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WEDNESDAY, 16 DECEMBER 1998
00.01 HRS GMT
THE RUSSIAN CRISIS: BY NO
MEANS A UNIQUE EVENT
The United Nations Economic
Commission for Europe announces the publication
of the third issue of its
1998 Economic Survey of Europe
The third issue of the Economic Survey of
Europe published by the United Nations Economic Commission
for Europe (UN/ECE) provides in its chapter 1 an overview of
economic developments in 1998 and discusses at length the policy
implications of the Russian crisis. It also suggests some
preliminary steps forward. Chapter 2 discusses the economic
situation in more detail in the western market economies and in
the transition economies of eastern Europe, the Baltic states,
and the CIS. Particular attention is given to an analysis of
the origins and unfolding of the Russian crisis and its impact on
other transition economies. Chapter 3 reviews international trade
developments in eastern Europe, the Baltics and the CIS; and
chapter 4 looks at the development of current account balances
and their financing, especially in the wake of the Asian and
Russian crises. Chapter 5 examines the attempts to create a
system of Production Sharing Agreements in Russia which, in their
promise and relative failure, illustrate at a micro-level many of
the problems which have held back the reform of the Russian
economy. Finally, the Survey contains a Statistical
Appendix containing long time-series for the principal
macroeconomic variables in the ECE member countries. These
tables, as well as those in the text, reflect revisions and
updates made by national statistical offices and available to the
secretariat as of mid-November 1998.
Lessons of the Russian crisis
This issue of the Economic Survey of Europe devotes particular attention to the Russian crisis (pp. 7-13 and
pp. 31-41). It concludes that the policy course that has been
followed so far has led precisely to the present unpromising
situation, and thus a fundamental reappraisal is necessary. The
standard policy prescriptions which were followed in Russia
turned out, given the institutional setting and the difficult
initial conditions prevailing in the country, not simply to be
ineffective, but to give increasingly perverse results which
moved the country further and further away from establishing
effectual free markets and stable government.
There is wide agreement that a major fiscal
imbalance was the proximate cause of the present Russian
financial crisis. But the persistent fiscal problem is itself the
consequence of the grave, and the more fundamental problems of
the process of economic and political change in Russia.
Essentially, the crisis reflects major failures in the actual
Russian transformation model. The Russian fiscal dilemma was made
progressively more, not less, acute by the policy mix adopted in
1995, and the actual dynamics of the particular stabilization
recipe in fact led to an increase in the budget deficit rather
than its reduction. The perverse incentives generated by
macroeconomic policy, moreover, were magnified by the deeply
flawed privatization process which produced a private ownership
structure which neither encouraged effective corporate governance
nor the efficient allocation of resources.
Given the profoundly inappropriate character of
so much of the Russian institutional infrastructure for the new
market environment, disinflation turned out to be a more easily
achievable goal, given the operational policy levers actually
available to policy makers. The increasingly excessive emphasis
on price stabilization necessitated increasing monetary austerity
as the commitment to what became, in effect, an exchange rate
anchor, involved a further policy commitment to high interest
rates. To help complete this particular vicious circle, the
higher interest rates raised the cost of debt service, and thus
increased the fiscal burden. This process ruled out a return to
growth, and fixed investment has continued to fall throughout the
entire period.
Whilst there is little doubt that there has
been some concealment of corporate profits, particularly in light
of the continued complex and arbitrary tax structures, aggregate
corporate profits have actually fallen. Enterprises and regions
increasingly resort to monetary surrogates and barter, further
extending the demonetization of the economy. All this has
continued to shrink the tax base. The issue of non-payment of
taxes by the important energy sector further reveals the unusual
character of the Russian fiscal dilemma. The popular perception
that arrogant oil and gas barons were simply unwilling to pay the
taxes they owed needs some correction. In the complex Russian
tangle of non-payment, the government also came to demand
effectively that energy be provided free of charge (that is, with
no disconnection for non-payment) to a substantial proportion of
users.
