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Stuck in Transit:
Rethinking Russian Economic Reform On 17 August 1998, Russia's
economy was finally punished for its delay in economic reform. The lack
of fiscal discipline and an overvalued exchange rate forced the
government to devalue the rouble and default on its debt. In the
immediate aftermath of the crisis, many forecasters predicted
hyperinflation and a large and rapid fall in production. Victor
Gerashchenko, dubbed 'the world's worst central banker' by Jeffrey
Sachs, had been reappointed as governor of the Central Bank of Russia (CBR),
and was expected to resort once again to printing money. Fortunately, this scenario has
not materialized. Instead, the Russian economy has been on a path of
recovery with impressive growth rates in industrial production, albeit
from a low base and mainly in import-substituting activities. Inflation
has come down, and Gerashchenko's actions have been very different from
those in 1992–4, with monetary growth kept at a reasonable level. But
the other side of Gerashchenko's record is equally telling: there has
been a failure to take action on restructuring the failed banking
sector. To put it simply, Russia experienced economic growth without
structural reform. A new CEPR Report, 'Stuck in
Transit: Rethinking Russian Economic Reform', explores the events of
August 1998, their underlying causes and the deep flaws they exposed in
the process of reform. Drawing on a series of major new research
initatives at the Russian European Centre for Economic Policy (RECEP) in
Moscow, the Report discusses the policy options for rebuilding the
Russian economy. Russia's decline under an
overvalued exchange rate and its revival since are not surprising. What
is surprising is unlike many other countries that have followed this
path in recent years – the UK, Mexico, Korea, Thailand – Russia has
not gone through a major recession in the wake of the currency crisis
and prior to recovery. On the contrary, the slump has been extremely
short-lived. The explanation for this phenomenon is that, unlike other
countries, Russia was not hit with a credit crunch. Before August 1998,
Russian banks mainly channelled money from local depositors and abroad
into short-term Treasury bills (GKOs) and the booming stock market.
Lending money to the real sector was considered too risky, given the
poor development of creditor rights, the dire state of industry and the
enormous risk-free gains that could be made in and around the GKO
market. As a result, credit to the Russian real sector was unaffected by
the crisis, since it had been largely non-existent beforehand. Arrears Since the beginning of
transition, the tide of arrears has been mounting relentlessly: from the
state to its employees; from taxpayers to the state; and from firms to
firms. Research documented in the report highlights the mechanisms of
arrears growth and offers indirect evidence that non-payment of taxes
reflects long-term corporate distress rather than temporary
difficulties. This observation suggests that the arrears phenomenon is a
feature associated with the fact that large segments of Russian industry
have not yet been restructured. Put differently, an acceleration of the
pace of industry-level reform is likely to reduce arrears to the budget
and not to increase them, despite claims to the contrary. The role of monetary policy in
this process is not clear-cut. Higher real interest rates increase
arrears but so does an increase in the real money supply. Causation
between real money and increases in arrears runs both ways (after 1994)
with two widely different interpretations. It may be that tight money
hurts firms or it may be that firms run arrears to accumulate money
because it is profitable to do so. Tight fiscal policy can also
increases arrears if it takes the form of a reduction in expenditures,
although the effect is relatively small. On the other side of the
budget, reductions in tax collection do not affect arrears. Hence, tight
macroeconomic policies may contribute to increasing arrears. Russia has announced several
tax amnesties in the hope of solving the problem once and for all.
Unfortunately, each amnesty was followed by another jump in tax arrears
as non-compliant taxpayers interpreted the amnesty as a promise of
further forgiveness and subsequently the cost of non-compliance fell. By
contrast, a tough approach to arrears works. Bankrupting firms that do
not pay taxes is likely to be the most powerful tool for combating
arrears to the budget. Taxes Few analyses of the crisis
have failed to highlight Russia's tax system as a key cause of the
collapse. Revenue raising measures have dominated the government's
discussions with the IMF, and on several occasions loan tranches were
withheld in order to punish Russia for failing to meet tax collection
targets. But does Russia really collect an unusually small amount in
taxes? Research documented in the report suggests not. Since 1994, Russia's general
government revenues have remained remarkably stable as a share of GDP,
despite variations in government personnel (including five prime
ministers, eight finance ministers and five heads of the state tax
service), political circumstances (two elections and two wars),
financial market conditions, tax legislation and IMF pressure. The
research presented in the report seeks to predict how much Russia can
expect to raise in taxes by identifying a steady-state level for
Russia's budget using cross-country data. Based on the 49 developed,
developing and transition countries for which data are available, Russia
is predicted to collect 32–33% of GDP, compared with an actual value
of tax collection of 33% of GDP. These results suggest that the
level of taxes in Russia is close to the level that would be expected of
a country of its size, income and economic structure. Tax evasion and
arrears are certainly rampant, but it seems that they should be
understood as the result of the state's attempt to extract more from the
private sector than is feasible for a country in Russia's position.
