CIAO DATE: 6/99

Rebuilding Russia Initiative: Economics Discussion Group
Discussion Paper # 3 _*

February 12, 1999

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 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’ economy. The Discussion Group’ 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 1999 budget, passed by the Duma on February 5, 1999 and airs policy proposals on banking sector reform and mobilization of personal savings. The paper includes presentations made at the Second economic roundtable, organized by the EastWest Institute Center in Moscow in early December 1998.

 

I. The 1999 Budget—New Pragmatism, or Smoke and Mirrors?

Our last discussion paper argued that the Russian government's commitment to fundamental economic reform would be revealed in its handling of the 1999 budget. In the event, the government drafted a budget described by Prime Minister Primakov as“tough, but honest,” and by IMF’ First Deputy Managing Director Stanley Fisher as“nether sufficiently ambitious, nor realistic.” Below, we examine the budget’ philosophy, assumptions, and shortcomings.

The proposed budget envisions spending of 575 billion rubles and revenues of 473.7 billion rubles (almost 400 billion of which is due to come from taxes). The budget projects (for the first time) a primary surplus of 1.7%, and overall budget deficit of 2.54% of GDP. The macroeconomic framework assumes gross domestic product of 4 trillion rubles, average exchange rate of 21.5 rubles per USD, and inflation not exceeding 30%.

The IMF has stated plainly that the proposed budget will perpetuate the cycle of large deficits and rising debt service obligations that led to the August 17^th crisis. Stanley Fisher criticized the government’ plans to lower VAT from 20% to 15%, arguing that cutting the VAT before tax receipts increase is a mistake. He also argued that the budget should have primary surplus of 4-5% of GDP (versus the projected 1.7%).

Many in Russia believe that the IMF’ position reflects a primary concern with Russia’ ability to service its foreign debt. Russian total foreign debt service in 1999 amounts to $17.2 billion according to Chase Securities, while the budget envisions payments of $9.5 billion. It is clear that something has to give. The first type of debt“to go” was the restructured Soviet-era commercial debt (PRINs and IANs): on January 20, 1999, the ‘London Club’ announced that it will not require immediate payments of the amounts due and will open negotiations on rescheduling. Of natural concern to the IMF is the $4.5 billion that Russia owes it in 1999. ₁ Russia, for its part, expects IMF assistance to help it service the IMF debt. Negotiations on the Fund’ program in 1999 are continuing. Expectations are that the IMF will not make any commitments before it observes the budget performance in the first several months of the year and the impact of the planned tax reform, which takes effect on April 1. To encourage the release of IMF credits, First Deputy Prime Minister Yurii Maslyukov announced that the Russian government would be ready to make some changes in the macro framework of the budget, if the IMF proves its case. Some analysts interpret this as a signal of the government’ readiness to rescind the reduction of VAT.

Reduction of taxes, however, is a prerequisite for resumption of economic growth in Russia. In a January interview on Moscow radio, the World Bank’ Moscow director, Michael Carter, disclosed that the bank seeks ways to make its financing more effective in promoting economic growth in Russia. ₂ Such expressions are well-received in Russian policy-making circles: besides signaling a possible difference with IMF’ approach, they may indicate sympathy with the underlying philosophy of the 1999 budget. The budget calls for corporate, social security, and VAT tax cuts to lighten the burden on firms, bring more of them into the official economy, and stimulate capital investment and, ultimately, growth. Support for domestically generated growth is the political thrust and the underlying philosophy of the budget. It envisions 21 billion rubles for development, at least 3 billion of which will be used to capitalize a new State Development bank. The bank’ goal would be to provide investment credits and support domestic industries, irrespective of ownership. Such discretionary largesse raises obvious issues in current Russian conditions: Russia’ inefficient and corrupt public administration can be counted upon to display more talent in picking“friends” than truly competitive“winners” in dispensing such financial support.

