The History of Russia's Economic Development
Although only half the size of the former Soviet economy, the Russian economy included formidable assets. Russia possessed ample supplies of the Communist Party, which controlled all aspects of economic activity. The central planning system left a number of legacies with which the Russian economy dealt with in its transition to a market economy.
Much of the structure of the Soviet economy that operated until 1987 originated under the leadership of Joseph Stalin, with only incidental modifications made between 1953 and 1987. Five-year plan and annual plans were the chief mechanisms the Soviet government used to translate economic policies into programs. According to those policies, the State Planning Committee (Gosudarstvennyy planovyy komitet - Gosplan) formulated countrywide output targets for stipulated planning periods. Regional planning bodies then refined these targets for economic units such as state industrial enterprises and state farms (sovkhozy; sing., sovkhoz) and collective farms (kolkhozy; sing., kolkhoz), each of which had its own specific output plan. Central planning operated on the assumption that if each unit met or exceeded its plan, then demand and supply would balance.
The government's role was to ensure that the plans were fulfilled. Responsibility for production flowed from the top down. At the national level, some seventy government ministries and state committees, each responsible for a production sector or subsector, supervised the economic production activities of units within their areas of responsibility. Regional ministerial bodies reported to the national-level ministries and controlled economic units in their respective geographical areas.
The plans incorporated output targets for raw materials and intermediate goods as well as final goods and services. In theory, but not in practice, the central planning system ensured a balance among the sectors throughout the economy. Under central planning, the state performed the allocation functions that prices perform in a market system. In the Soviet economy, prices were an accounting mechanism only. The government established prices for all goods and services based on the role of the product in the plan and on other noneconomic criteria. This pricing system produced anomalies. For example, the price of bread, a traditional staple of the Russian diet, was below the cost of the wheat used to produce it. In some cases, farmers fed their livestock bread rather than grain because bread cost less. In another example, rental fees for apartments were set very low to achieve social equity, yet housing was in extremely short supply. Soviet industries obtained raw materials such as oil, natural gas, and coal at prices below world market levels, encouraging waste.
The central planning system allowed Soviet leaders to marshal resources quickly in times of crisis, such as the Nazi invasion, and to reindustrialize the country during the postwar period. The rapid development of its defense and industrial base after the war permitted the Soviet Union to become a superpower.
The record of Russian economic reform through the mid-1990s is mixed. The attempts and failures of reformers during the era of perestroika (restructuring) in the regime of Mikhail Gorbachev (in office 1985-91) attested to the complexity of the challenge. Since 1991, under the leadership of Boris Yeltsin, the country has made great strides toward developing a market economy by implanting basic tenets such as market-determined prices. Critical elements such as privatization of state enterprises and extensive foreign investment went into place in the first few years of the post-Soviet period. But other fundamental parts of the economic infrastructure, such as commercial banking and authoritative, comprehensive commercial laws, were absent or only partly in place by 1996. Although by the mid-1990s a return to Soviet-era central planning seemed unlikely, the configuration of the post-transition economy remained unpredictable.
Economists have struggled to achieve accurate measurement of the Russian economy, and they have questioned the accuracy of official Russian economic data. Although the market now determines most prices, the Government (Russia's cabinet) still fixes prices on some goods and services, such as utilities and energy. Furthermore, the exchange rate of the ruble (for value of the ruble) to the United States dollar has changed rapidly, and the Russian inflation rate has been high. These conditions make it difficult to convert economic measurements from rubles to dollars to make statistical comparisons with the United States and other Western countries.
According to official Russian data, in 1994 the national gross domestic product (GDP) was 604 trillion rubles (about US$207 billion according to the 1994 exchange rate), or about 4% of the United States GDP for that year. But this figure underestimates the size of the Russian economy. Adjusted by a purchasing-power parity formula to account for the lower cost of living in Russia, the 1994 Russian GDP was about US$678 billion, making the Russian economy approximately 10% of the United States economy. In 1994 the adjusted Russian GDP was US$4,573 per capita, approximately 19% of that of the United States. A second important measurement factor is the extremely active so-called shadow economy, which yields no taxes or government statistics but which a 1996 government report quantified as accounting for about 50% of the economy and 40% of its cash turnover.
Economic reform in the 1990s
Two fundamental and interdependent goals — macroeconomic stabilization and economic restructuring — marked the transition from central planning to a market-based economy. The former entailed implementing fiscal and monetary policies that promote economic growth in an environment of stable prices and exchange rates. The latter required establishing the commercial, legal, and institutional entities — banks, private property, and commercial legal codes— that permit the economy to operate efficiently. Opening domestic markets to foreign trade and investment, thus linking the economy with the rest of the world, was an important aid in reaching these goals. The Gorbachev regime failed to address these fundamental goals. At the time of the Soviet Union's demise, the Yeltsin government of the Russian Republic had begun to attack the problems of macroeconomic stabilization and economic restructuring. By mid-1996, the results were mixed.
