THE RUSSIAN CRISIS
16 October 1998
Paper prepared jointly by the
secretariats of the United Nations Conference on Trade and
Development (UNCTAD) and the United Nations Economic Commission
for Europe (UN/ECE) and presented at UNCTAD's Trade and
Development Board (October 1998)
A. Introduction
The underlying origins of the Russian crisis of
1998 are to be found in the country's economic structure,
institutional environment and political processes. But the
character of the crisis has much in common with others in the
series of recent financial crises in emerging markets. Whilst the
crisis must be seen in the context of policy failures and
abortive reform efforts during the 1990s, its unfolding reflected
mismanagement of the opening of the country's financial markets
to foreign lenders and investors which left the country
vulnerable to the risk that domestic financial difficulties (such
as those of the management of the market for government debt
instruments) could be transformed into a full-blown currency
crisis. The crisis brings out the interaction of weaknesses in
external and internal economic policy which have resulted in the
hardships endured by the public at large during the Russian
government's efforts to transform a centrally planned into a
market economy.
B. The economic and institutional background
The process of economic transformation in
Russia has been marked by a prolonged transitional depression and
macroeconomic instability: seven years of continuing decline
resulted in a cumulative drop of GDP by more than 40 per cent
between 1989 and 1996; in that period there were also several
outbursts of near-hyperinflation. The first radical effort to
tackle inflation was the IMF-supported stabilization programme of
1995. It focussed on tight monetary control and nominal exchange
rate targets; subsequently, direct central bank financing of the
budget was discontinued and the exchange rate was placed under
control. In the years that followed Russia made marked progress
towards price and exchange rate stability and this prompted
positive expectations in the West and a widespread - but in the
event deceptive - perception that the country was pursuing the
right course of reforms.
It is important to point out that the 1995
stabilization effort was not underpinned by deep structural and
institutional reforms. Russia inherited from the past an
overindustrialized economy, dominated by highly inefficient heavy
industry (including the military-industrial complex). The
liberalization of prices and the discontinuation of subsidies
resulted de facto in the destruction of a large share of
the existing capital stock. Restructuring these industries is a
daunting policy task: simply closing down the large number of
non-viable or inefficient enterprises would not be socially and
politically tolerable, while their active restructuring would
require - if it is possible at all - new investment of a
magnitude which, when compared with Russia's absorptive capacity,
was simply implausible even in the medium run.
In these circumstances the Russian authorities
opted for a speedy, give-away mass privatization programme which
was carried out during 1992-1994. However, this resulted in most
cases in the concentration of effective property rights in the
hands of insiders (company managers) who had neither the
incentives nor the capital to perform the necessary deep
restructuring of the enterprises. The newly emerging system of
private ownership was not conducive to effective corporate
governance and was in fact another obstacle to the process of
enterprise restructuring. Moreover, the loopholes in regulation
and perverse incentives seem to have incited a continued
stripping of the assets of the privatized enterprises rather than
their market-oriented restructuring.
The progress in institutional and legislative
reforms in Russia in the 1990s has thus been modest and the
emerging market infrastructure in the country is extremely
feeble. This is especially so in the areas of commercial and
corporate law and, indeed, in the establishment of the rule of
law in general. Contractual agreements are among the basic
foundations of market relations but they have never been
supported by an adequate legal framework in Russia: their
execution most often relies on the good will of the parties,
while contract enforcement is often impossible by legal means.
Very little was done to reform the functioning
of Russian public administration whose lack of transparency and
irregular practices are well known. This omission gave birth to
widespread rent seeking which even in the early phases of the
reform process (when the country's assets, including the control
of mineral resources, were being privatized) resulted in the de
facto concentration of wealth in a relatively small group.
The latter in turn used its newly acquired economic power to
pressure the legislative and regulatory bodies for new
concessions. This distorted the socio-political and institutional
environment, and the presence of a deliberately malfunctioning
public administration has created a vicious circle which is a
major obstacle to reforms and to social justice.