In sum, the path taken in an attempt to restore
fiscal balance in Russia since 1995 has proved to be
counterproductive and, in the end, has resulted in a disastrous
financial and political crisis. In this unpromising atmosphere,
it is easy to be paralysed by the sheer scale of the problems,
yet positive first steps can lead to others, provided that there
is an overall sense of direction. The greatest source of
disorientation, however, has come from the belief that economic
policies can be advocated in an institutional vacuum. A critical
lesson which emerges yet again from consideration of the Russian
crisis is that active assistance in the creation of appropriate
institutions should never have been relegated to the rank of
"second-generation" transition issues.
The implementation of any set of economic
policies must perforce be done through institutions, the state
and its public administration. Arguably the most serious
consequence of the "policy overshooting" on
transformation issues was the widespread and deliberate
downgrading of the role of the state. Even for the establishment
of an effective fiscal administration, there will be little
progress without the creation of a professional civil service, a
functioning public administration, and the development of broader
societal attitudes regarding the legitimacy of the state and of
its right to levy taxes. It is evident that the gap which must be
bridged in this respect is substantially greater for Russia and
other countries of the CIS than for most of the states of central
and eastern Europe.
The Survey argues (pp. 10-11) that the
policy impasse, however desperate it may appear at present, can
be broken by articulating a coherent and long-term strategy to
tackle these myriad problems. A carefully sequenced programme is
needed in which high priority must be given to creating the key
institutional foundations of the market economy and for changing
the structure of incentives so as to encourage entrepreneurship
and fixed investment. The precise content should be decided by
the Russians themselves, but it must be designed to convince the
G-7 and the Russian public of the credibility of the strategy and
therefore attract the necessary financial and popular support for
the programme. This will be costly B but there are no qUick
solutions, and further delay will be even more costly.
The Russian crisis is by no means a unique
event. Recent cases of economic distress in other transition
economies (for example Bulgaria, Romania and some of the CIS
countries, especially Ukraine and the Republic of Moldova) in
fact have much in common. The 1997 exchange rate crisis in the
Czech Republic although not so acute and devastating was also
symptomatic of important, transformation-specific economic
weaknesses and was followed by a painful economic downturn. A
common feature is that the causes of these crises are deep-rooted
in the microeconomics of transition. The principal microeconomic
factors that have led to macroeconomic distress during the
transition are often related to market distortions and/or the
malfunctioning of markets; perverse incentives and the perverse
behaviour of economic agents; weak or poorly functioning
regulatory, judicial and other state institutions; weakness and
poor regulation of the banking system; and inherent
inefficiencies in the corporate sector of the economy. The lesson
here is that without microeconomic reforms macroeconomic
stabilization is likely to be short-lived and may even produce
perverse effects; but without a reasonable degree of
macroeconomic stability, the micro-reforms may not be undertaken.
Russia's experience has once again highlighted
the daunting policy task of restructuring and rehabilitating the
corporate sector in many transition countries. The lack of
satisfactory progress in structural reforms in some transition
economies, especially in dealing with unviable enterprises, has
often been due not so much to a lack of understanding of the
problems and an absence of "political will" to address
them, but to the very severe political and resource constraints
stemming from the sheer magnitude of the required restructuring
effort. The existence of a large, critical mass of unviable firms
is a major stumbling block to the successful implementation of
the whole transformation policy agenda. Its restructuring will
continue to require special efforts not only by national policy
makers but also by the international community at large.
The global context
Recent developments in the global economy have
prompted a more pessimistic assessment of short-term economic
prospects in the ECE region. This reflects in the main the
recession in Japan and the Asian emerging markets, which has
turned out to be much deeper and longer-lasting than expected
earlier this year. The crisis in Asia was transmitted to the rest
of the world via the steep fall in domestic absorption in
the region and the adverse change in financial conditions facing
emerging markets.
The sharp fall in international commodity
prices in 1998 is also largely due to the crisis in east Asia.
Falling commodity prices have improved the terms-of-trade of the
developed market economies, thus supporting growth in real
incomes, but increasingly their exports have been negatively
affected by the reduced import capacity of the commodity
exporters.
In contrast to Asia, Russia's role in world
trade is very small, and the deep crisis there has affected other
regions mainly through the financial channel, with significant
adverse trade effects limited in the main to some of the
transition economies. Essentially, the Russian crisis has
amplified the recessionary forces originating in Asia.
The international financial situation looked
quite precarious for some time in late summer and early autumn,
but fears of a global liquidity crisis appear to have receded in
late October 1998 although further setbacks cannot be excluded.
