FUNDAMENTAL ASPECTS OF THE RUSSIAN CRISIS Robin Matthews Kingston University Business School UK. Roman Golov Moscow State Aviation University and Kingston University Business School. ABSTRACT We address problems of debt, virtuality, and destructive feedback in the Russian economy. Official data fails to reflect reality. Much of the advice by reformers was flawed in that it ignored the importance of market. A positive feedback cycle of arrears, barter, and non-competitiveness evolved. Feedback systems are critical to market economies generally. Contagion from Asia was merely the trigger for a crisis waiting to happen. On the upside, no one seriously suggests a reversal of the positive changes in the Russian economy and constitution. I. INTRODUCTION This paper examines the fundamental causes and consequences of the crisis of August 1998. At the macro level, positive feedbacks took the form destabilising contagion from Asia. These are well-documented; see for example, Golov and Matthews, (1999). We focus on interrelationships between events at the macroeconomic level, and their microeconomic reflection in the energy sector. We are especially concerned with positive feedbacks at the industry level that disturb market systems. Unless fundamental flaws in the management of firms and industries are rectified, Russian problems will persist. These failures stem from a number of sources; deficient market institutions, under investment, and shortage of management expertise. Essentially many of the problems have a historical root, and their resolution takes time. They arise from failures of Statism everywhere to deal with problems of the new economic environment that emerged in the 1970 s. Statism (Castells, 1997) describes an economic system in which the surplus created by society is appropriated by a political class, and used to enhance the power of the state in one way or another. In the Soviet version of Statism, the surplus was largely devoted to industrialization and the militarization. In 1998, contagion from Asia caused the Russian crisis to emerge from behind the virtual screen where it had been hidden by artificial accounting systems (Gaddy and Ikes, 1998). The virtual economy is one in which what is reported, especially about the industrial sector bears little resemblance to the realities of the situation. The gap between the virtual and the real economy in Russia is manifested in unpaid wages, taxes, pensions and so on. The gap reflects the nature of the long term Russian crisis, and prevents its resolution. Most important it distracts the attention of investors from real, if modest, economic achievements up to the crisis, as indicated in the table below.

Main Macroeconomic Indicators in 1994-97

˚

1994

1995

1996

Total

Total

Total

1997 Q1

Q2

Q3

Q4

1.GDP trillion roubles 611 1585 2200 541 620 715 726 % of same period a 87 96 97 99 99.5 102 103 year ago 2. Industrial Output trillion roubles 384 1054 1414 377 384 395 420 % of same period a 79 97 96 101 101 103 103 year ago 3. Agricultural Output % of same period a 88 92 95 93 95 106 99 year ago 4. Inflation CPI 315.0 231.0 121.8 105.4 103.0 100.5 101.8 5. Real Personal Cash Incomes % of same period a 112.0 84.0 99.0 101.0 104.4 101.5 103.5 year ago Source: The Central Bank of Russian Federation

Total 2602 100.8 1576 101.9

100.1 111.0 102.8

In a smoothly working price mechanism, bankruptcy of inefficient firms acts as a self regulating or negative feedback control system. The Russian system effectively precludes bankruptcy and other incentives to become more competitive. Hence despite significant reforms, Russian industry remained, during the 1990’s, in a parlous state, waiting for a crisis to happen. The Asian meltdown was just such a crisis. It revealed the inadequacies of Russian economic development. But it was the trigger, rather than the fundamental cause of the current crisis. Failure of the Russian market system stems from a misunderstanding of the role of institutions in capitalism and underestimation of the length of time necessary for such institutions to evolve. They will not arise, like phoenix from the ashes of the Soviet planning system, merely because people are able to trade goods and services on the market, and public assets are privatized. Nor will acceptance of IMF conditions about opening up the economy to trade and capital flows cure the problem. Curbing financial deficits and national debt are necessary but not sufficient conditions in the absence of an effective system of financial regulation. II. THE RUSSIAN VIRTUAL ECONOMY Virtuality describes the economic system in Russia (Gaddy and Ikes 1998). It is virtual that it is based on illusory parameters: prices, sales, wages, taxes, and budgets. Essentially it is a pretense that the economy is much larger than it really is. It allows larger government expenditures than Russia can afford. It masks the web of indebtedness from which Russia cannot extricate itself.