One frequent characteristic of the Russian nouveaux-riches is the apparent deficiency of entrepreneurial spirit combined
with a high propensity to consume. The wealth of numerous members
of the new class was not acquired as a result of entrepreneurial
success; it was simply "easy money", obtained in some
cases from illegal or semi-legal activity. Huge amounts of
capital left Russia and were spent on luxury goods and investment
in real estate or just placed in safe havens instead of being put
to productive use within the country. The unprecedently rapid
stratification of society and the public perception of a lack of
social justice in the process of policy development eroded
initial public support for the reforms and strengthened the
revival of a conservative opposition to the reform process.
It was in this economic and institutional
environment that the Russian government launched the 1995
stabilization programme. Despite the progress in disinflation,
the climate for productive investment in Russia remained hostile,
mostly due to the negative impact of this environment. Owing to
the persistent lack of investor confidence which changed little
after 1995, the dramatic fall of investment in productive assets
continued, leading to further decapitalization of the economy and
undermining the sources of future growth. In real terms, gross
fixed investment in 1997 was a mere quarter of its 1991 level.
Hence the long awaited recovery failed to materialize and the
modest economic upturn in 1997 turned out to be short-lived.
In the absence of a coherent and consistent
policy mix, the considerable tightening of monetary policy after
1995 had a marked negative impact on economic activity. The
combined effect of tight monetary policy and the large
public-sector borrowing requirement was exceptionally high
interest rates (table 1). But, as discussed below, the Russian
financial markets were dominated by lucrative speculative
operations, and the banks had no incentive to engage in normal
lending. As a result, after 1994, total credit to the
non-government sector declined as a share of GDP and stayed at a
very low level (table 1), and the corporate sector's access to
bank finance was extremely limited.
The prolonged financial squeeze on enterprises
provoked an acute credit crunch and the emergence of various
monetary surrogates (acting as payment substitutes) and
widespread barter (closely related to the diffusion of
loss-making activity) which eroded further the tax base. Wage
arrears kept mounting not only in the public domain but also in
the corporate sector: in 1996-1997 the latter was responsible, on
average, for about 85 per cent of outstanding wage arrears.
After a short-lived and meagre recovery in 1997
the economic situation started to deteriorate in early 1998.
Russia depends heavily on exports of energy resources and other
primary commodities which make up 80 per cent of merchandise
exports, and the weakening of global demand and the unprecedented
fall in their prices in the aftermath of the Asian crisis had a
significant negative impact on its economy. There was a sharp
fall in export earnings (by some 11 per cent year-on-year in the
first half of 1998) and this had a major impact on Russia's
external and fiscal balances. The tightening of fiscal policy
squeezed the economy further and as early as the second quarter
of 1998 economic decline resumed.
C. The fiscal problem
There is wide agreement that mismanagement of a
major fiscal imbalance and of the market for government debt was
the proximate cause of the present Russian financial crisis. But
it is more accurate to say that the persistent Russian fiscal
crisis is itself just the expression of the overall crisis of the
Russian transformation. Fundamental institutional reform of both
taxation and expenditure, an immense challenge in any event, has
been repeatedly set back by political conflicts and centrifugal
forces. As alternative estimates of the budget deficit suggest,
none of the fiscal campaigns to address the imbalance have ever
succeeded in reducing deficits to sustainable proportions. The
principal change has been simply in the method of financing the
gap, the major shift from the inflation tax to bond and bill
financing occurring in 1995. In view of the high real interest
rates necessary to place domestic debt, a sustainable level of
the fiscal deficit in relation to GDP could have been attained
only if there had been more successful efforts to increase
government revenue and economic growth than those actually made.
For the first half of 1998, the consolidated
budget deficit (federal, regional and local, but excluding
"off-budget" funds) stood at 4.8 per cent of GDP,
according to the lowest (Russian State Statistical Committee,
Goskomstat) figures. The overall position was considerably worse
than this, particularly because the major extra-budgetary fund,
the Pension Fund, is reportedly also running an exceptionally
large deficit. These figures must also be seen in the context of
mounting payments and wage arrears throughout all sectors of the
economy.