World output is now forecast to grow by only 2
per cent in 1998, the smallest annual increase since 1991. This
stands in sharp contrast to the optimism prevailing a year ago,
when a growth rate of about 43 per cent was forecast. But at that
time the impact of the Asian crisis on trade, profits and other
economic variables was still difficult to gauge.
The western market economies
In the western market economies of the ECE
region, the pace of economic expansion has lost momentum in the
course of 1998. The pronounced strengthening of industrial and
consumer confidence in the course of 1997 was partly reversed
over the first ten months of 1998. Exports were increasingly
affected by the weakening demand in Japan and developing
countries, although this was offset by relatively robust domestic
demand.
Real GDP in western Europe is now forecast to
increase by 2.8 per cent in 1998, broadly the same rate as in
1997. In the United States, the annual growth rate is likely to
be some 3.5 per cent this year, down from 3.9 per cent in 1997.
The relatively favourable economic performance in western Europe
and North America in 1998 contrasts with the deep recession in
Japan, where real GDP is expected to decline by 2.5 per cent this
year. Altogether, the rate of economic expansion in the dEveloped
market economies will be only 2.2 per cent in 1998, down from 3
per cent in 1997.
The outlook for 1999 is currently very
uncertain. Against the background of the recent turmoil in
financial markets, the deep crisis in Asia and the lingering
uncertainty as to whether financial stability can be maintained
in Latin America, growth forecasts have been steadily reduced
since the summer.
For western Europe, total output is now
expected to increase by about only 23 per cent next year,
about half a percentage point lower than the average of forecasts
made in the spring of 1998. In the EMU area, aggregate economic
growth will be only slightly higher than the European average.
There are, however, considerable differences among individual
countries. Of the four major economies, a pronounced slowdown in
the growth rate is forecast for the United Kingdom, but a
clear weakening of cyclical growth forces is also expected in
France and Germany. In contrast, the expectation is still for
relatively robust growth in the smaller economies.
In the United States, the broad consensus of
forecasters is for a slowdown to an average growth rate of 2 per
cent in 1999. A slightly higher output growth is expected for
Canada.
In Japan, there are hopes that the recession
will bottom out, but no significant growth, if any, is expected
in 1999. Much will depend on the restoration of business and
consumer confidence. A coherent policy designed to stimulate
economic activity and to resolve the crisis in the banking sector
is therefore primordial.
All told, economic growth in the developed
market economies will be only some 1: per cent in 1999 compared
with the previous year. This is the lowest growth rate since
1993.
These rather benign prospects for the
industrialized countries, however, are surrounded by serious
downside risks. A key assumption of all the forecasts is that
there will be no further round of turmoil in the financial
markets. It is assumed that economic performance in the emerging
markets of Asia and Latin America will stabilize or even improve,
if only slightly, in 1999. But above this scenario, the financial
and economic crisis in Japan is still hanging like the sword of
Damocles.
In western Europe, there are widespread
concerns that the average growth forecast paints too optimistic a
picture of likely economic developments in 1999. It should be
recalled that these forecasts are mainly based on statistical
information covering at best the first seven or eight months of
1998, i.e. the Russian crisis and its likely ramifications on
economic activity can only be appraised, for the moment, in broad
qualitative terms. In fact, recent short-term economic indicators
appear to confirm the downside risks to the forecasts for 1999
noted in the Survey. If the cyclical slowdown turns out to
be more pronounced than currently expected, this will be bad news
for the labour markets of western Europe where even with the
current optimistic forecasts, the average unemployment rate will
still be around 10 per cent in 1999, only half a percentage point
less than in 1998. A more severe slowdown would also mean that
the expected gains in employment and incomes would be smaller
than forecast, with negative feed-back effects to private
consumption, business profits and fixed investment.
Although fears of a credit crunch appear to
have receded in the United States, the lending behaviour
of the commercial banks has become more cautious, as is reflected
in a tightening of the credit terms on business loans. A major
uncertainty concerns the spending behaviour of private
households. Savings fell to a negligible proportion of disposable
income in the third quarter against a background of continuing
strong demand for loans. The strong rise in the spending
propensity of US households reflects to a large degree the surge
in financial wealth over the past few years, which, on paper, has
offset the rise in debt stemming from rapid credit expansion.
