Russia at the Crossroads

Devaluation of Ruble Reflects Need for Further Economic Reforms

When Russia defaulted on her debts and devalued the ruble last August, Americans felt the effects as well.

When Russia defaulted on her debts and devalued the ruble last August, Americans felt the effects as well. Investors were concerned that this might signal another round of attacks on the currencies of emerging economies. Russia may account for only one-half of one percent of American exports, but investors feared that if speculators were successful there, they would move on to Latin America. The impact of speculation in those currencies would have a much greater impact on American businesses. This fear helped trigger a dramatic downturn in the American stock market.

In addition, some financial institutions had substantial exposure through investments in Russian securities, and they incurred real losses. Chase Manhattan Corporation, for example, was reported to have lost $200 million for the months of July and August. Other American companies doing business in Russia lost sales as the ruble fell and imports became too expensive for the Russians to buy.

Since August there have been other economic impacts as well. The United States and the European Union made commitments in November to provide five million tons of food aid to Russia this winter to help counter the effects of a bad harvest. Potential impacts on the American economy include the price of wheat, availability and cost in the transportation sector, and government expenditures for buying and storing surplus commodities.

Americans need to be aware of what is happening in Russia for even more important reasons however. Russia has great natural resources and a well-educated population. It could become a significant source of markets and competition, and a formidable force in the world economy if the country can work its way through the immediate crisis and move quickly toward greater economic freedom. On the other hand, if the immediate crisis is not satisfactorily resolved, there is the possibility of social unrest and/or a move to re-establish an authoritarian government that would rely on military might. Russia is still a major force in geo-politics given her size, her history, her store of nuclear weapons, and the knowledge base of her scientific community. Americans need to understand and stay alert to what is happening in this vast country.

The previous communist regime created economic catastrophe and instilled an anti-capitalist mindset that older citizens may never lose. However, many younger people have embraced the ideas of change, freedom, and markets. Their initial experiments in capitalism may resemble the American Robber Baron period more than they do contemporary western markets. Certainly the disparities in wealth remain enormous. Nevertheless, the basis for a viable market economy is being established. It must be nurtured, however, for it could easily be delayed — or even derailed — by the current crisis. Success is not inevitable.

The recent crisis in the Russian financial markets again highlighted the fundamental structural deficiencies of the Russian economy. That economy is likely to worsen during the next year unless a profound structural reform is initiated and maintained.

The Problem

The Soviet economy was value-subtracting rather than value-adding throughout its life span. Explained simply, the world market value of almost all Soviet-made products was below the world market value of the natural resources and direct labor used to produce those products. The seemingly inexhaustible supply of easily-extracted natural resources made this possible. These resources were traded to communist allies in exchange for desperately needed manufactured goods and agricultural commodities. This “picking the low-hanging fruit” policy sustained the Soviet government until the late eighties, but the economy began to disintegrate as the demands of the deprived consumers and bloated military increased. Much of Russia’s enormous gold stockpile was sold off to prolong the inevitable, but the empire collapsed in 1991. The tragic irony of this debacle is that most Russians believe that the economy imploded because of the fall of the communist government, not the other way around.

This foolish misunderstanding is a major contributor to the current reality. Seven years after the breakup of the Soviet Union, the overwhelming majority of its industries and enterprises have been inherited from the late Soviet Union, and remain value-subtracting.

Accentuating this problem is the fact that world markets presently show little interest in anything from Russia other than her natural resources and, interestingly enough, her people. Many thousands of Russians are currently employed by multinational organizations as managers, analysts, engineers, and scientists both in Russia and abroad.

The Importance of the Private Sector

Falling oil prices triggered the current Russian economic crisis. However, the fundamental problem lies in the structural deficiency of the Russian value-subtracting economy. The crisis cannot be overcome by reversal of crude oil prices, or by an IMF-sponsored debt restructuring. This latest quick fix arguably may actually deepen and prolong the crisis. At best these remedies are a bandage on a cancer. At worst they will permit inefficient industries to persist, encourage more fraud, rationalize tariff increases, and make it even harder to reverse the downward spiral. The crisis can only be overcome when new value-adding industries are built.

The building of new industries must be initiated and managed entirely by the private sector. Left alone, small competing firms eventually will gravitate to those products and services that best serve Russian talents and interests, and then will evolve into industries where Russia can sustain international competitive advantages. Historically, most successful new businesses initially operate at a loss to finance aggressive expansion, develop at least one core competency, and, most relevant to Russia, create significant added value.

However, the current Russian tax environment inhibits the creation of value-adding new businesses in three punitive ways:

  1. By aggravating inevitable losses inherent to all young expanding businesses by vigorously enforcing pre-profit taxes such as mandatory contributions to a suspect national pension plan, tariffs on imported production equipment, and road taxes;
  2. By discouraging foreign investment with a wide assortment of anti-business regulations such as minimum wages, customs abuse, visa harassment, and currency controls;
  3. By imposing a value added tax (VAT) on intermediate goods produced by outsourcing or subcontracting, thereby defeating efforts to create a single core competency.

The final point requires a more detailed treatment. The existence of VAT creates a tremendous disincentive to outsource or subcontract domestically, forcing a business to do as much as possible in-house. The existence of tariffs further aggravates the problem by creating an even stronger disincentive to outsource or subcontract internationally. Finally, currency controls do not allow Russian businesses to invest abroad, thereby eliminating the advantage of using low-wage countries for labor intensive production requirements. Not incidentally, these currency controls also inhibit exports by penalizing (or forbidding) expenditures on marketing and distribution in high-income countries.

