In December 1998, Russia defaulted on a
critical portion of its foreign debt to the London Club by failing
to make a $360 million cash payment. It offered to pay 2.5 cents on
the dollar in new state-issued paper. Only the Deutsche
Bank and Chase Manhattan Bank accepted the offer. Russia also
offered 1 cent on the dollar for overdue GKO bonds. After this move,
an international credit rating agency downgraded Russia's
post-Soviet Eurobonds, giving them the lowest rating possible, and
declared the pre-1992 Soviet debt in default.
MOSCOW'S SOLUTION: A "VIRTUAL" BUDGET
that it would appear to be correcting many of the problems that
prevented the economy from turning around, the Russian government
issued a new budget in January 1999 which it hailed as "austere"
and "realistic." IMF and Western
experts did not agree. IMF First Deputy Managing Director Stanley
Fischer observed in January 1999, for example, that the budget was
"neither sufficiently ambitious nor realistic," and would cause "a
continuation of the cycle of large deficits and ever-growing
interest payments that led to the current crisis."
Russia's 1999 budget was based on the
An exchange rate of 21.5 rubles to the
U.S. dollar. As of June 8, 1999, $1 equaled 24.45 rubles.
A 2 percent increase in gross domestic
product (GDP) for 1999. However, the World Bank projects a decline
of 4 percent to 6 percent.
An inflation rate of no more than 30
percent. Today, inflation is projected to reach 50 percent.
An increase in central government tax
receipts. In reality, federal tax collections are dropping and
currently amount to around 9 percent to 10 percent of GDP.
Repayment of $9 billion of the $17.5
billion Russia owes in interest and principal on its debt this
year. Russia projected it would be able to borrow an additional $5
billion to $7 billion abroad.
Russia's monetary base is increasing to
195 billion rubles, while foreign exchange reserves are decreasing
to $12 billion--a negative sign of a low base-to-reserves ratio.
(See Chart 4.) With exports falling and oil prices at a historic
low, foreign exchange revenues will continue to decline. The
foundations for a healthy exchange policy currently rest on
Curiously, the IMF's Stanley Fischer had predicted in January 1998
that Russia would see "a low budget deficit, sustainable public
debt position, low rate of inflation, an improved rate of
investment," and a 6 percent annual growth in the economy. In July 1998, he
also predicted that the IMF bailout package approved on July 20,
1998, would boost investor confidence in Russia and lend support
for the ruble. Unfortunately, he
was wrong. By June 1998, the State Duma and Central Bank admitted
that the Russian economy needed fundamental restructuring and
announced a wide-ranging structural agenda with
reforms of public utility and transport
monopolies, legislative and institutional changes...[for]
furthering the transition to a market economy...fostering private
investment and growth...continued liberalization of the trade and
exchange system, consolidation of the banking system, and
strengthening of the supervisory and monetary policy functions of
the Central Bank...to improve revenue collection...and explicit
program, designed to encourage Western investment and IMF loans,
remains unrealized. The government failed to implement timely
payments to foreign creditors or to ensure transparency in such
state-run monopolies as the natural gas company (Gazprom), the
national electric company, the railways, or the oil pipeline
company. Moscow shelved privatization of land and a number of
government-owned assets. It failed to
reform capital markets or bankruptcy law, or to introduce
internationally recognized accounting and auditing standards.
Duma, which for the past six years has been dominated by communists
and anti-Western nationalists, did not approve the ambitious
IMF-inspired reform package required in the 1998 loan agreement.
Nevertheless, based on a promise of reform, a $22.6 billion IMF
loan package was negotiated and a $4.8 billion tranche released to
Russia in July 1998. This year, the IMF
and the Clinton Administration are demanding some conditionality
with the IMF loans, but the IMF is likely to release the credits
regardless of Russia's performance. A major default by a large IMF
debtor country would set an unwelcome precedent and reflect
negatively on the decisionmaking abilities of the IMF board.
Primakov's Economic Legacy.
Under former Prime Minister Primakov, Russia reverted to some of
the former socialist economic management approaches without fully
resurrecting central planning. Primakov's economic team was headed
by the former head of the Soviet Union's central planning agency,
Yuri Maslyukov, and by Viktor Gerashchenko, a Soviet-era Central
Bank official. Though Primakov enjoyed the overwhelming support of
the State Duma, his cabinet failed to implement an effective
economic reform program.
Prime Minister Stepashin has yet to
establish a new economic policy agenda, so Primakov's policies
remain in place. Unfortunately, the Primakov plan is an unworkable
amalgam of market-based economics and Soviet-style policy
prescriptions. The Primakov
cabinet had promoted state-owned enterprises and worked to set up a
state-run Russian Development Bank. Four large oil companies were
approved to merge into one state-run entity with 75 percent state
ownership. This giant company, which controls the world's largest
explored oil reserves, is expected to produce 55 million tons of
oil per year.