The Yeltsin economic program
Yegor Gaidar. In October 1991, two months before the official collapse of the Soviet regime and two months after the August 1991 coup against the Gorbachev regime, Yeltsin and his advisers, including reform economist Yegor Gaidar, established a program of radical economic reforms. The Russian parliament, the Supreme Soviet, also extended decree powers to the president for one year to implement the program. The program was ambitious, and the record to date indicates that the goals for macroeconomic stabilization and economic restructuring programs may have been unrealistically high. Another complication in the Yeltsin reform program is that since 1991 both political and economic authority have devolved significantly from the national to the regional level; in a series of agreements with the majority of Russia's twenty-one republics and several other subnational jurisdictions, Moscow has granted a variety of special rights and powers having important economic overtones.
Macroeconomic stabilization measures. The program laid out a number of macroeconomic policy measures to achieve stabilization. It called for sharp reductions in government spending, targeting outlays for public investment projects, defense, and producer and consumer subsidies. The program aimed at reducing the government budget deficit from its 1991 level of 20% of GDP to 9% of GDP by the second half of 1992 and to 3% by 1993. The government imposed new taxes, and tax collection was to be upgraded to increase state revenues. In the monetary sphere, the economic program required the Russian Central Bank (RCB) to cut subsidized credits to enterprises and to restrict money supply growth. The program called for the shrinkage of inflation from 12% per month in 1991 to 3% per month in mid-1993.
Economic restructuring measures. Immediately after the dissolution of the Soviet Union was announced, the Government lifted price controls on 90% of consumer goods and 80% of intermediate goods. It raised, but still controlled, prices on energy and food staples such as bread, sugar, vodka, and dairy products. These measures were to establish a realistic relationship between production and consumption that had been lacking in the central planning system.
To encourage the development of the private sector, fundamental changes were made in the tax system, including introduction of a value-added tax (VAT) of 28% on most transactions, a progressive income tax, and a tax on business income; revisions in the system of import tariffs and export taxes; new taxes on domestic energy use to encourage conservation (a necessary step because energy prices were still controlled); and new taxes on oil and natural gas exports to narrow the gap between subsidized domestic prices and world prices and to prevent domestic energy shortages. A fixed exchange rate was to be established for the ruble, which then would become convertible. Many restrictions on foreign trade and investment also were to be lifted to expose Russia to the discipline of world prices.
Monetary and fiscal policies
In 1992 and 1993, the Government expanded the money supply and available credit at explosive rates that led directly to high inflation and to a deterioration in the exchange rate of the ruble. In January 1992, the government clamped down on money and credit creation at the same time that it lifted price controls. However, beginning in February the Central Bank loosened the reins on the money supply. In the second and third quarters of 1992, the money supply had increased at especially sharp rates of 34% and 30%, respectively. By the end of 1992, the Russian money supply had increased by eighteen times.
The sharp increase in the money supply was influenced by large foreign currency deposits that state-run enterprises and individuals had built up, and by the depreciation of the ruble. Enterprises drew on these deposits to pay wages and other expenses after the Government had tightened restrictions on monetary emissions. Commercial banks monetized enterprise debts by drawing down accounts in foreign banks and drawing on privileged access to accounts in the Central Bank.
Government efforts to control credit expansion also proved ephemeral in the early years of the transition. Domestic credit increased about nine times between the end of 1991 and 1992. The credit expansion was caused in part by the buildup of interenterprise arrears and the RCB's subsequent financing of those arrears. The Government restricted financing to state enterprises after it lifted controls on prices in January 1992, but enterprises faced cash shortages because the decontrol of prices cut demand for their products. Instead of curtailing production, most firms chose to build up inventories. To support continued production under these circumstances, enterprises relied on loans from other enterprises. By mid-1992, when the amount of unpaid interenterprise loans had reached 3.2 trillion rubles (about US$20 billion), the government froze interenterprise debts. Shortly thereafter, the government provided 181 billion rubles (about US$1.1 billion) in credits to enterprises that were still holding debt.
The government also failed to constrain its own expenditures in this period, partially under the influence of the conservative Supreme Soviet, which encouraged the Soviet-style financing of favored industries. By the end of 1992, the Russian budget deficit was 20% of GDP, much higher than the 5% projected under the economic program and stipulated under the International Monetary Fund (IMF) conditions for international funding. This budget deficit was financed largely by expanding the money supply. These monetary and fiscal policies were a factor along with price liberalization in an inflation rate of over 2,000% in 1992.