The budget matches the planned cuts in tax revenue with severe cuts in spending on government staff, foreign debt service, the military and emergency expenditures. The budget’ viability will depend upon making these cuts in reality as well as on paper, and making them stick. Domestic pressure from well-connected and increasingly disgruntled interest groups will mount in the course of the year as will international impatience with Russia’ erratic debtor performance.

The proposed 1999 budget was passed in the Duma with an overwhelming support: on the fourth and final reading on February 5, 308 deputies voted in favor, 58 against and 6 abstained. The upper house of the Russian parliament, the Federation Council, is excepted to adopt the budget at its next sitting on February 17.

 

II. The Banking System—Reforms Delayed

In the last Discussion Paper we initiated discussion of Russian banking sector reform, failure to achieve which remains a principal obstacle to normal economic activity and growth. Russian banks are estimated to have lost 50% of their total assets as a result of the August’98 crisis and more than half of their liquid assets. The volume of foreign exchange credits fell 12%, and of ruble-denominated ones 16.5%. According to the Economist Intelligence Unit, hard-currency retail bank deposits halved to just over $3 billion between August and October 1998. Rouble deposits fell to their lowest level in four years ($6 billion), bestowing on Russia one of the lowest per capita savings rates in the world. A widely anticipated bank consolidation failed to materialize: since August, only 68 banks have shut down (out of a pre-crisis total of 2,552). The Agency for Restructuring Credit Organizations, conceived by the government and the Central Bank, has yet to start functioning. Its planned duties include bankrupting insolvent banks, helping salvageable banks by injecting liquidity and restructuring their debts, and attracting new investments in the sector. The Agency’ share capital of 10 billion rubles, however, is considered by many inadequate for any real impact.

Below, we present some Russian economists’ views on the subject of banking reform, expressed at the second Economics Roundtable organized by the EastWest Institute Moscow center in early December.

Vadim Buglai, Professor at the Moscow State Institute of International Relations, argues that the roots of the Russian banking crisis are substantially different from those of the Asian financial debacle:

• The growth of the financial sector in Russia, as well as its downfall, took place amidst steady decline of production.

• After the collapse of the Soviet Union, Russia quickly added to the already sizable Soviet debt, which it assumed: $80 billion of new indebtedness was incurred in 1995-96 alone. Not a single requirement of the extended official credits was met, yet the exchange rate was kept in the narrow boundaries of the currency corridor. Budgets assumed the receipt of new credits.

According to the Russian economist and banking expert, Andrey Zhuravlev, the Central Bank cannot conduct an effective monetary policy as long as it fails to understand the workings of a true market economy. The bank utilizes data that reflects the barter-driven“virtual” economy, rather than the real one. What is needed is a resumption of open-market operations to determine the real financing needs of market participants and establish a market rate of interest.

Alexander Basov, Director of the Financial Institute of the Plekhanov Academy of Russian Economics, separates Russian banks into two groups:

• large banks which engaged in financial speculations and did not diversify their asset portfolio, and

• small and medium-sized banks, which did not have exposure to financial markets and invested in the real economy.

The latter group now desperately needs corporate lending skills - loan officers and operating procedures to assess credit risk, develop loan in-take mechanisms and execute micro-lending programs.

Pavel Nefidov, President of the failed Tokobank, argues that the main problem of the Russian banking sector is establishing the rules of the game. According to Mr. Nefidov, there is no legal basis for extending credits to the real sector. Regional banks never serviced investment loans and have not developed serious bank products. There is no banking system as such, no sense of belonging to a community; each bank, instead, goes its own way.

To revitalize the financial system, Prime Minister Evgenii Primakov suggested in December that the government is ready to ease the requirements for opening foreign banks’ branches in the country, provided that the bulk of the resources attracted will be invested in the Russian economy. Foreign bank branches will be allowed to open anonymous accounts for Russian individuals, which will not be subject to declaration. Prior to the crisis, most of the foreign banks’ clients in Russia were enterprises from the real sector. Chase Manhattan Bank financed Lukoil and Sibneft; CSFB banked Severstal; Dresdnerbank worked closely with the Leningrad metallurgical works and the chemical works“Akron”; and Citiban was closely associated with the Russian operations of Proctor & Gamble, McDonalds, and PepsiCo.