Under Primakov, the economic team had
established an array of tax reductions and transportation tariff
breaks for products defined by the bureaucracy as "socially
significant" and "vital." Some industries qualify legitimately for
these targeted tax credits; others do not. Only government
officials would be able to define which goods and industries would
be targeted, creating an opportunity for corruption in the issuing
of permits and licenses. The program allows enterprises to cancel
each other's debts through barter. It also includes harsher
currency controls: Businesses are forced to exchange 75 percent of
their hard currency revenues into rubles.
These policies--tariff breaks, subsidies,
and the legalization of barter for tax payments--ensure that the
Russian government will continue to face a revenue shortfall.
1998, most deputies in the State Duma seemed more concerned with
their political survival in the upcoming December elections than
with passing legislation to improve the economy or repay the
foreign debt. Nevertheless, in a hopeful move, the Duma passed a
Production Sharing Agreement in December 1998 to allow Western
companies to invest in over 50 Russian oil fields, generating as
much as $50 billion in foreign investment over the life of projects
(25 or 30 years) covered by the legislation. This amount,
however, will not be enough to repay Russia's foreign debt or boost
Currently, the Federation Council (the
upper house of Parliament) is focusing on increasing revenues for
regional governments and boosting the political power of the
governors. But economic mismanagement has plagued regional and
central governments as well. For example, the Leningrad and
Sverdlovsk regions (oblasts) have been cited as likely to default
on their foreign loans.
The FIMACO Scandal.
On February 1, 1999, Russia's Prosecutor General Yury Skuratov
revealed in a letter to Duma Chairman Gennady N. Seleznev that the
Central Bank had placed about $50 billion in a previously unknown
offshore asset management company called the Finance Investment
Management Company (FIMACO). The Paris-based
Eurobank, which is owned by the Russian Central Bank, set up FIMACO
in 1990 using $1,000 in start-up capital.
According to Skuratov, since 1993, FIMACO
handled up to $37 billion in U.S. dollars and about $13 billion in
other currencies. Shortly after his
announcement, Skuratov resigned his post for "health reasons" and
checked into a Kremlin hospital for fatigue. He resumed his duties
a few weeks later, although Yeltsin tried repeatedly to fire
Foreign governments usually manage their
own reserves or use the services of major Wall Street or London
investment firms. But the revelations of Central Bank chairman
Gerashchenko and his predecessor, reformer Sergey Dubinin, were
unusual. Gerashchenko acknowledged that FIMACO managed the Central
Bank's funds, justifying this by
saying that the Central Bank did not have the capacity to handle
foreign exchange reserves at the time. Dubinin went even further:
He acknowledged that the purpose of FIMACO was to hide assets from
foreign creditors and that its actions therefore were justified. Dubinin indicated
that part of the funds managed by FIMACO came from the World Bank
and the IMF. He added that the matter involved state secrets and
the facts about FIMACO became known, the Central Bank's top
officials refused to disclose the names of FIMACO's managers or
reveal who was benefiting from commissions on the reportedly
gigantic sums it managed. They would not disclose where the
commissions were deposited or who had paid taxes on them. The Bank
later admitted that FIMACO had private partners in Eurobank
(FIMACO's owner), including Russia's leading oil and banking
Former Finance Minister Boris Fedorov
admitted that he knew about the offshore dealings of the Central
Bank in 1993, but Gerashchenko had refused to disclose the
specifics. "[A]s I understand, friends were given a chance to make
some money," Fedorov observed. Former First
Deputy Prime Minister Alexander Shokhin disclosed that in 1998, the
Central Bank parked $1 billion in a zero-interest account in
Eurobank--a highly suspicious practice.
Finally, the bank's officials admitted
that the Central Bank played the highly lucrative treasury bill
(GKO) market--which yielded annual interest rates of up to 300
percent--even as it set the GKO interest rates. Between March and
September 1996, FIMACO made $38.9 million on an investment of
$143.3 million in GKOs.
letter made public by the State Duma, Yuri Ponomarev, a top
Eurobank official, ordered FIMACO staff to trade through phone
buy-and-sell orders and to use code words, leaving no paper
trail--a highly unusual practice in managing Central Bank reserves.
The Bank's former First Deputy, Chairman Oleg Khandruyev, noted
that decisions about FIMACO were not made by the Bank's board;
instead, they were "quiet decisions."
Although Russian officials at first had
denied that the IMF knew about FIMACO, on February 18, 1999, Deputy
Central Bank Chairman Oleg Mozhaiskov reportedly admitted that the
IMF did know of the arrangement. On March 22,
former Central Bank chairman Dubinin admitted that the IMF knew
about FIMACO, but he insisted that Russia had done nothing wrong. If officials at
the IMF knew of this arrangement and did nothing, they allowed the
fraudulent practices of the Russian Central Bank to remain hidden,
and even to continue. If they did not know, they demonstrated
enormous negligence in performing their responsibilities.