To make matters worse, the Russian government continually introduces new import tariffs and increases old ones. For example, the tariff based on the weight of a traveler’s luggage doubled between March and July of this year. This discourages businesspeople and insults other visitors. Incredibly, last fall some Russian officials even proposed imposing an import tariff on the wheat that the United States was donating as food aid! Import tariffs may produce short-run revenue for the state’s coffers. However, the negative long-run effect on business and economic development should be obvious even to a free-market neophyte.

The Importance of Oil

The dearth of value-adding industries makes Russia extremely vulnerable to world natural resource markets. The precipitating cause of the present turmoil in the Russian financial markets was the dramatic fall in world oil prices. Oil prices dropped 32% in 1998 on the New York Mercantile Exchange from $17.64 per barrel at the end of 1997 to $12.07 a barrel at the end of 1998. This was even up a little from its December 10 low of $10.72.

Oil is Russia’s primary export commodity, and depressed oil prices devastate the Russian current account. This weakens the ruble, and both Russian and international investors make speculative attacks on it. The Bank of Russia responded to a May speculative attack by temporarily raising interest rates to 150% and then subsequently lowering them to 60%.

Devaluation of the ruble and default on debt payments in August worsened the situation further. The government has experienced intense political pressure to print money to pay pensions, salaries, and other obligations to the Russian people. This is inflationary of course. Average daily inflation was 0.285 percent during the first two weeks of January 1999, and that was down from a daily average of 0.355 percent in December.

The Continuing Danger

Given the economic crisis of last August, the accompanying inflation increases, and the continuing dependency on oil as a primary export, Russian interest rates will continue to fluctuate. In this financial environment, the Russian banks will most likely return to speculating in government bonds and interbank loans and abandon their trade financing practice. The banking system may even go one step further and limit its functions to currency exchange alone because of the uncertainty following the Russian government’s recent default on domestic bonds. Rising interest rates create an enormous incentive for corrupt government officials and crooked industry managers to hold up wages and pensions in order to participate in these wild speculations. This will cause a new wave of wage and pension arrears similar to what happened just a few years ago and bring increased pressure on the government to print money.

Exacerbating the problem is the current crisis in food production. It is estimated that Russian grain output was only about 52 million metric tons in 1998, down 39.5% from the previous year’s crop. This was partially due to a severe spring drought combined with heavy fall rains. It was also partially due to inefficient production methods. There was some debate late last fall about whether or not Russia actually needed to import food to avoid widespread starvation this winter, with some arguing that the problem was simply one of distributing existing supplies or lowering the import tariffs on food so that the market would work. The concerns about shortages are real enough, however, that the United States and the European Union are providing almost five million tons of food aid. Some of this is an outright grant, and some is to be paid for through long-term loans.

The most serious shortages of food were initially reported to be in the far northeast. However, without this aid — and without changes in the government-run distribution system — the major cities of Russia could well have faced serious shortages as the winter progressed. They import 60-80% of their food. By mid-winter the inhabitants likely would have faced increasing food prices, limited quantities, and limited varieties. In the current inflationary environment their incomes would also pay for less of what was available. In such a situation, the outcome is predictable: widespread, politically dangerous social disruption — especially in the cities — which would be enthusiastically supported (if not directly inspired) by those seeking to destroy the present government.

The Immediate Remedy

A real and legitimate concern in Russia is that if the usual practices of government distribution are followed, supplies provided by the West will be siphoned off for private gain by a few well-connected individuals and not reach the sectors of the population that need them. To guard against this, the donor countries are providing the supplies in installments rather than all at once. They have also demanded the right to monitor food distribution. Shipments will cease if it appears that supplies are not being distributed as promised.

This may be helpful as a short-term solution this winter. However, it cannot be overemphasized that in the longer term, profit-seeking private enterprise is the only way to ensure the successful distribution of food. In the food business, the perishable nature of inventory requires undivided attention and hands-on, around-the-clock participation. The only way to encourage this kind of effort is to allow food distributors to reap whatever profits the market may offer.

The Long Term Priorities

Russia’s heavy dependence on oil exports must end. The building of new value-adding businesses must not be obstructed. In practice, this will require dismantling currency controls and shifting the bulk of the government revenues from VAT, excise taxes, and tariffs to individual and corporate income taxes.

In addition, an accounting reform emphasizing compatibility with International Accounting Standards is in order. Requiring these reporting standards, coupled with an absence of tariffs and a dismantling of currency controls, would attract more foreign investment than any conceivable program of government or multilateral guarantees.

More importantly, along with foreign capital must come much-needed modern business practices. Russia surely has the best-educated citizens among the less developed economies of the world. They can, and will, learn quickly to combine the concepts and models imported by their international peers with their own knowledge of Russian realities and the Russian consumer.

It is our considered belief that the people of Russia, not her natural resources, are the true source and cause of Russia’s present endurance and future prosperity. The Russian people deserve peace, liberty, and the just rule of law. A freely elected government must deliver these to maintain its existence and preserve Russia’s future.

Nikolai V. Chuvakhin is a professor in the Market Economy Fundamentals Seminar Program in Moscow, Russia.

Steven T. Ekstrand is an International Attorney and Director of the Market Economy Fundamentals Seminar Program in Moscow, Russia. He is a graduate of Pepperdine University’s joint J.D./MBA Program.

Authors of the article
L. Wayne Gertmenian, PhD
L. Wayne Gertmenian, PhD,
Nikolai V. Chuvakhin
Nikolai V. Chuvakhin,
Steven T. Ekstrand
Steven T. Ekstrand,
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