Recent acute fiscal distress occurred despite a
remarkable primary federal budget surplus for the first
five months of 1998 so that the overall deficit was increasingly
showing the impact of the harsh arithmetic of a debt spiral: debt
service was fully one-third of federal spending in the first
quarter of 1998. This visible strain was in itself another factor
undermining confidence in the ability of the government to
correct the situation and thus led to increasing difficulty in
placing new debt. In July the government-owned Sberbank declined
to roll over its holdings of maturing short-term treasury bills
(GKOs), a remarkable indicator of the fragility of the situation.
The growing burden of interest payments was
built into the measures taken in 1995: while Russian official
figures continue to record the 1995 budget deficit at 3.0 per
cent of GDP, interest payments on the growing stock of GKOs were
actually adding nearly the same amount to the financing needs in
that year. To avoid a debt spiral, any programme adopted then
would have had to assume all of the following: a return to
economic growth in Russia - indeed, to rapid growth of 4 per cent
or more; a stable exchange rate; rising world commodity prices; a
government able to manage progress towards a primary budget
surplus by means of a major fiscal reform; and the willingness of
initial bond holders to roll over and increase their holdings.
Not surprisingly, these conditions turned out for the most part
to be mutually inconsistent or unattainable. A rise in world oil
prices in 1995 and 1996 initially masked this impossibility.
The first issues of GKOs were available only to
residents, and offered very high interest rates. In 1996, and in
part as a result of IMF insistence, the market was opened to
non-residents. This did eventually succeed in lowering the
interest rates (although the fears that drove up rates before the
presidential election of July 1996 locked in subsequent high
payments for the debt incurred at that time), but it also clearly
meant that the dangerous accumulation of debt could be continued.
Until the first major crisis of confidence in November 1997 this
is what, in fact, occurred.
D. The financial crisis of summer 1998
The Russian financial crisis of the
summer of 1998 shared many features of other financial crises in
recent years. Each of these crises can be partly explained in
terms of problems specific to the country affected, in Russia's
case the shortcomings of its fiscal system described above being
particularly important. But recent episodes of financial crisis -
and Russia's was no exception - typically involve the attraction
of capital inflows associated with an interest rate differential,
generally resulting from tight monetary policy introduced for
macroeconomic balance, and a currency regime designed to
stabilize the exchange rate. The inflows are facilitated by
relatively liberal rules for capital-account transactions and
deregulation of the financial sector, which leave banks free to
borrow abroad, thus benefiting from international interest rate
arbitrage but building up foreign exchange exposure. The
resulting dependence on foreign capital flows leaves the economy
vulnerable to their reversal which can be triggered by
unfavourable changes in domestic or external conditions (or
both). The outflow of capital following the reversal is likely to
cause a devaluation which leads to capital losses on the balance
sheets of banks and other firms carrying unhedged currency
exposures. The subsequent surge in the demand for foreign
exchange generated by attempts to cover these losses can create a
free fall in the country's currency and a hike in interest rates,
producing widespread bankruptcies.
As part of its efforts to achieve macroeconomic
stabilization, as explained above, the federal government had
made increasing use of the issuance of GKOs. As can be seen from
table 1, of the government deficit (excluding off-budget funds)
as much as 50 per cent was due to interest payments, and under
the new policy the resulting obligations were financed in Ponzi
fashion by sales of new government paper. Much of this paper was
bought by Russian banks which financed their purchases by
borrowing from foreign banks through repo contracts, in the
process exposing themselves to substantial currency risk. But an
important part of the debt was also purchased directly by foreign
investors, non-resident holdings of GKOs being estimated at about
30 per cent of the total in mid-1998. Currency risks associated
with their investment were offset through the purchase of forward
contracts from Russian banks (payments under which, as explained
below, have been frozen under a 90-day moratorium on selected
external obligations).