In late 1992, deteriorating economic conditions and a sharp conflict with the parliament led Yeltsin to dismiss neoliberal reform advocate Yegor Gaidar as prime minister. Gaidar's successor was Viktor Chernomyrdin, a former head of the State Natural Gas Company (Gazprom), who was considered less favorable to neoliberal reform.
Chernomyrdin formed a new government with Boris Fedorov, an economic reformer, as deputy prime minister and finance minister. Fedorov considered macroeconomic stabilization a primary goal of Russian economic policy. In January 1993, Fedorov announced a so-called anticrisis program to control inflation through tight monetary and fiscal policies. Under the program, the government would control money and credit emissions by requiring the RCB to increase interest rates on credits by issuing government bonds, by partially financing budget deficits, and by starting to close inefficient state enterprises. Budget deficits were to be brought under control by limiting wage increases for state enterprises, by establishing quarterly budget deficit targets, and by providing a more efficient social safety net for the unemployed and pensioners.
The printing of money and domestic credit expansion moderated somewhat in 1993. In a public confrontation with the parliament, Yeltsin won a referendum on his economic reform policies that may have given the reformers some political clout to curb state expenditures. In May 1993, the Ministry of Finance and the Central Bank agreed to macroeconomic measures, such as reducing subsidies and increasing revenues, to stabilize the economy. The Central Bank was to raise the discount lending rate to reflect inflation. Based on positive early results from this policy, the IMF extended the first payment of US$1.5 billion to Russia from a special Systemic Transformation Facility (STF) the following July.
Fedorov's anticrisis program and the Government's accord with the Central Bank had some effect. In the first three quarters of 1993, the Central Bank held money expansion to a monthly rate of 19%. It also substantially moderated the expansion of credits during that period. The 1993 annual inflation rate was around 1,000%, a sharp improvement over 1992, but still very high. The improvement figures were exaggerated, however, because state expenditures had been delayed from the last quarter of 1993 to the first quarter of 1994. State enterprise arrears, for example, had built up in 1993 to about 15 trillion rubles (about US$13 billion, according to the mid-1993 exchange rate).
In June 1994, Chernomyrdin presented a set of moderate reforms calculated to accommodate the more conservative elements of the Government and parliament while placating reformers and Western creditors. The prime minister pledged to move ahead with restructuring the economy and pursuing fiscal and monetary policies conducive to macroeconomic stabilization. But stabilization was undermined by the Central Bank, which issued credits to enterprises at subsidized rates, and by strong pressure from industrial and agricultural lobbies seeking additional credits.
By October 1994, inflation, which had been reduced by tighter fiscal and monetary policies early in 1994, began to soar once again to dangerous levels. On 11 October, a day that became known as Black Tuesday, the value of the ruble on interbank exchange markets plunged by 27%. Although experts presented a number of theories to explain the drop, including the existence of a conspiracy, the loosening of credit and monetary controls clearly was a significant cause of declining confidence in the Russian economy and its currency.
In late 1994, Yeltsin reasserted his commitment to macroeconomic stabilization by firing Viktor Gerashchenko, head of the Central Bank, and nominating Tat'yana Paramonova as his replacement. Although reformers in the Russian government and the IMF and other Western supporters greeted the appointment with skepticism, Paramonova was able to implement a tight monetary policy that ended cheap credits and restrained interest rates (although the money supply fluctuated in 1995). Furthermore, the parliament passed restrictions on the use of monetary policy to finance the state debt, and the Ministry of Finance began to issue government bonds at market rates to finance the deficits.
The government also began to address the interenterprise debt that had been feeding inflation. The 1995 budget draft, which was proposed in September 1994, included a commitment to reducing inflation and the budget deficit to levels acceptable to the IMF, with the aim of qualifying for additional international funding. In this budget proposal, the Chernomyrdin government sent a signal that it no longer would tolerate soft credits and loose budget constraints, and that stabilization must be a top government priority.
During most of 1995, the government maintained its commitment to tight fiscal constraints, and budget deficits remained within prescribed parameters. However, in 1995 pressures mounted to increase government spending to alleviate wage arrearages, which were becoming a chronic problem within state enterprises, and to improve the increasingly tattered social safety net. In fact, in 1995 and 1996 the state's failure to pay many such obligations (as well as the wages of most state workers) was a major factor in keeping Russia's budget deficit at a moderate level. Conditions changed by the second half of 1995. The members of the State Duma (beginning in 1994, the lower house of the Federal Assembly, Russia's parliament) faced elections in December, and Yeltsin faced dim prospects in his 1996 presidential reelection bid. Therefore, political conditions caused both Duma deputies and the president to make promises to increase spending.