Explanations for the fiscal crisis should be sought in the level of
expenditure and the distribution of revenues among levels of government
rather than in the performance of the tax system. An important cause of
the federal government's default was an outflow of revenues from the
federal budget to the regions. Fiscal Federalism The main underlying principle
of fiscal federalism (i.e. independence of different tiers of
government) has been violated at both the regional and sub-regional
level in Russia. Over the last decade the federal government has signed
bilateral treaties with different levels of the federation that
individually regulate its relationships with the regions. The terms of
these treaties vary substantially, which creates a confusing and
non-transparent system. In general, sub-federal (local) governments are
responsible for provision of the most important and inelastic
expenditures such as health, education and housing subsidies, while the
most inelastic revenues accrue to the centre. This mismatch creates a
need for an unreasonable amount of fiscal redistribution. The Russian system of
intergovernmental relations gives incentives to government officials at
all levels for poor tax collection, rebellion against the federal centre
(in the case of regions) and against the region (in the case of
localities), and for inefficient overspending and subsidies. Lack of
clarity in the division of revenue and expenditure responsibilities
leads to constant bargaining between regions and the federation. The
main findings of research on sub-federal relations are that localities
have still not gained independence from the regional governments. Local
officials have not been given sufficient responsibility for their
decisions on expenditures and have not been granted the right to raise
their own revenues. In addition, the fiscal dependence of local
governments affects the distribution of public spending over different
budget items and has a negative effect on the efficiency of local public
goods provision. The report concludes that a
federal law is needed that would clearly regulate the redistribution
process between the federation and regions and localities. On both the
federal and sub-federal levels, funds should be distributed according to
a fixed, long-term formula based on objective criteria. Regions could
themselves design the rules for redistribution between localities. The
most important criterion for such rules should be that local tax
revenues are not redistributed in a confiscatory manner, thus leaving
incentives for efficient tax collection and fostering of the local tax
base. Restructuring the Banking System Despite various reform
proposals, the collapse of the Russian banking sector has barely been
addressed and numerous problems remain. Citizens' confidence in banks
remains extremely low: CBR data indicate that there was a net outflow of
household deposits from commercial banks between September 1998 and
January 1999 towards cash and Sberbank (the state owned savings bank),
with commercial banks' volume falling by 18%. It is essential to bring
domestic private savings back into the financial system in order to
reduce interest rates and fund restructuring and the state budget. The report proposes a strategy
of 'jump-starting' bank restructuring that has three main components.
First, the establishment of a narrow bank sector that will ensure a
country-wide retail operation network and the essential core payment
system. Only in this sector would deposits be insured and then only
partially. This provision will provide competition for the de facto
monopoly of the retail sector enjoyed by Sberbank, which is the sole
insured bank. Narrow banks would be able to invest only in safe assets,
mostly government and CBR liabilities. Second, the sequential closure
of over 90% of all banks and the creation of a de facto concentrated
commercial banking segment, to be achieved via extremely strict bank
licensing. And third, the creation of a more transparent bank
supervisory institution, which must be able to impose asset freezes and
force shareholders to dilute their control through recapitalization via
new share issues well ahead of financial distress. This arrangement is
critical to ensuring an exit route and an ultimate source of discipline. Financial-Industrial Groups Related to the problems in the
banking sector is the emergence of the Financial-Industrial Groups (FIGs).
These groups involve close relationships between financial institutions
and industrial enterprises, which allow firms access to capital without
the need for arm's-length contracting with financial institutions and
capital markets. West Germany and Japan relied on such structures to
rebuild their post-war economies and similar entities appeared in the
less developed countries of South East Asia and Latin America. But there
is increasing scepticism about their efficiency, as the crises in the
Asian economies and in Russia have cast a shadow over the benefits of
such conglomerations. The political power held by
the FIGs played an important role in the process that caused the crisis.