As Russia's current account deteriorated from a
position of surplus in 1997 (table 1) to a deficit now forecast
at 1.5-2 per cent of GDP for 1998 as a whole, the rouble came
under pressure and monetary policy was tightened with the result
that the interest rates on GKOs reached levels of more than 100
per cent (more than 40 per cent above those on dollar-denominated
instruments with similar maturities). The consequent decline in
the value of government securities led to calls by the foreign
creditors of Russian banks for additional collateral for their
repo loans. Russian banks thus came under pressure to raise
additional funds at just the time when the central bank was
draining liquidity from the market as part of its attempt to
defend the exchange rate. With the repo market in disarray owing
to the falls in the value of government securities, banks'
efforts to borrow were transferred to the interbank market which
proved unable to sustain these extra demands for funding and
eventually ceased to function. These difficulties signalled the
liquidity squeeze on Russian banks to international lenders, and
increased their fears of widespread insolvencies in the country's
financial sector. At the same time the government faced
increasing difficulties over borrowing to meet the interest
obligations on its debt. The banks had no alternative to closing
their repo positions by repaying their borrowing in dollars, and
these repayments put further downward pressure on the exchange
rate and international reserves, thus leading to additional
monetary tightening and falls in the prices of government
securities.
The package of international loans from the
IMF, the World Bank and Japan arranged in July was to provide
Russia with funding of $17 billion during the remainder of 1998
and 1999 (which was in addition to financing from the IMF and the
World Bank of more than $5 billion during this period made
available under earlier decisions). However, the attempt to
defend the exchange rate which followed (and which cost
approximately $4 billion in a month) was eventually abandoned,
and a wider band for the rouble/dollar exchange rate was
introduced in the third week in August around a new central rate
corresponding to a rouble depreciation of more than 25 per cent
from the previous level of 6.1 roubles to the dollar. This
decision was accompanied by other emergency measures including a
90-day moratorium on obligations on selected private foreign
debts with a maturity of more than 180 days and on those due to
margin calls and foreign exchange contracts, other capital
controls such as a ban on purchases by non-residents of domestic
bonds with a maturity of up to one year, and guarantees for
private bank deposits. The government also announced a moratorium
on its own debt which is to precede an eventual forced conversion
of GKOs and other bonds maturing in 1999 into longer-term debt
instruments (a step which followed a largely unsuccessful attempt
earlier in the year to persuade investors to exchange their
holdings of GKOs for longer-term dollar-denominated debt).
The moratorium on government debt caused large
losses to foreign banks as the value of the debt was written
down, and additional losses resulted from the abortion of forward
exchange contracts under the moratorium on selected external
obligations. For Russian banks the losses associated with the
crisis are estimated at 40 per cent of their assets. The events
and the emergency policy response took place during a period when
Russia was formally observing an IMF stabilization programme.
At the outbreak of the crisis the total
exposure of non-residents to the Russian economy in the forms of
debt and equity amounted probably to $200-250 billion, though
subsequent falls in asset prices are likely to mean that the
figure is now lower. The exposure is unequally distributed, a
high proportion being concentrated among West European lenders
and investors. This figure constitutes a very small fraction of
investors' and lenders' global external exposure: in the case of
German banks, for example, whose lending to Russia amounts to
more than 50 per cent of the total by international banks, their
assets in Russia are less than 5 per cent of their total foreign
assets.
But despite the small scale of international
exposure to Russia, the emergency measures taken by its
government nevertheless were accompanied by significant declines
in prices in international financial markets, substantial
downward revisions in forecast levels of capital inflows to
developing and transition economies, and unfavourable shifts in
indicators of such economies' creditworthiness as the yield
spreads on their external bonds in secondary markets. The
pervasive declines in equity prices, which were particularly
large in several emerging financial markets, reflected partly
investors' liquidation of positions elsewhere to make provision
for their losses in Russia, but were also influenced by a
reassessment of price levels in stock markets more generally
associated with fears that financial disturbances might produce a
global recession. Despite a continuation of relatively high yield
spreads in secondary markets on the international bonds of most
borrowers from developing and transition economies in the first
half of 1998, forecasts by various financial institutions for
capital inflows remained relatively optimistic. However, since
the outbreak of the Russian crisis these forecasts have been
revised downwards, the changes being substantial, for example, in
the case of Latin America. The reassessment of the
creditworthiness of borrowers from developing and transition
economies has also been reflected in a virtual standstill of
their international issues of debt instruments and in increases
in the already fairly high levels of the yield spreads on their
international bonds in secondary markets just mentioned (chart
1).