Equity prices in the United States still appear to be overvalued
in view of the expected deterioration in corporate earnings in
the latter half of 1998 and in 1999. There is a risk that any
sharp and sustained fall in US equity prices could trigger a
major downward shift in households' spending. This would also
affect the cost of investment finance in the corporate sector.
The combined effect would be a much stronger slowdown in the
growth of domestic demand than is currently expected.
In the United States, the Federal Reserve has
reacted to the recent financial turmoil and the deterioration in
the economic outlook by relaxing, albeit moderately, the stance
of monetary policy. In addition, the recent dollar depreciation,
if sustained, should provide support to exports. A much stronger
than expected cyclical downturn would also justify a change in
the stance of fiscal policy.
In western Europe, the focus of monetary policy
in most countries has been on the preparations for the
forthcoming introduction of the euro and the shift to a single
monetary policy which will be conducted by the new European
Central Bank. In the spring of 1998, expectations were that the
cyclical upswing in the EMU area would strengthen in the second
half of the year and that therefore the ECB might have to raise
interest rates to stem inflationary pressures. But the balance of
risks has changed decisively in the course of 1998. Inflation has
fallen to historic lows and there appears now to be an increasing
probability that the cyclical upswing in western Europe could
once again be negatively affected at an early stage by a
deterioration in the international economic environment. The
timing and extent of changes in the stance of monetary policy is
often a matter of controversy, not least because of the
"long and variable lags" involved before the measures
are felt in the real economy. Outside the future Euro-area,
concerns about the increasing risks of recession in the United
Kingdom in 1999 led to a cut in the central bank's base rate in
early October and early November.
The Survey argues that in view of the
increasing risk that the growth of domestic demand will be less
robust than expected and insufficient to offset a deterioration
in export performance, a pre-emptive lowering of interest rates
in the "core countries" of EMU before the end of 1998
or by the new ECB early in 1999 was warranted. (After the Survey was completed the central banks of France, Germany and other
countries in the euro-zone lowered their interest rates on
3 December 1998, a move which appears to confirm these
concerns about deteriorating economic prospects.)
Given the diverging cyclical positions of the
EMU members, the easing of monetary policy, however, may require
an offsetting tightening of fiscal policy in a number of the
smaller economies. The dilemma, however, is that there is no room
for manoeuvre for an expansionary countercyclical fiscal policy
in the three large member countries of EMU because of the rules
of the Stability and Growth Pact. This puts the full burden of
adjustment to the deteriorating economic environment on monetary
policy.
Actual budget deficits in some of the smaller
economies are still not down to levels at which policy makers
would be free from the constraints of the Stability Pact. There
is agreement among European policy makers that budget deficits
have to be reduced to near balance in order to create a
sufficient cushion for the working of automatic stabilizers (or
countercyclical policy measures) in the event of a serious
cyclical setback. This requires either additional discretionary
measures or a sustained period of rapid growth to boost
government net revenues. A sustained period of robust economic
growth is also what is required to lower cyclical unemployment
and to create an environment more conducive to labour market
reforms and for starting the urgently needed reforms of the
national pension systems.
The cyclical slowdown now being forecast for
1999 could therefore be a source of conflict between European
governments, which are committed to growth and lower
unemployment, and the new ECB, which is focused on keeping the
inflation rate below 2 per cent.
The ECE transition economies
In the first half of 1998 output performance in
many ECE transition economies remained relatively strong and
aggregate GDP in the region grew by 2.1 per cent which was more
than in 1997 as a whole. However, taking into account the
negative changes in the second half of the year, the aggregate
outcome for the ECE transition economies for the whole of 1998 is
likely to be zero growth of GDP or even a small decline. The main
reason for this is the economic downturn in Russia which, taking
into account the size of its economy, will also result in a
negative rate of growth of the aggregate GDP of the CIS taken as
a whole. In eastern Europe, despite some deceleration in the
second half of the year, aggregate GDP for 1998 as a whole is
still expected to grow by more than 3 per cent, while the Baltic
states remain the fastest growing region in Europe with aggregate
GDP expected to grow by almost 6 per cent.