According to Russian polls, the people of
Russia question their government officials' ability to manage
Central Bank reserves, and many believe that these officials
embezzle the funds Russia receives in financial assistance from the
West. Before the FIMACO
scandal emerged, 60 percent of Russians polled said they believed
IMF funds were being embezzled. Some 35 percent said their country
did not benefit from the IMF assistance, compared with 31 percent
who believe it did. Such numbers
highlight the aura of corruption and the lack of trust in Russia's
government. The findings of an upcoming audit of the Russian
Central Bank by PriceWaterhouseCoopers, which the Duma
commissioned, may shed some light on this case; its findings should
be fully disclosed.
WHAT RUSSIA MUST DO
Russian government's high level of corruption and official policies
aimed at preserving the vestiges of the Soviet military-industrial
complex are destroying the Russian economy. After seven years of
borrowing from the International Monetary Fund, debt is escalating
and the economy is deteriorating. Yet IMF officials try to justify
their past lending policies, which focused on alleviating fiscal
and budgetary inefficiencies and disregarded both Russia's
structural weaknesses and the existence of a "virtual" economy so
keenly dependent on the barter system.
Russians, however, can no longer afford to
ignore their economic problems. As Director of the USA-Canada
Institute in Moscow Sergei Rogov wrote, "The Russian Federation has
turned into a sort of `financial drug addict,' becoming more and
more dependent on foreign credits." The decision to
turn the Russian economy around can come only from within Russia's
political class. Without a real transformation of the political
climate in Russia, the prospects for stimulating domestic economic
growth and attracting foreign investment will remain bleak.
Primakov's team was unwilling and unable
to take the steps necessary to restore economic stability and bring
about an enduring recovery. It is hoped that the new government
recently installed by Boris Yeltsin will have a better chance of
turn the economy around, Russia needs to take three important
- Enforce a thorough and sustained
crackdown on crime and corruption to restore popular support for
market reforms and revive the confidence of Western investors in
To encourage foreign investment, law enforcement officials and
the judiciary need uniform and enforceable standards of
investigation, prosecution, and punishment. As Under Secretary of
the United Nations for Crime Prevention Pino Arlacci has stated,
"Russia is the first large state completely overtaken by organized
crime and corruption."
So far, anti-corruption measures have been
used primarily as tools to settle political scores among the power
elite. But corruption undermines the legitimacy of the current
regime and increases the cost of doing business. The government
should conduct a full investigation and audit of FIMACO and all
foreign assistance programs to determine how much Western
assistance was channeled through FIMACO; how much in commissions
and profits was generated and who benefited; whether these profits
were repatriated to Russia and, if so, whether taxes were paid on
them; what the IMF or other donors knew; and what, if anything,
they did about it.
Inadequate laws and the breakdown of the
judiciary have led many Russians to invest abroad and have
convinced foreigners not to invest in Russian companies. As long as
the courts and arbitration tribunals are not the only venues of
dispute resolution and contract enforcement, organized crime and
corrupt officials will continue to determine how disputes are
settled. Property rights must be expanded to protect investors and
entrepreneurs and to encourage investment and the development of
the real estate market and agriculture. The legal system also must
recognize and protect creditor rights.
- Appoint an economic team that
understands the principles of market economics.
This team must have practical experience with successful
economic decision making in Russia to gain credibility. However,
the new team headed by Aksenenko and Khristenko has many oligarch
friends who have been accused repeatedly of abusing their political
ties for personal enrichment.
- Undertake a comprehensive program
of radical economic restructuring.
This program should be implemented with a new level of
discipline and cooperation between the
federal government in Moscow and regional governors. At this time,
however, the Russian government has not released any new economic
policy documents. In order to jump start economic recovery, the new
economic team needs to take the following steps:
Secure current and future loans with
collateral. Russia's record of debt repayment in this century is
poor. After the 1917 Bolshevik coup, Russia defaulted on the
czarist debt. After World War II, Stalin refused payments to the
United States under the lend-lease program that had contributed
greatly to the Soviet victory in World War II. A Soviet debt of
over $90 billion is outstanding, yet former top Soviet leaders
remained in the highest offices in Moscow until May 12, 1999. If
Russia continues to borrow, it should secure its previous and
future loans with collateral, such as natural resources, oil
fields, and property. This could generate a positive cash flow with
long-term leases. An example would be leasing the Northern
Territories (Kurile Islands) to Japan.
Improve debt management. Debt management
should be concentrated in a high-level government agency, possibly
within the Finance Ministry, and headed by an official who has
extensive experience in international finance and is supported by a
highly trained staff. Portfolio managers must be experienced in
risk-management techniques and given ample resources with which to
do their work. Several developed debtor nations, including Austria,
Belgium, Ireland, and New Zealand, as well as such emerging markets
as Hungary and Colombia, have taken this path successfully.
