Rebuilding Russia Initiative #7

CIAO DATE: 2/00

Rebuilding Russia Initiative: Economics Discussion Group
Discussion Paper # 7 _*

September 17, 1999

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 and political 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’s economy. 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. This discussion paper continues the debate on Russia’s barter economy from Discussion paper #6 and looks at the causes and sustainability of some recent positive economic developments in Russia.

Barter—what is it good for?

Commenting on the barter discussion in RRDG #6, Daniel Arbess from the investment firm Triton partners (incorporating Taiga Capital Group), expresses his support for the “Brookings” paradigm on barter. ₁ Mr. Arbess argues that no macro policies can save industrial production that subtracts rather than adds value. The main need of Russia’s economy is enterprise restructuring and/or liquidation. The government’s role is to create conditions to attract knowledge and capital, which in turn will depend on the development of a body of substantive law and legal process necessary to establish and enforce stock ownership, corporate governance and a functioning capital market—or, in Mr. Arbess’ words, a “Civil Market Society.” Mr. Arbess also points out that the practical impact of the tax regime was not given the attention it deserves in the discussion on barter so far. Enterprises would rather stay away from cash, he observes, since cash migrates to the payment of a plethora of taxes, whereas barter can be used to end-run certain types of tax levy.

Stephen Moody, a registered securities dealer in Russia and a consultant to number of multinational corporations, takes a different view on barter and its role in Russia’s economy. He argues that Russia’s current industrial expansion appears to refute the contention that barter simply masks deceptive pricing among enterprises and that its primary benefit to practitioners is tax evasion. To the contrary, it appears barter has allowed Russian industry to capitalize on the economic benefits of the August 1998 devaluation, channeling Russian consumer spending into real increases in capacity utilization and, as recent anecdotal evidence suggests, genuine import substitution. This is something that the Russian commercial banking system was unable or unwilling to do. The “virtual economy,” Mr. Moody argues, seems not quite as virtual as some thought since virtual economies do not spawn real growth.

According to Mr. Moody, real growth notwithstanding, demonetization still cripples the Russian economy. Since 1994 the broad measure of Russian money supply (M2) has never exceeded fifteen percent of GDP, compared with 56 percent in the United States and more than 100 percent in some West European economies. Likewise, commercial bank credits to the Russian economy have also remained at consistently low levels — ten to fifteen percent of GDP. Under the best of circumstances, Mr. Moody contends, such extraordinarily low levels of money and credit could never have adequately funded even half of reported Russian GDP. This has led some to believe that, if money supply and credit are real, then the unfunded portion of reported GDP must be virtual. GDP, argue the “virtualists,” is really what money supply and bank credit imply it should be, and all the rest is phony barter transactions or phony barter prices which, in the final analysis, result in dramatic shortfalls in government tax receipts—the acid test for real economic growth.

Mr. Moody finds the above theory flawed. He argues that the real explanation for the demonetized state of the Russian economy and the discrepancies among GDP, money supply and bank credit is not barter but non-payments (neplatezhi). The total stock of non-payments (essentially accounts payable) in Russia is estimated at 3.1 trillion rubles, or about 100 percent of GDP. ₂ According to Mr. Moody, about half of that are tax arrears, penalties and interest due tax collectors; others are government pensions and wage arrears due to civil employees (teachers, the military, et al.), and the rest are commercial payments. Historically, commercial accounts receivable (payables’ counterparts) in Russia have run, according to Mr. Moody, at 25 to 30 percent of GDP, roughly comparable to the level of commercial receivables in the United States.

The essential difference between Russian accounts receivable and receivables anywhere else in the world, argues Mr. Moody, is that only a tiny fraction of Russian receivables are financed by Russian commercial banks. As a rule, Russian banks do not make working capital loans to Russian industry, nor do they discount its receivables. Russian industry finances itself with the result that its receivables are not backed by bank loans and do not show up as demand deposits in banks. Therefore, they are not counted in Russian money supply and the Russian Central Bank is under no obligation to fund them.

Mr. Moody contends that industrial expansion does not necessarily trigger a commensurate expansion of the money supply. The reverse is also true: expanding money supply does not necessarily beget industrial growth. Russian enterprises use barter for cash and non-payments for credit because the supply of rubles—cash and credit—is too tight. The essence of economic reform in Russia, therefore, should be remonetization. The Russian Central Bank has to increase the money supply, even if it might risk inflation (which it should not, since production and productivity are rising). The government, according to Mr. Moody, has to get Russian banks out of the business of collecting taxes and into the business of discounting commercial paper. It should also accept veksels (promissory notes) in payment of taxes in spite of explicit IMF covenants forbidding it. If the Treasury takes veksels, Mr. Moody suggests, the banks will buy them, and non-payments will start showing up where they rightly belong—in the money supply.

In the meantime, a recent Bank of Finland analysis shows that Russian industrial firms have reduced their reliance on non-monetary transactions. ₃ While in August 1998 the share of barter trade by industrial producers comprised 54 percent of their turnover, by January 1999 the share had fallen to 46 percent. For example, the car manufacturer AvtoVAZ now operates on a 100 percent cash basis, while cash transactions at another carmaker, GAZ, is up to 60 percent of total. Last year, only about 40 percent of turnover for either company involved monetary instruments. The electrical power provider UES has increased its share of cash payment from 18 to 30 percent and the oil producer Lukoil from 10 to 50 percent. According to a survey by the Troika Dialog investment bank, the reduction in reliance on non-monetary exchanges is the result mostly of improved price competitiveness.