The strong recovery which was underway in a
number of central European and Baltic countries in 1997 and in
the first half of 1998 was predominantly export driven. Exports
from the east European and Baltic countries continued to grow in
the first half of 1998 at some 11-14 per cent in dollar value - a
rate which was comparable to that in the second half of 1997 -
supported by buoyant west European demand. However, the value of
total exports from the ECE transition economies declined slightly
in the first half of 1998, following 4 per cent growth in 1997.
This solely reflects the poor export performance in Russia and
the rest of the CIS whose exports were badly affected by
declining prices on world markets, an unfavourable trend which
continued in the third quarter of 1998. One of the direct effects
of the Russian crisis was a sharp decline in Russian imports
which has had a negative impact on a number of transition
economies (and which may also have longer-run negative effects if
Russian demand remains depressed for a long time).
Rates of inflation continued to fall in most
transition economies in the first three quarters of 1998.
Compared with 1997, disinflation in 1998 was not only more
widespread but also more rapid. Both domestic and external
inflationary pressures weakened considerably. In the majority of
countries restrictive monetary policies, and in some also a tight
fiscal stance, dampened domestic demand. Wage inflation, except
in a few of the smaller economies, also slowed down, albeit to
rates still out-pacing price inflation. However, given the
continued improvement in labour productivity, the growth in unit
labour costs decelerated markedly in most transition economies.
Furthermore, the weakening in import price pressures, which was
already underway in 1997, became more accentuated.
In the first half of 1998, the slow employment
growth of the previous two years decelerated further in eastern
Europe and the Baltic region. In the CIS countries employment
continued to fall, but at a slower rate. Registered unemployment
rates, therefore, remained high in eastern Europe (11 per cent);
in the CIS they increased further, but still remain very low
compared with eastern Europe and given the cumulative decline in
their output.
The impact of the global financial crisis on
the current account balances in the ECE transition countries has
been generally negative, largely because of its indirect effects.
Current account deficits in relation to GDP on average remain
high, in some cases at, or close to, double digit levels. The
fall in commodity prices contributed to the transformation of
Russia's long-standing current account surplus into a deficit in
early 1998. The overall volume of capital flows into eastern
Europe and the Baltic states in the first half of 1998 remained
high; flows of foreign direct investment (FDI), which are more
determined by long-term considerations, continued to rise, and
for several months capital market activity partially recovered.
As for the second half of 1998, there was a general deterioration
in the conditions on international financial markets. The global
"flight to quality" also substantially raised the cost
of funds, essentially excluding most eastern countries from
further borrowing. The activity of emerging market economies in
the international capital markets came to a standstill again and
there were sizeable outflows of short-term capital from several
transition economies.
Two major external factors appear to be
dominant for the short-term outlook for the ECE transition
economies: the state of west European demand and conditions on
the international capital markets. The high exposure of the ECE
transition economies to foreign markets, while a mark of their
integration in the world economy, is at the same time a source of
vulnerability for the transition economies, even for the more
advanced ones, in the short run. Preliminary and partial data
already indicate a slowdown in the growth of exports from the
transition economies in the third quarter of 1998 and this was
also associated with a deceleration of industrial output growth
in these countries. If this process continues or deepens, it
would lead to a general and significant weakening of economic
growth in the transition economies in 1999. While at this stage
this can only be regarded as a "worst case" scenario
with a relatively low if increasing degree of probability, it is
important that policy makers be alert to the potential downside
risks to the outlook so that contingency plans can be prepared to
cope better and more efficiently with the consequences of a
possibly sharp deterioration in the external environment.
The successful reconstruction of the transition
economies depends crucially on maintaining growth and fixed
investment, and a continuing inflow of foreign capital,
especially foreign direct investment. A deceleration of these
flows may slow the process of restructuring and recovery as well
as lowering future growth potential. As a result of the
deterioration of the situation on global financial markets some
transition countries B especially those with structural problems
and stalled reforms B may start to face difficulties in raising
the funds necessary to cover their financial needs.
For any further information and queries
please contact:
Economic Analysis Division
United Nations Economic Commission for
Europe (UN/ECE)
Palais des Nations
CH B 1211 Geneva 10, Switzerland
Tel: + (4122) 9172718
Fax: + (4122) 9170309
E-mail: [email protected]