In addition, late in 1995 Yeltsin dismissed Anatoly Chubais, one of the last economic reform advocates remaining in a top Government position, as deputy prime minister in charge of economic policy. In place of Chubais, Yeltsin named Vladimir Kadannikov, a former automobile plant manager whose views were antireform. This move raised concerns in Russia and the West about Yeltsin's commitment to economic reform. Another casualty of the political atmosphere was RCB chairman Paramonova, whose nomination had remained a source of controversy between the State Duma and the Government. In November 1995, Yeltsin was forced to replace her with Sergey Dubinin, a Chernomyrdin protege who continued the tight-money policy that Paramonova had established.
By mid-1996 many Duma deputies raised concerns about the government's failure to meet its tax revenue targets. Revenue shortages were blamed on a number of factors, including a heavy tax burden that encourages noncompliance and an inefficient and corrupt tax collection system. A variety of tax collection reforms were proposed in the parliament and the government, but by 1996 Russian enterprises and regional authorities had established a strong pattern of noncompliance with national tax regulations, and the Federal Tax Police Service was ineffectual in apprehending violators.
In 1992, the first year of economic reform, retail prices in Russia increased by 2,520%. A major cause of the increase was the decontrol of most prices in January 1992, a step that prompted an average price increase of 245% in that month alone. By 1993 the annual rate had declined to 240%, still a very high figure. In 1994 the inflation rate had improved to 224%.
Trends in annual inflation rates mask variations in monthly rates, however. In 1994, for example, the government managed to reduce monthly rates from 21% in January to 4% in August, but rates climbed once again, to 16.4% by December and 18% by January 1995. Instability in Russian monetary policy caused the variations. After tightening the flow of money early in 1994, the Government loosened its restrictions in response to demands for credits by agriculture, industries in the Far North, and some favored large enterprises. In 1995 the pattern was avoided more successfully by maintaining the tight monetary policy adopted early in the year and by passing a relatively stringent budget. Thus, the monthly inflation rate held virtually steady below 5% in the last quarter of the year. For the first half of 1996, the inflation rate was 16.5%. However, experts noted that control of inflation was aided substantially by the failure to pay wages to workers in state enterprises, a policy that kept prices low by depressing demand.
An important symptom of Russian macroeconomic instability has been severe fluctuations in the exchange rate of the ruble. From July 1992, when the ruble first could be legally exchanged for United States dollars, to October 1995, the rate of exchange between the ruble and the dollar declined from 144 rubles per US$1 to around 5,000 per US$1. Prior to July 1992, the ruble's rate was set artificially at a highly overvalued level. But rapid changes in the nominal rate (the rate that does not account for inflation) reflected the overall macroeconomic instability. The most drastic example of such fluctuation was the Black Tuesday (1994) 27% reduction in the ruble's value.
In July 1995, the Central Bank announced its intention to maintain the ruble within a band of 4,300 to 4,900 per US$1 through October 1995, but it later extended the period to June 1996. The announcement reflected strengthened fiscal and monetary policies and the buildup of reserves with which the government could defend the ruble. By the end of October 1995, the ruble had stabilized and actually appreciated in inflation-adjusted terms. It remained stable during the first half of 1996. In May 1996, a "crawling band" exchange rate was introduced to allow the ruble to depreciate gradually through the end of 1996, beginning between 5,000 and 5,600 per US $1 and ending between 5,500 and 6,100.
Another sign of currency stabilization was the announcement that effective June 1996, the ruble would become fully convertible on a current-account basis. This meant that Russian citizens and foreigners would be able to convert rubles to other currencies for trade transactions.
Anatoly Chubais. The essence of economic restructuring, and a critical consideration for foreign loans and investment in Russia's economy, is the privatization program. In most respects, between 1992 and 1995 Russia kept pace with or exceeded the rate established in the original privatization program of October 1991. As deputy prime minister for economic policy, the reformist Chubais was an effective advocate of privatization during its important early stages. In 1992 privatization of small enterprises began through employee buyouts and public auctions. By the end of 1993, more than 85% of Russian small enterprises and more than 82,000 Russian state enterprises, or about one-third of the total in existence, had been privatized.
On 1 October 1992, vouchers, each with a nominal value of 10,000 rubles (about US$63), were distributed to 144 million Russian citizens for purchase of shares in medium-sized and large enterprises that officials had designated and reorganized for this type of privatization. However, voucher holders also could sell the vouchers, whose cash value varied according to the economic and political conditions in the country, or they could invest them in voucher funds.
By the end of June 1994, the voucher privatization program had completed its first phase. It succeeded in transferring ownership of 70% of Russia's large and medium-sized enterprises to private hands and in privatizing about 90% of small enterprises. By that time, 96% of the vouchers issued in 1992 had been used by their owners to buy shares in firms directly, invest in investment funds, or sell on the secondary markets. According to the organizers of the voucher system, some 14,000 firms employing about two-thirds of the industrial labor force had moved into private hands.