Russian economic miracle?

Official data for the first half of 1999 show an increase in industrial output and improvement in Russia’s trade balance. The State Statistics Committee reports that industrial output increased 4.5 percent over the same period in 1998, with production rising by 9 percent in June and 12.8 percent in July. Russia’s foreign trade surplus for the period January-May rose to $10.9 billion, up from $0.3 billion for the same period in 1998. Exports were valued at $27.2 billion and imports were $16.3 billion. For January-May 1998, exports were $ 30.5 billion and imports $30.2 billion.

Vlad Sobell, senior economist at Daiwa Institute of Research Europe, points that the rebound in industrial output has resulted in an improved financial position of Russian companies and a reduction of barter trade. This has created conditions for the reduction of payment arrears throughout the economy. Budget revenue collection has also improved. The budget deficit in the first five months of 1999 amounted to 4.4 percent of GDP, down from 4.9 percent in 1998, with the primary balance (excluding interest payments) close to zero (compared with a surplus of 0.6 percent of GDP in 1998). The surplus on the current account, observes Mr. Sobell, further widened in the first quarter of 1999 to $5.1 billion compared with a deficit of $1.5 billion a year ago. Monetary restraint and stabilization of the exchange rate have resulted in subdued inflation, with CPI growing by 2.2 percent in May and 1.9 percent in June. The January-June index rose by only 24.5 percent—hardly the hyperinflation predicted by the analytical community. Year-on-year inflation is running high, at over 120 percent, but this, according to Mr. Sobell, is entirely due to the high inflation rates of the second half of 1998 in the wake of the August devaluation.

Mr. Sobell argues that while the dampened inflation and stable exchange rate can be explained (respectively) by a restrictive monetary stance and re-imposition of restrictions on the foreign exchange market, the output revival is clearly the result of the ruble devaluation in 1998. The substantially weaker ruble has resulted in a cutback in imports and a shift to import substitution, while exporters have benefited from greater competitive edge. The increase in oil prices and commodity prices in general have boosted the financial position of companies. The collapse of the GKO market in 1998 has released more funds for investment in the real sector. The high yield offered on this market, points Mr. Sobell, crowded out investment in the real sector; now the banks have real incentives to take a look at the latter.

The main problem in this picture, according to Mr. Sobell, is that the industrial output recovery has taken place against the background of a continued decline in the demand components of GDP, with gross fixed investment and consumer demand continuing to fall. Real wages are about a third below the level of a year ago. On this basis, it would seem that the growth is primarily bolstering the build-up of stocks rather than consumption. Furthermore, observes Mr. Sobell, data suggest that the growth is concentrated mainly in intermediate product branches: non-ferrous metallurgy, chemicals, wood and paper and construction materials. Consumer-oriented light industry output continued to plummet (down by 13.2 percent in January-April). Skeptics have described this recovery as a “Soviet type” or “Belarus type” of growth, ₄ bound to run out of steam sooner rather than later.

On the other hand, Mr. Sobell notes, optimists have argued that the current industrial growth is unlikely to fizzle out because it is based on a fundamental realignment within the Russian economy. The devaluation of 1998 has brought the real exchange rate down from unsustainable levels, to which it had previously been driven by the strength of the country’s energy sector. The real exchange rate is unlikely to return to these heights over the medium term. The current recovery and gradual re-monetization of the economy are, therefore, set to provide a propitious “window of opportunity” for structural, institutional and microeconomic change in the non-commodity sector needed to ensure sustainable growth.

A look ahead

It is possible, according to Mr. Sobell, to present two views of Russia in the years ahead. First, one could argue that the country will continue to stagger from crisis to crisis, as it has been doing over the last decade, with no serious prospect of stability and economic regeneration in sight. On the other hand, a more optimistic view can interpret developments of the last decade not as aimless progression amidst interminable chaos, but as a difficult and inherently destabilizing (indeed, chaotic) search for stability on the basis of a completely new culture of democracy and market economy. Instability and chaos were unavoidable and inherent in the starting conditions after the collapse of the Soviet Union, and it should not be surprising that they are yet to be overcome (in fact it would have been surprising if it had been fully overcome). The chaotic conditions of failed reforms in the 1990s, Mr. Sobell argues, were not a “waste of time and effort”; they represent a vibrant trial and error process in which post-Soviet Russia has been gradually edging its way out of the economic and political cul-de-sac that was the Soviet Union. Only this reading of the situation is able to reconcile the apparently contradictory phenomena that have puzzled (and confused) many analysts of Russia’s transition: rapid and indisputable fundamental change on the one hand, accompanied by persistent deep disorder on the other.

Endnotes

*: This Discussion paper was prepared by Rado Petkov, Aleksey Makushkin, and Nina Khrushcheva at the EWI. 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. Back.

Note 1: The Brookings Institute economists Clifford Gaddy and Barry Ickes treat barter as a transaction that reflects no true costs and revenues for the parties involved and is often used to conceal the subtraction of value in the production process. See Gaddy, Clifford and Ickes, Barry. “Beyond a Bailout: Time to Face Reality About Russia’s “Virtual Economy.” Brookings Institute Working Paper, August 1998. Back.

Note 2: See Rebuilding Russia Discussion Paper #6, p. 2. Back.

Note 3: Russian and Baltic Economies 29, July 23, 1999. Bank of Finland Institute for Economies in Transition Back.

Note 4: This refers to the largely artificially driven expansion—in effect “production for production’s sake” de-coupled from consumer preferences and spending power. Back.