E. Interpretation and conclusions
1. Structural weaknesses of Russia's fiscal
management
Policy makers are now faced with the urgent
tasks of restoring financial stability in Russia and drawing up a
coherent programme of reform which will necessarily have to focus
on building the institutional framework for market-based
activity. But before the latter can be achieved, it is important
to reach a more realistic understanding of what has gone wrong
over the past several years. At present, the mainstream diagnosis
seems to be that the short-termism of the Russian programme was
part of a necessary gamble which did not pay off: Russian
stabilization has failed, on this view, because the time gained
was not used to implement necessary reforms, especially in the
fiscal field. In particular, dismay has been expressed at the
failure of the Duma in July to implement a full set of emergency
measures, which would have included a shift towards individual
income taxation.
The conventional wisdom on this question does
recognise that further fiscal reform in Russia is a Atall order@,
although at times it has been presented simplistically as a
simple question of political will. There has yet to be a
recognition, however, of more fundamental design flaws in the
programme pursued from 1995. The core problem for fiscal policy
is that owing to the limited resources and the restricted set of
operational policy instruments available in a structurally
unreformed Russia the programme was inherently unable to achieve
a sustainable degree of economic stabilization. This runs counter
to the view often expressed by the international financial
institutions. On the contrary, the measures which were feasible
to extract revenue and to cut spending propelled the economy
further away from an orderly path to a market economy, and
instead drove it towards increased reliance on barter, monetary
surrogates and mutual Aoffsets@, and mounting arrears, public and
private, of which wage arrears are only the most visible,
journalistically interesting and potentially explosive
manifestation.
Throughout recent years the fiscal problem has
always demanded more than a marginal adjustment of expenditure to
revenue. The Russian state, weak from its inception, has not been
able to establish a budgetary process, oversight and audit, and a
working system of fiscal federalism, which would allow genuine
control over expenditure. On the other side of the balance sheet,
the institutional deepening necessary to create a law-governed
system of tax administration, to introduce a workable tax code,
and thus to strengthen tax collection lagged behind the demands
for revenue. In the context of a chaotic, opaque and arbitrary
system, periodic campaign-style attempts to improve fiscal
discipline to meet IMF targets generally succeeded in worsening
fundamentals for the longer run.
The mechanism by which the almost exclusive
focus on the only clearly achievable goal, price stability, sowed
the seeds of its own destruction, lay first of all in the
development of a pernicious cycle in the fiscal process. The
budget adopted annually consciously chose simply to paper over
the gap between the revenue which could actually be collected and
the expenditure being proposed. This meant, on the one hand, that
revenues always had to be collected by "campaign
methods", and, on the other, that non-payment by the
government of its own bills was endemic. Not only was there
formal sequestration with revenue shortfalls, but also a welter
of ad hoc non-payment and "offset" processes,
the extensive development of monetary surrogates (especially at
the regional level), and, necessarily, an increased toleration of
tax arrears by those who, in turn, had not been paid sums due
from the budget. This established, first of all, a culture of
non-payment and an intricate web of arrears. The constant press
of demands of tax collection, set in a legal framework famous for
its inconsistency and room for "discretion",
consistently penalised those entities which attempted to live
legally, and thus continued to narrow the tax base.
The issue of non-payment of taxes due from the
important energy sector reveals the unusual character of the
Russian fiscal dilemma. The popular perception in the West that
arrogant oil and gas barons simply were unwilling to pay the
taxes due needs some correction. In the complex tangle of
non-payment, the Russian government also came to demand that
energy be provided free of charge (that is, with no disconnection
for non-payment) to a substantial proportion of users. The demand
for cash payments in addition to this effective
"tax-in-kind" understandably appeared as a form of
double taxation.
