light industrial sectors. A vibrant SME sector is important not only for its direct contribution to economic expansion and enhancement of tax revenues but for its ability to absorb labor shed in the processes of corporate restructuring and administrative reform (i.e. de–regulation). The Russian government’s program promises aid to small innovative enterprises and simplification of registration procedures, pledges frequently defaulted upon in the past. Two other good intentions — the creation of a State Development Bank and measures to attract foreign investments — also require more detail. It is not clear where the funds for a State Development Bank and a planned government agency to guarantee investments against non–commercial and political risks will come from. This may be an area in which foreign financial and technical assistance may be better utilized, provided efficient administration of the two planned institutions.

    To attract foreign direct investment, the program promises a legislative package including laws on mineral resources, concession agreements and production–sharing. The transition experience of Central and Eastern Europe demonstrates that foreign direct investment typically lags rather than leads indigenous economic growth. In the case of Russia, the scale of needed resources and corporate management skills makes foreign direct investment a necessary, but not a sufficient, condition for corporate restructuring and economic recovery. Many foreign investors have decided to wait until Russians make substantial re–investments in the legal economy of their own country before committing additional capital: the return of Russian flight capital (estimated at $80–300 billion), the re–emergence of ‘mattress money’ (estimates range from $20–50 billion) and the gradual normalization of the shadow economy are therefore more likely to influence the flow of FDI than targeted government incentives. For further discussion of the role of foreign investment and ways to channel Russians’ savings into the real economy, see Sections II.3 and II.4 below.

  • Executive power as a means of enhancing economic initiative. This part of the program envisions increasing the efficiency of use of the federal and state budgets and transferring "operational and executive powers from federal executive bodies to those of constituent parts of the Russian Federation.” Both proposals depend on marked improvements in the professional efficiency and personal motivation of the federal and state civil services. Russia’s current bureaucratic system is notoriously inefficient and corrupt. Its reform, while arduous and politically–charged task, must now be tackled.

The real test for many of the Russian government’s proposals for revitalization of the economy and the banking system will be the parliamentary debate on the draft 1999 budget. The government’s proposal, described by Prime Minister Primakov as “tough and honest,” envisions a primary surplus of 1.7% of GDP and 2.53% overall fiscal deficit on revenues of Rbs 474 billion and expenditures of Rbs 573 billion. The 1999 GDP is estimated at Rbs 4 trillion (approximately USD 200 billion).

 

II. Policy Recommendations

II.1. Enterprise Restructuring

The fundamental problem of the Russian economy, as argued above, is an unrestructured and uncompetitive production sector. State–owned and recently privatized companies have been drained of working capital and starved of capital investment over the past five years. Corporate management, in both the state and ‘private’ sector, exploit economic opportunities for private gain, treating their enterprises in essentially the same way Gosplan did. Small and medium enterprises are choked by heavy (and arbitrarily assessed) taxes, and by an oppressive (and frequently corrupt) bureaucracy. Several Discussion Group members have identified and commented on these interrelated problems.

Daniel Arbess, President of Taiga Capital, argues that foreign direct investments are critical to the survival and growth of promising enterprises. Foreign investors have the experience to build key non–manufacturing commercial functions which ex–Soviet factories typically lack — namely, finance, purchasing, sales and marketing. Even in the best of macroeconomic and political times, however, many foreigners will refrain from buying shares of Russian enterprises even at ‘fire sale’ prices: they fear acquisition of a balance sheet with huge contingent liabilities (typically wage, tax and energy arrears). Mr. Arbess therefore suggests that the government should implement widespread tax amnesties, effectively forgiving enterprise tax arrears, and take additional measures to improve companies’ balance sheets.

The state, according to Mr. Arbess, should also use its majority control of Gazprom to insist that it only accept cash for energy deliveries. This would trigger the rapid collapse of insolvent enterprises, whose ability to operate depends in large measure on bartered payment for energy supplies, and will remove a central player in the barter economy. Another necessary measure, Mr. Arbess argues, is improving the bankruptcy law and streamlining bankruptcy procedures, a need recognized by several other members of the Discussion Group. Enterprises that begin to run up arrears to suppliers or the tax authorities should be bankrupted and liquidated immediately, with their assets sold to the highest bidders (hopefully foreigners). Policy–makers have shied from such an approach for fear of massive unemployment and resulting social and political instability. Mr. Arbess believes, however, that if widespread bankruptcies were allowed to occur, the real impact would be less disastrous than feared because most workers have already found other ways to live than from their non–paid "salaries" (though often it is by directly stealing from their factories). He also believes that, if the process were properly explained as the logical prerequisite to resumption of economic growth and improved living standards, the dreaded "social explosion" would be muffled. History, Mr. Arbess points, suggests that social unrest is triggered more by passivity and drift than by decisive steps, right or wrong.