The next phase of the privatization program called for direct cash sales of shares in remaining state enterprises. That phase would complete the transfer of state enterprises and would add to government revenues. After that procedure met stiff opposition in the State Duma, Yeltsin implemented it by decree in July 1994. But the president's commitment to privatization soon came into question. In response to the monetary crisis of October 1994, Yeltsin removed Chubays from his position as head of the State Committee for the Management of State Property, replacing him with little-known official Vladimir Polevanov. Polevanov stunned Russian and Western privatization advocates by suggesting renationalization of some critical enterprises. Yeltsin reacted by replacing Polevanov with Petr Mostovoy, a Chubays ally. In the ensuing eighteen months, Yeltsin made two more changes in the chairmanship position.
In 1995 and 1996, political conditions continued to hamper the privatization program, and corruption scandals tarnished the program's public image. By 1995 privatization had gained a negative reputation with ordinary Russians, who coined the slang word prikhvatizatsiya, a combination of the Russian word for "grab" and the Russianized English word "privatize," producing the equivalent of "grabification." The term reflects the belief that the privatization process most often shifted control of enterprises from state agencies to groups of individuals with inside connections in the Government, the mafiya, or both. Distrust of the privatization process was part of an increasing public cynicism about the country's political and economic leaders, fueled by the seeming failure of Yeltsin's highly touted reform to improve the lot of the average Russian.
The second phase of the privatization program went ahead with the sale of state-held shares for cash. Although the process was virtually complete by the end of the first quarter of 1996, the Government failed to garner expected revenues. Meanwhile, Yeltsin's June 1996 bid for reelection brought a virtual halt in privatization of state enterprises during the campaign period. In February 1996, the Procuracy announced a full-scale investigation into privatization practices, in particular a 1995 transaction in which state banks awarded loans to state firms in return for "privatization" shares in those enterprises. This loans-for-shares type of transaction characterized the second phase of privatization; banks provided the government badly needed cash based on the collateral of enterprise shares that banks presumably would be able to sell later. But most of the twenty-nine state enterprises originally slated to participate withdrew, and the banks that received shares appeared to have a conflict of interest based on their role in setting the rules of the bidding procedure. In the most widely publicized deal, the Uneximbank of Moscow received a 38% interest in the giant Noril'sk Nickel Joint-Stock Company at about half of a competing bid. Other banks and commercial organizations joined the traditional opponents of privatization in attacking the loans-for-shares program, and in 1996 the Government admitted that the program had been handled badly. As a result of corruption allegations, the State Duma formed a committee to review the privatization program. And Prime Minister Chernomyrdin requested off-budget funds to buy back shares from the banks.
Because the faults of the Yeltsin privatization program were an important plank in the 1996 presidential election platform of the Communist Party of the Russian Federation (Kommunisticheskaya partiya Rossiyskoy Federatsii, or KPRF), the strongest opposition party, Yeltsin's campaign strategy was to reduce privatization as far as possible as a campaign issue. Part of that strategy was to shift the privatization process from Moscow to the regions. In February 1996, a presidential decree simply granted shares in about 6,000 state-controlled firms to regional governments, which could auction the shares and keep the profits.
After Yeltsin's reelection in July 1996, his financial representatives announced continuation of the privatization program, with a new focus on selling ten to fifteen large state enterprises, including the joint-stock company of the Unified Electric Power System of Russia (YeES Rossii), the Russian State Insurance Company (Rosgosstrakh), and the St. Petersburg Maritime Port. The Communications Investment Joint-Stock Company (Svyazinvest), sale of which had failed in 1995, was to be offered to Western telecommunications companies in 1996.
The new, postelection privatization stage also was to reduce the role of enterprise workers in shareholding. Within the first years of such ownership, most worker shares had been sold at depressed prices, devaluing all shares and cutting state profits from enterprise sales. Therefore, to reach the budget target of 12.4 trillion rubles (about US$2.4 billion) of profit from privatization sales in 1996, distribution was to target recipients who would hold shares rather than sell them immediately.
Despite periodic delays, the inept administration of the program's more recent phases, and allegations of favoritism and corrupt transactions in the enterprise and financial structures, in 1996 international experts judged Russia's privatization effort a qualified success. The movement of capital assets from state to private hands has progressed without serious reversal of direction — despite periodic calls for reestablishing state control of certain assets. And the process has contributed to the creation of a new class of private entrepreneur.