 

III. Re-Monetization Revisited—Some Unorthodox Approaches

Alexandre Goodwin, Partner in Jupiter Investments, has proposed a scheme similar to the Singapore pension/mortgage financial plan, as a way of mobilizing for economic reconstruction the significant amounts of personal savings held ‘under the mattress’ in Russia. For this purpose, a pension scheme would be established, backed by an explicit international guarantee or insurance fund and managed by Sberbank, the banking institution that Russians trust most. ₃ Under the scheme, Russians would be offered individual pension accounts in exchange for their savings. Part of the dormant domestic financial resources would thereby enter the banking system, enticed by the credible and enforceable guarantee. A second step would be to institute a mortgage-backed lending facility, under which Russian banks would provide consumer and mortgage loans to the pension account holders in amounts up to four times their personal holdings. Russians would therefore have the ability to leverage their personal savings and to stimulate domestic production (hence employment) in house construction and consumer goods. This will also increase their personal involvement in the Russian economy and strengthen political support for reforms.

A crucial link in the proposal by Mr. Goodwin is the transmission mechanism. A well-regulated inter-bank market must be established to channel the savings from Sberbank to re-capitalized and restructured commercial banks. To service the consumer and mortgage loans, those reconstituted“good” banks must quickly acquire loan-management skills. An international program of technical assistance should thus complement any financial contributions from international donors to the pension/mortgage scheme. The end result will be the“resurrection” of“mattress” money and its redeployment in the real economy. If only a quarter of the estimated $20 billion under the mattresses can be coaxed into play under the scheme, then $20 billion can be put to work in the economy during the“first round”.

Former Deputy Prime Minister Alexander Shokhin has proposed another interesting means of re-routing Russian savings into the real economy. A guarantee fund and bank consortium set up outside Russia and sponsored by the G-7 could, in his opinion, attract Russian flight capital (i.e. funds currently held outside the country) and make them available for investments in Russia. The foreign-managed fund could also issue promissory notes and other securities to fund massive investment projects in the country.

Mr. Goodwin, however, points out that a crucial factor for economic development in Russia remains the establishment of a clear, predictable, and transparent business operating environment. This effort, he notes, goes beyond formal institution building and legislative reform; it must address underlying social mentalities and a set of behavioral principles rooted in the Russian public mind and incarnated in an entrenched class of“red directors.”

Hannes Kulvik, a Geneva-based investor and member of this Discussion Group, asserts that no good policy proposals can be implemented until three fundamental problems are solved:

• the absence of important elements of government infrastructure and the dysfunctionality of significant elements which do exist;

• lack of discipline in most sectors of the society; and

• a widespread if not total lack of confidence in the proper functioning of the state.

Until those basic problems are addressed, he believes that any reform efforts are doomed. How to arrive at solutions of these fundamental societal problems remains an unanswered question. Rumen Dobrinsky, from the UN Economic Commission for Europe, points out that the main problem in Russia at the moment is the political situation: there is no political force which is capable of carrying out any meaningful reform and there is no underlying public support for new reforms due to the perceived failure of so-called“reforms” undertaken so far.

 

---

Endnotes

*: This Discussion paper was prepared by an EWI team led by Rick Petree and including Rado Petkov, Kathy Ford, Bob Orttung, and Allen Collinsworth. We invite your response and insights on the Russian economy, including criticisms or disagreement with what you read here. Please address your questions and comments to Rado Petkov at 212-824-4133, mailto:rpetkov@iews.org. For reports on economic developments in the regions, please see the EWI Russian Regional Investor at http://www.iews.org Back.

Note 1: Russia’ total outstanding debt to the IMF is estimated at $19 billion. Back.

Note 2: World Bank financing under consideration for 1999 is $1.85 billion, $1.2 billion of which is in the form of a Structural Adjustment Loan. Back.

Note 3: Sberbank holds 85% of personal bank deposits. Back.