II. 2. Tax Reform

The principle of comprehensive reform of the Russian tax system is universally espoused by economic experts and policy makers in Russia and abroad. Agreement on practical measures remains elusive, however, and it is doubtful whether the necessary political will exists among the political elite. Steve Moody, an independent consultant on Russia and another member of the Discussion Group, urges that efficient and practicable tax reform depends upon understanding how most enterprises fall into massive arrears on local and federal taxes. Under current regulations, tax authorities in Russia are empowered to levy and seize funds in the transaction account (raschetnyi schet) of enterprises with tax arrears. Under the law governing kartoteka, banks are obliged to divert to the tax authorities (budgetary and non–budgetary) 80% of funds received in a delinquent enterprise’s transaction account. Enterprises, which are otherwise solvent and operational, cannot therefore operate in the "cash economy" because their bank accounts are subject to automatic levy and seizure. In order to monetize the economy, Mr. Moody argues, the government must first eliminate either the system of kartoteka or the tax arrears that trigger it. Since the right of levy and seizure are critical to fiscal control, the more reasonable approach would be to eliminate tax arrears, most of which are in any case uncollectable. Until May 1996, penalties on unpaid taxes were assessed at the rate of 256% per annum and, from that time to the present, the penalty rate has been 135% per annum. In order to restore the bank payments system nationwide, it will eventually be necessary to forgive all accumulated penalties and interest (peni and shtrafnye sanktii) on taxes unpaid since 1992. The benefit of having an operational commercial bank payments system and re–monetizing the economy far outweigh the benefit of collecting the remaining one–fifth of the total. The accumulated unpaid taxes themselves will probably have to be partially forgiven and restructured.

II.3. Reform Of The Banking System

There is universal acknowledgement that the Russian economy cannot resume growth without a viable banking sector. Banks are needed to execute payments on time, assure the safety of deposits (hence re–introducing national savings as a source of capital), and perform the role of financial intermediaries including the provision of commercial credit to private enterprise. The current government program offers guidelines, but little concrete plans for restructuring of the banking system: these remain to be elaborated by the Central Bank in the near future.

Several of the members of the Discussion Group have suggested ways of restoring and strengthening the banking sector in Russia. Alex Goodwin, President and CEO of Jupiter Investments, has formulated the following proposals:

  1. Re–nationalize (at fair market value — technically negative worth!) the top banks, thereby taking the oligarchs out and recapturing key chunks of Russian industry, which these banks control, for a fresh start on privatization;

  2. Sell strategic stakes in key banks to foreign banks (with some sort of fair market value repurchase rights 5–15 years out), thereby infusing outside capital and better, less corrupt management;

  3. Re–privatize control packages taken in bank nationalization through a carefully crafted 3–7 year program emphasizing de–centralization of the economy and optimizing values. Place these packages under decentralized control of an independent Privatization Board.

Commenting on the Russian banks’ involvement with the GKO market, Steve Halliwell, President of River Capital Management, points out that although Russian banks operated more like hedge funds because of their primary involvement in the GKO market, there is ample Western precedent for central banks re–capitalizing weakened commercial banking sectors by offering high yields on government paper while maintaining low deposit rates. The U.S. Federal Reserve followed that approach in the early 90’s, when Latin American losses inflicted severe losses on big U.S. institutions. The Russian banking system was starting de novo, and a similar transitory subsidy may have been justifiable. Unfortunately, banks did not develop a credit business while receiving the GKO subsidy, which is both a cause and an effect of the larger crisis in the real economy discussed above.

II.4. Re–Monetization

Another recognized deficiency of the Russian economy is its de–monetization resulting both from tight anti–inflationary monetary policies in 1995–97 and the population’s distrust of the country’s banking system. 2 Steve Moody has suggested several possible measures to re–monetize the economy, provided the banking system is restored to operational health. These include:

  1. The Central Bank of Russia should guarantee all citizens' deposits in federally chartered commercial banks up to the equivalent of 5 years worth of salary.

  2. The government will pay all wage and pension arrears into citizens' accounts in commercial banks, from which citizens may withdraw in cash the equivalent of one month’s salary immediately and in each of the next three months, and thereafter the equivalent of one month’s salary every two months, in addition to current payments.

  3. The Central Bank of Russia will guarantee 100% of principal and interest of commercial bank loans extended to enterprises for the purposes of (a) paying current local and federal taxes and (b) paying salaries from which personal income tax (podokhodnyi nalog) has been withheld.

 

Endnotes

*: This Discussion paper was prepared by an EWI team led by Rick Petree and including Rado Petkov, Kathy Ford, Allen Collinsworth, and Robert Orttung. 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.

Note 1: This and the other quotations from the program are taken from the ITAR-TASS news agency publication on November 15th. Back.

Note 2: According to the Russian Central Bank, the monetary base on November 23th stood at Rbs 192.9 billion, 17 percent higher than at the beginning of the year (Rbs 164.5 bn). The Central Bank governor Viktor Geraschenko expects money supply in 1999 to rise by 18-26 percent. Back.

 

 

CIAO home page