Russia's economic depression in the 1990s was largely borne by the weakest elements of Russian society As of mid-1996, four and one-half years after the launching of Russia's post-Soviet economic reform, experts found the results promising but mixed. The Russian economy has passed through a long and wrenching depression. Official Russian economic statistics indicate that from 1990 to the end of 1995, Russian GDP declined by roughly 50%, far greater than the decline that the United States experienced during the Great Depression. (However, alternative estimates by Western analysts described a much less severe decline, taking into account the upward bias of Soviet-era economic data and the downward bias of post-Soviet data.) Such a decline, however, was to be expected in an economy going through the transition from central planning to a market structure. Much of the decline in production has occurred in the military-industrial complex and other heavy industries that benefited most from the skewed economic priorities of Soviet planners but have much less robust demand in a free market.
But other major sectors such as agriculture, energy, and light industry also suffered from the transition. To enable these sectors to function in a market system, inefficient enterprises had to be closed and workers laid off, with resulting short-term declines in output and consumption. Analysts had expected that Russia's GDP would begin to rise in 1996, but data for the first six months of the year showed a continuing decline, and some Russian experts predicted a new phase of economic crisis in the second half of the year.
The pain of the restructuring has been assuaged somewhat by the emergence of a new private sector. Western experts believe that Russian data overstate the dimensions of Russia's economic collapse by failing to reflect a large portion of the country's private-sector activity. The Russian services sector, especially retail sales, is playing an increasingly vital role in the economy, accounting for nearly half of GDP in 1995. The services sector's activities have not been adequately measured. Data on sector performance are skewed by the underreporting or nonreporting of output that Russia's tax laws encourage. According to Western analysts, by the end of 1995 more than half of GDP and more than 60% of the labor force were based in the private sector.
An important but unconventional service in Russia's economy is "shuttle trading" — the transport and sale of consumer goods by individual entrepreneurs, of whom 5 to 10 million were estimated to be active in 1996. Traders buy goods in foreign countries such as China, Turkey, and the United Arab Emirates and in Russian cities, then sell them on the domestic market where demand is highest. Yevgeniy Yasin, minister of economics, estimated that in 1995 some US$11 billion worth of goods entered Russia in this way. Shuttle traders have been vital in maintaining the standard of living of Russians who cannot afford consumer goods on the conventional market. However, domestic industries such as textiles suffer from this infusion of competing merchandise, whose movement is unmonitored, untaxed, and often mafia -controlled.
The geographical distribution of Russia's wealth has been skewed at least as severely as it was in Soviet times. By the mid-1990s, economic power was being concentrated in Moscow at an even faster rate than the federal government was losing political power in the rest of the country. In Moscow an economic oligarchy, composed of politicians, banks, businesspeople, security forces, and city agencies, controlled a huge percentage of Russia's financial assets under the rule of Moscow's energetic and popular mayor, Yuriy Luzhkov. Unfortunately, organized crime also has played a strong role in the growth of the city. Opposed by a weak police force, Moscow's rate of protection rackets, contract murders, kickbacks, and bribes — all intimately connected with the economic infrastructure — has remained among the highest in Russia. Most businesses have not been able to function without paying for some form of mafia protection, informally called a krysha (the Russian word for roof).
Luzhkov, who has close ties to all legitimate power centers in the city, has overseen the construction of sports stadiums, shopping malls, monuments to Moscow's history, and the ornate Christ the Savior Cathedral. In 1994 Yeltsin gave Luzhkov full control over all state property in Moscow. In the first half of 1996, the city privatized state enterprises at the rate of US$1 billion per year, a faster rate than the entire national privatization process in the same period. Under Luzhkov's leadership, the city government also acquired full or major interests in a wide variety of enterprises — from banking, hotels, and construction to bakeries and beauty salons. Such ownership has allowed Luzhkov's planners to manipulate resources efficiently and with little or no competition. Meanwhile, Moscow also became the center of foreign investment in Russia, often to the exclusion of other regions. For example, the McDonald's fast-food chain, which began operations in Moscow in 1990, enjoyed immediate success but expanded only in Moscow. The concentration of Russia's banking industry in Moscow gave the city a huge advantage in competing for foreign commercial activity.
In mid-1996 the national government appeared to have achieved some degree of macroeconomic stability. However, longer-term stability depends on the ability of policy makers to withstand the inflationary pressures of demands for state subsidies and easier credits for failing enterprises and other special interests. (Chubais estimated that spending promises made during Yeltsin's campaign amounted to US$250 per voter, which if actually spent would approximately double the national budget deficit; most of Yeltsin's pledges seemingly were forgotten shortly after his reelection.)
By 1996 the structure of Russian economic output had shifted far enough that it more closely resembled that of a developed market economy than the distorted Soviet central-planning model. With the decline in demand for defense industry goods, overall production has shifted from heavy industry to consumer production. However, in the mid-1990s the low quality of most domestically produced consumer goods continued to limit enterprises' profits and therefore their ability to modernize production operations. On the other side of the "vicious circle," reliance on an outmoded production system guaranteed that product quality would remain low and uncompetitive.