An economy has emerged in which prices are charged which no one pays in cash; where no one pays anything on time; where huge mutual debts are created that cannot be paid off in reasonable periods of time; and wages are declared and not honored. This creates illusory earnings, which in turn lead to unpaid taxes, and business being conducted via barter and virtual prices. Many enterprises fail to pay suppliers or workers or taxes. While the nonpayment of taxes and wages attracts media attention, it is in a sense not the real story. Barter replaces transactions in money. The share of barter in payments among all industrial enterprises in Russia was more than 73% in 1997 (Gaddy and Ikes 1998). The destruction of the socialist common market two years prior to the dissolution of the Soviet Union created an extremely difficult situation for Russian enterprises. Almost overnight, the tight production and supply links which had characterized the centrally planned system’s were disrupted, and the accompanying payments system was left in chaos, and this was intensified by the breakup of the Soviet Union, and the collapse of the Russian economy. The consequences of dissolution of empire and economy was a chain of arrears. Enterprises suffer overdue receivables from customers an are, in turn, in arrears to suppliers (inter-enterprise or trade credit arrears). Enterprises postpone their tax payments, and the federal government is overdue on payments to public employees and pensioners. Inter-enterprise arrears are the largest. Non payment of tax in 1997 amounted to 5% of GDP. These are recorded arrears whose impact on the economy is inflated by evasion in the shadow or black economy and by legal, state-authorized tax exemptions or offsets. III. THE ENERGY SECTOR Specific problems at the microeconomic level have led to significant tax arrears in the energy sector, an important area of potential competitive advantage for Russian firms. Tax and unpaid debts are found not only in the chronically feeble enterprises, many of whom will eventually have to be liquidated, but in stronger firms. Surprizingly, many weak firms are found in the energy sector - supposedly the richest sector in Russia. There are three interacting reasons for arrears in the energy sector; price liberalization, non-competitiveness, and failure to enforce payments. As a result of price liberalization, enterprises are formally required to pay their bills or go into liquidation. In fact this does not happen. Many firms and local authorities find it hard to pay energy bills. As a result of failure to modernize, the coal industry, for example, is inefficient as compared to foreign suppliers. As a result of its non-competitiveness it fails to attract the funds that would enable it to do so. Yet enterprises in the coal industry are able to stay in production because they are not required to meet their obligations. So they fail to pay taxes, or to pay suppliers. In turn their suppliers, the electricity industry for example, are in deficit. Hence they too fail either to meet their obligations or to modernize. Local and central authorities are unable to meet their commitments, as a result, and so the story continues. Non competitiveness feeds non-competitiveness, and deficit feeds deficit, in a destructive positive feedback cycle. Consider the Russian electricity industry, the main customer for coal. Coal could be purchased in China where it is cheaper. But to support the Russian