They offered a convenient route for tax evasion and capital flight via
under-invoicing for exports and over-invoicing for imports. The
recklessness of many banks' practices and the credibility granted to
them by foreign investors can only be understood in terms of easy access
to political and financial favours. The main drawback of conglomeration
is that it often leads to the concentration of economic and political
power in the hands of a few businessmen. A bankruptcy threat is often
not credible for a FIG and, as a result, its directors have fewer
incentives to operate efficiently than the managers of small
enterprises. The softness of the budget constraint can be manifested in
many ways, ranging from subsidies to FIG enterprises and tolerance of
FIG tax arrears to bailouts of bankrupt FIG banks. Other favours include
cheap credits and import barriers. Although FIGs do contribute to growth
in the early stages of their development, they can eventually lead to
inefficiencies by promoting too close a relationship between businesses,
banks and the government. Industrial Restructuring In contrast with most Russian
firms, firms in the Central European countries have restructured.
Whether state-owned, corporatized or privatized, they reacted to
increased product market competition and a hardening of the budget
constraint. Their adjustment was mainly defensive, but the
survival-oriented strategy of the state-owned sector led to significant
downsizing and asset sales. This facilitated the transfer of assets to
more productive uses and contributed to the development of a new private
sector. What are the conditions that
could trigger a similar process in Russia? Beyond obvious steps, such as
the elimination of corruption and enforcement of contracts, the report
advocates a number of measures that focus directly on the enterprise
sector. First, competition should be increased in the product market. It
must deal with the formation of new types of large and powerful
organizations, such as FIGs. The creation of large private enterprises
should not be forbidden but neither should they be encouraged by special
fiscal advantages. Second, the hardening of bank
credit to firms. This must involve not only supervision and regulation
of the financial sector, but also the creation of adequate incentives
for commercial banks to enforce hard budget constraints on their
borrowers and to initiate bankruptcy procedures. If banks became tougher
on bad debtors and undertook measures to ensure the repayment of
established enterprises’ debts then the new private sector may find it
easier to finance its growth. Third, the enforcement of
bankruptcy laws. The credible threat of bankruptcy may change the
expectations of employees and managers and encourage them to adopt
various measures, including scaling down production and employment to
avoid insolvency. Non-enforcement of bankruptcy procedures often comes
from the fear of massive, politically unsustainable waves of lay-offs.
But even without official bankruptcies, employees can become de facto
unemployed – e.g. by no longer receiving their wages. Barter Economy One of the striking features
of Russia's economic transition has been the enormous growth in the use
of barter. What was a transitory phase of transition in Central Europe
has become an endemic feature of the Russian situation. In 1992, barter
accounted for around 5% of enterprise transactions; by 1997 this had
increased to at least 47%. The proliferation of barter imposes huge
externalities on the economy as a whole. By definition, barter
transactions are much less observable and are therefore less taxable.
But barter can also act as an entry barrier and therefore hinder both
restructuring and competition. The key results of the
empirical research documented in the Report are that the likelihood that
an enterprise will engage in barter is independent of its financial
position; and that barter is more common in larger enterprises and in
more concentrated industries. These findings imply that since the search
costs of finding countertrade partners are very low, the Russian economy
may be in a barter trap where barter is so common that it is less costly
to carry out exchanges without money. The Report argues that printing
more money will not solve the problem: an increase in the nominal money
supply will merely result in inflation, and the real money supply will
remain unchanged. But why is barter prevalent in
Russia, while it is virtually non-existent in other economies? One
possible explanation for the peculiarity of the Russian experience is
the existence of multiple equilibria. The Report's analysis suggests
that at some level of competitiveness the barter equilibrium disappears
and industry jumps to the no-barter equilibrium. Even if competition
policy may have had little effect so far, barter may fall dramatically
when a certain threshold level of competition is achieved. This multiple
equilibria argument is one way of interpreting the so-called
'post-Washington consensus', which states that institutions that are
essential for transition may fail to emerge spontaneously. The Report concludes that both
parliamentary and presidential elections have created a post-crisis
environment in which politicians were taking a cautious approach to
economic policy. This has both positive and negative consequences:
positive in that policies have become predictable, but negative in that
the political will to engage in large-scale institutional and structural
reforms was still absent. Once Russia recovers from campaign fever, a
new parliament and president will have to face the underlying structural
problems and lack of institutional development. |
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