Most prices are left to the market, although local and regional governments control the prices of some staples. Energy prices remain controlled, but the Government has been shifting these prices upward to close the gap with world market prices.
Problems of economic reform
The insider buyout. In hindsight, prominent Sovietologist Marshall Goldman has argued that Yeltsin should have extended property ownership to land, facilitated the formation of new companies, reformed the currency, liberalized prices, scrapped taxes on wages, brought fiscal policy under control, and moved toward convertibility of the ruble before implementing the process of privatization.
Marshall Goldman, Joseph Stiglitz (the winner of the 2001 Nobel Prize in economics), and other critics of Russia's implementation of privatization generally argue that "insider buyout," which allowed state managers to usually wound up with the controlling share of the stock, further accounted for Russia's poor implementation of economic restructuring.
The "insider buyout" supposedly induced 'employee dominant ownership', inevitably leading to the tendency for the stockholders, who are managers or employees themselves, to vote for increased wages, reduced investments, and fewer layoffs, which all disfavor the growth of market economy.
In Russia a far higher share of state-owned assets were sold to managers and workers, or "insiders," compared to the former Czechoslovakia, Hungary, and Poland. In this sense, it is more precise to describe Russia's privatization as "insider privatization" (the first stage) and "oligarch privatization", and thus distinct from the general pattern of privatization in other, more successful countries in Eastern Europe.
Many have therefore argued that it would be more accurate to say that real economic reform was never tried, given that it was quickly subverted by actors outside the government's control, such as the Central Bank, ministries, regional governments, and industrial managers.
Aside from the distortions associated with the lack of competition, employee ownership in general keeps wages and employment at levels that were too high. The impact of "insider buyout" in Russia can be seen from the abnormally low unemployment rates and very high underemployment levels in privatized industries. Generally speaking, large-scale privatization of moribund, money-losing state owned enterprises should increase unemployment. Some Soviet industries, after all, were not even value adding, with cost of inputs exceeding the cost of outputs (though it must be noted that in a planned economy this can sometimes be reasonable). Sixteen percent of the workforce became unemployed in both the former East Germany and Poland.
As a point in comparison, even in Communist China, where organized, large-scale privatization has not been carried out, the unemployment rate in 1998 was conservatively counted at 8 to 9%. But in Russia, in the most radical stage of privatization, 1994, only 6.3% of the economically active population was unemployed (a far larger share of the population is underemployed).
According to major surveys of Russian enterprise directions about whether they would be willing to sell a majority of the shares of their enterprise to an outside investor who would bring in the capital needed to invest in modernizing the firm, two-thirds said they would not be willing. In other words, they would rather remain majority owners of an unprofitable enterprise than minority owners of a much more profitable one. Very few firms have experienced much management turnover.
According to Stiglitz, the key economic mistakes of the transition were the emphasis on privatization over competition and the emphasis on restructuring existing enterprises over creation of new jobs and enterprises. With emphasis on just transferring ownership to private hands in order to create a lobby for private enterprise in order to prevent a communist comeback and push for creation of institutions to govern the market instead of competition, price controls were lifted without dismantling key Soviet-era monopolies. Prices thus were not able to properly equilibrate according to levels dictated by supply and demand since private profit-seeking monopolies lacked the incentives provided by competition to lower prices.
Asset stripping and barter. According to the "Washington Consensus", privatization would lead to incentives to improve productivity of Soviet-era state enterprises. However, privatized enterprises would be difficult to revitalize, given the high interest rates and lack of financial institutions to provide capital.
With inflation at double-digit rates per month as a result of instantaneous price liberalization, the macroeconomic stabilization program enacted to curb this trend entailed the tightening the money supply and raising interest rates. During the early 1990s the focus on macrostabilization led to interest rates from 20% to 250%. With interest rates so high, "non-insiders" were left largely incapable of borrowing the capital to invest in Russian enterprises, a major factor leaving privatized industries starved of cash. In addition, shock therapy had wiped out the savings of most Russians, leaving ordinary Russians largely incapable of investing in enterprises left up for auction.
Until around 1996-1997, due partly to the lack of competition, many enterprises did not have enough working capital to pay the wages and taxes on time, and traded with one another using barter. Not able to pay wages, upgrading and modernizing their facilities was out of the question.
The high interest rates and shortage of financial capital forced some industries to barter, leading to a new system of distorted prices (barter creates unreal values). By 1998, at least half of enterprise output was being "sold" through barter or trade. The federal government has effectively allowed them to avoid paying much of their federal taxes in return for keeping key customers, such as military bases and major industrial enterprises, supplied with energy and power.