real production sector, the Russian government does not allow to the electricity industry to buy coal abroad: even if the state did so, given the cycle of non-competitiveness and non payment, the electricity industry could not pay for imports in cash. The electricity industry uses Russian coal and produces the electricity at an inflated price. Similar situations exist in other sectors, because electricity is central to so many economic activities. So the destructive positive feedback cycle spreads like a virus. IV. CONCLUDING REMARKS We return to the issue raised in our introductory remarks; The crisis " revealed the inadequacies of Russian economic development. But it was the trigger, rather than the fundamental cause." Previous paragraphs imply a recommendation to close the gap between the virtual and the real economy. Only then can the price system act as a negative feedback or self -correcting mechanism. This recommendation however itself has an underlying precondition; that appropriate capitalist institutions be created in Russia. The precondition itself is hedged by qualifications of time and political feasibility. Legal, regulatory and institutional frameworks in the commercial, natural resource, government and financial sectors, take time to evolve. In developed economies they took many centuries and are still far from ideal. Much of our narrative highlights problems of the market system. In ideal economies, and perhaps, and only perhaps, many economies exist in this state for good lengths of time, the price mechanism acts as a negative feedback control mechanism - dampening rather than heightening problems, eliminating inefficient firms through bankruptcy and competition, encouraging innovation for profit, providing signals and incentives to guide the allocation of resources. Without appropriate institutions, feedbacks are almost inevitably positive. Instead of dampening oscillations, such institution deficient market systems accentuate them. Sometimes chaos emerges. The presence of chaos in the Russian economy is the subject of our further research. Here we note what has become obvious to anyone who considers a market system seriously. At certain times and under certain conditions market systems become unstable. We identify Russia as such a system. Oscillations are magnified, and economic, social, and political crises interact. Such is the situation in Russia. The Asian contagion brought issues into the open. We might summarize our conclusions by saying that market systems require appropriate institutions. They take time to emerge. The time dimension gives a clue as to a contagion more fundamental than the Asia crisis itself. That is the contagion of naive advice. Early reformers and their Western advisers assumed that such institutions would emerge almost overnight if only assets were privatised and markets created. The folly of this assumption was revealed in 1998. In a sense however the narrative of positive feedback contains a certain inevitability. In the late 1980 s Russia was presented with no alternative but to institute a market system that was fundamentally flawed. Globalization, advances in information technology and Cold War pressures meant that Russia could no longer be sheltered from international competition. Dramatic liberalization in politics and economics were required, and so were instant measures. The heartening

aspect of the last ten years is that despite appalling problems, no one seriously suggests a reversal of the political and social advances that have taken place in the last ten years; elected governments, a constitution and a freedom to express criticism.

V. SELECTED REFERENCES Castells, Manuel. The End of the Millenium, Blackwells. Oxford, 1997. Central Bank of Russian Federation (1998), Main Macroeconomic Indicators in 1994-97, Internet, homepage, Credit Suisse First Boston (1995), A Guide to Russian Debt Markets, December. "Fedorov: Russia’s taxman." Euromoney., (353), September, 1998, 66-62. Fisher, Stanley (1998), The Russian economy at the Start of 1998, International Monetary Fund, Internet, homepage, http://www.imf.org/external/np/speeches/1998/010998.htm Foreign Investment Promotion Center under the Ministry of Economy of the Russian Federation (1998), Development of Russian Economy in 1997 for the Social and Economic Development of the Country for 1998, Internet, homepage, http://www.fipc.ru/fipc/reviews/ruseconomy1997.html Gaddy, C.G. The Price of the Past: Russia’s Struggle with the Legacy of a Militarized Economy. Washington DC: Brookings, 1996. Gaddy, C.G. and Ickes, B.W. "Russia’s Virtual Economy." Foreign Affairs., 77, (5), September-October, 1998, 53-67. Golov, R.S. "Problema neplatezhey v sovremennoy rossiyskoy ekonomike i organizatciia sistemy regionalnych vekselnych raschetov mezhdu mestnym budgetom i predpriiatiiami regiona kak odin iz sposobov eye preodoleniia." Innovatcii., 14-15, (4-5), October, 1998, 70-78. Golov, R.S. and Matthews, R. The Russian crisis: Causes, Consequences, and Implications for the Future. Occasional Paper. Kingston University, 1999. Metodologicheskie polozheniia po statistike. Goskomstat. Moscow, 1996 a. OECD, Economic Surveys, Russian Federation. CCET, Paris, 1997. Rutland, P."The Russian Economy in 1996: Another Lost Year." OMRI Annual Survey of Eastern Europe and the Former Soviet Union. ME Sharpe, 1996,1997. Skvortsov, V. "Most nad biudzhetom.", Kommersant., (16), 1997,13. "Materialy k zasedaniiu prezidiuma pravitelstva Rossiiskoi Federatsii po voprosu "O merrakh po usileniiu gosudarstvennogo kontrolia za nalogovoi distsiplinoi krupnykh kompanii I predpriiatii — neplatelshikov." State Tax Service (materials prepared for the federal government)., 1997. Tikhomirov, V. "Capital Flight from Post-Soviet Russia." Europe-Asia Studies., 49, (4), 1997, 591-615.