Reform the tax system, improve tax
collections, and revise the state budget. Russians have a saying:
"The government is pretending to collect taxes, while we are
pretending to pay." Large corporations and the super-rich in
particular avoid paying taxes. Russia should implement a simple
system of taxation and tax collection that will generate revenue
from wealth-generating industries such as oil and gas and high
net-worth individuals, and provide exemptions or very low tax rates
for the majority of the population. Russia needs to stop the
precipitous decline of GDP by cutting government expenditures,
including subsidies to heavy industry and agriculture. Equally
important are further cuts in the size of the military and
significant nuclear arms reduction to reduce maintenance costs.
Eliminate the barter system in
non-competitive goods and arrangements to pay tax arrears. Up to 80
percent of all transactions, including local, regional, and federal
taxation, are conducted by barter. This occurs when
enterprises cannot sell their products for "real" money because
their products are not competitive, or when they arrange with local
governors or federal tax officials to reduce their tax liabilities
by bartering off goods--usually goods that are unmarketable and
non-competitive. If bankruptcy procedures were working and the
government refused to sustain money-losing industrial enterprises,
the necessary restructuring of the industrial base in Russia
already would be occurring. Only this kind of restructuring can
guarantee long-term growth in GDP. The government, working with
foreign economic experts, needs to design measures to monetize the
barter system and to restructure the industrial base to reduce the
importance of bartering in government operations.
Stop the disruption of interstate commerce
by regional governors. Unhampered interstate commerce guarantees
optimal functioning of an economy, and disruptions in such commerce
may lead to food shortages and declining outputs. After the August
1998 ruble crisis, a number of governors and autonomous republic
administrations banned food exports from their regions. For
example, the ultra-nationalist governor of the Krasnodar region,
Nikolai Kondratenko, restricted farmers from exporting grain, the
area's main commodity. Other regions and republics licensed and
regulated exports. This practice should cease.
Moscow must ensure the open flow of commerce within the Federation
to prevent food shortages and encourage business to develop.
Draft and pass a Land Code to allow the
creation of a real estate and agricultural land market, including
mortgaging, and to facilitate the development of privately owned
farms and agribusiness. In the Duma, the communists and their
allies in the Agrarian Party have blocked even the restrictive Land
Code developed by the Yeltsin administration, claiming that it is
against the national spirit of Russia to buy and sell land. Yet
land was privately owned, traded, and developed in the late 19th
and early 20th centuries in Russia. Today, such a Land Code would
stimulate the economy and the development of a housing market, a
registry of deeds, and the mortgage industry.
Consider the benefits of a currency board.
Currency boards have an impressive track record of bringing
financial stability to such diverse countries as Argentina,
Bulgaria, Estonia, Hong Kong SRA, Lithuania, Latvia, and Singapore.
A currency board would stabilize the ruble and improve Russia's
banking system. Support for such a board is widespread, ranging
from analysts at the Cato Institute to
financier/philanthropist George Soros. One of the
critical concerns in implementing a currency board is the adequacy
of foreign reserves. This concern highlights the need for the
Russian Central Bank to implement a policy to stop the hemorrhaging
of foreign reserves; otherwise, it will have no viable monetary
new economic team must move quickly to implement these reforms to
reverse Russia's economic decline and put the economy on a path
that leads to greater prosperity for the Russian people.
President Clinton meets with President Yeltsin in Germany this
month, he should convey the importance America places on Russia's
economic recovery. Because the Russian economy is failing so
desperately, the remedy will be bitter,
but it must be of the "homegrown" variety and self-administered.
International financial assistance will never take the place of
solid economic policies based on market principles.
new government installed recently by Yeltsin may represent Russia's
last chance to step back from the edge of a socioeconomic abyss
before popular discontent brings communists and nationalists to
power or widespread anger scuttles the political system altogether.
The reforms attempted by the Russian government since 1992 have
been half-hearted, inept, and riddled with corruption. In large
measure, they have failed. A real market economy, with complex
institutions based on the rule of law, could not take root. The
result is so flawed that it has backfired, undermining the faith of
ordinary Russians in the principles of free markets and democratic
Russia today is like a rudderless ship;
members of the crew, without maps, are fighting among themselves
over whether to sail in one direction or the other. Whoever wins
the power struggle in Moscow will need to jump start the economy,
facilitate entrepreneurship, and attract investment. Moscow needs
modern market institutions, but this effort will not succeed unless
the rule of law is firmly established.
Dr. Ariel Cohen is Senior
Policy Analyst in Russian and Eurasian Studies in the Kathryn and
Shelby Cullom Davis International Studies Center at The Heritage