As this cycle developed, the economic system
was effectively demonetised, with a particularly sharp impact on
the payment of wages and pensions. Attempts to solve this problem
also took on a campaign air: thus there were energetic efforts to
pay off wage and pension arrears on several occasions. The
systemic character of the arrears and barter problem, however,
was increasingly revealed by the ultimately abortive nature of
these efforts. This can be seen from one notable example: from 1
January 1998 the federal authorities (successfully) insisted on
payment only in monetary form, but the outcome was a worsening in
the fiscal position of the regional authorities and the
off-budget funds, and a dramatic rise in wage arrears, which
increased 38.5 per cent in real terms from the start of
the year to the end of July.
The orientation towards stabilization through
borrowing was further exacerbated by the setting of inflation
targets which were inappropriately low for an economy undergoing
major restructuring. To continue this course, very high rates of
interest were often required. Although credit to the real sector
has been low throughout this period, high rates of interest
inevitably helped to reduce fixed investment, and thus almost
certainly played a major role in choking off growth in 1998.
This, in turn, had further negative implications for the fiscal
position.
There are no institutional fiscal adjustments
which could have dramatically improved the fiscal balance in an
inexpensive way, through simple rationalization, given the
conditions in which the reform process began in Russia.
Restructuring is never inexpensive. The present financial crisis
is thus the outcome of a series of decisions, domestic and
foreign, which have persistently denied the sheer magnitude of
the transformation required in Russia.
2. The currency crisis, transparency and
contagion
The dangers inherent in the inadequacy of the
efforts to achieve fiscal balance have been exacerbated by
dependence on foreign financing both in the form of direct
investment in government debt instruments and in that of lending
to finance Russian banks' purchases of these instruments. This
dependence increased the vulnerability of the Russian economy to
a generalized debt run as part of a currency crisis whose
consequences are much more extensive than those of a debt run by
the creditors of domestic debtors.
Lessons drawn concerning the external dimension
of Russia's financial crisis should not be limited to the
government's mismanagement of the opening of its financial
markets to foreign investors and lenders or the vulnerabilities
associated with reliance on capital inflows for financing fiscal
deficits. This experience also highlights once more the
irrational exuberance and herd behaviour of international lenders
and investors in entering as well as exiting emerging markets.
Since the crisis in East Asia inadequacy of
information and lack of transparency regarding structural
weaknesses in emerging financial markets have been the subject of
greatly enhanced attention as an explanation of build-up of
external fragility and crisis. However, much of the increase in
the external financial exposure to Russia took place during a
period when information was widely available concerning the
shortcomings of Russian macroeconomic policy, the weaknesses of
the country's banks, and the underdeveloped state of the
country's legal and regulatory framework and of its system of
corporate governance. Moreover, as noted earlier, most of the
recent capital inflows into Russia took place when the country
was carrying out IMF stabilization programmes. The Russian
experience thus raises serious questions as to the effectiveness
of enhanced transparency in influencing the behaviour of
international lenders and investors, and as to the relation
between programmes of official external financial support and
moral hazard.
The immediacy and scale of falls in asset
prices and other unfavourable shifts in indicators of the
creditworthiness of emerging financial markets in Asia and Latin
America noted above are a stark reminder of the potency of
contagion effects and of the vulnerability of recipients of
capital flows to the so-called "flights to quality" of
investors in today's global network of financial markets. The
aftermath of the Russian crisis has once again emphasised the
inadequacy of current arrangements for dealing with global
financial instability.
For enquiries, please contact:
Mr. Yilmaz Akyüz, Chief
Macroeconomic and Development Policies
United Nations Conference on Trade and Development (UNCTAD)
Palais des Nations
CH - 1211 Geneva 10, Switzerland
Tel: ++ (4122) 907 58 41
Fax: ++ (4122) 907 02 74
E-mail: [email protected]
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Mr. Paul Rayment, Director
Economic Analysis Division
United Nations Economic Commission for Europe (UN/ECE)
Palais des Nations
CH - 1211 Geneva 10, Switzerland
Tel: ++ (4122) 917 27 18
Fax: ++ (4122) 917 03 09
E-mail: [email protected]
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