Existing institutions were abandoned before the legal structures of a market economy that govern private property, oversee the financial market, and enforce taxation were functional. Yet, the two major components of a macroeconomy are banking system and the state budgetary system. Complicated markets require strong contract enforcement, accepted customs and practices, and financial and regulatory institutions account for the bulk of economic output. Instead, Russia was left with Soviet-era institutions with organization. Privatized enterprises would thus be difficult to revitalize, given the lack of financial institutions to provide capital.
Several devastating blows were dealt to the potential capital market. First the savings of the people in state-owned Sberbank were frozen and effectively destroyed by hyperinflation. Second, a large number of financial pyramids extracted huge amounts of money from unsuspecting public. Third, the government has successfully repeated the scheme with their short-term government obligations, extracting tens of billions of dollars from unsuspecting investors and then defaulting on domestic obligations.
As a result, the Russian stock market remains almost irrelevant. As of 2004, there have been only two IPOs in Russia and the investment activity in money markets remains low.
Capital flight. "Insider privatization," accompanied by the opening of the capital markets, led to incentives for capital flight in addition to barter, leading to movements $2 billion to $3 billion of capital per month. According to Stiglitz, "Anyone smart enough to be a winner in the privatization sweepstakes would be smart enough to put their money in the booming U.S. stock market, or into the safe haven of secretive offshore bank accounts. It was not even a close call; and not surprisingly, billions poured out of the country." Capital flight continues uninterrupted until the present day.
The "brain drain". Among other things destroyed during the transition to market economy were Soviet educational and science systems. Teachers and scientists, together with doctors, were the hardest hit by the transition. As the government was unwilling to index fixed salaries according to inflation or even to make salary payments on time, education and science incomes quickly dropped below the level of subsistence, ridding the schools, universities and research institutes of qualified specialists in record time. Some scientists fled to the West, attracting some attention to the problem of "brain drain," but nothing was done.
Economic history, 1996-2006
Russia posted gross domestic product growth of 6.4% in 1999, 10% in 2000, 5.1% in 2001, 4.7% in 2002, 7.3% in 2003, 7.2% in 2004, 6.4% in 2005 with industrial sector posting high growth figures as well. Russia became the fastest growing economy in the G8. It is expected to grow about 6.5% in 2006.
The Russian GDP, however, contracted an estimated 40% between 1991 and 1998, despite the country's wealth of natural resources, its well-educated population, and its diverse - although increasingly dilapidated - industrial base.
By the end of 1997, Russia had achieved some progress. Inflation had been brought under control, the ruble was stabilized, and an ambitious privatization program had transferred thousands of enterprises to private ownership. Some important market-oriented laws had also been passed, including a commercial code governing business relations and the establishment of an arbitration court for resolving economic disputes.
But in 1998, the Asian financial crisis swept through the country, contributing to a sharp decline in Russia's earnings from oil exports and resulting in an exodus of foreign investors. Matters came to a head in August 1998 when the government allowed the ruble to fall precipitously and stopped payment on $40 billion in ruble bonds.
In 1999, output increased for only the second time since 1991, by an officially estimated 3.2%, regaining much of the 4.6% drop of 1998. This increase was achieved despite a year of potential turmoil that included the tenure of three premiers and culminated in the New Year's Eve resignation of President Boris Yeltsin. Of great help was the tripling of international oil prices in the second half of 1999, raising the export surplus to $29 billion.
On the negative side, inflation rose to an average 86% in 1999, compared with a 28% average in 1998 and a hoped-for 30% average in 2000. Ordinary persons found their wages falling by roughly 30% and their pensions by 45%. The Vladimir Putin government has given high priority to supplementing low incomes by paying down wage and pension arrears. Many investors, both domestic and international remain on the sidelines, scared off by Russia's long-standing problems with capital flight, reliance on barter transactions, widespread corruption among officials, and endemic organized crime.
The Russian economy underwent tremendous stress as it moved from a centrally planned economy to a free market system. Difficulties in implementing fiscal reforms aimed at raising government revenues and a dependence on short-term borrowing to finance budget deficits led to a serious financial crisis in 1998. Lower prices for Russia's major export earners (oil and minerals) and a loss of investor confidence due to the Asian financial crisis exacerbated financial problems. The result was a rapid decline in the value of the ruble, flight of foreign investment, delayed payments on sovereign and private debts, a breakdown of commercial transactions through the banking system, and the threat of runaway inflation.
Russia, however, appears to have weathered the crisis relatively well. Real GDP increased by the highest percentage since the fall of the Soviet Union, the ruble stabilized, inflation was moderate, and investment began to increase again. Russia is making progress in meeting its foreign debts obligations. During 2000-01, Russia not only met its external debt services but also made large advance repayments of principal on IMF loans but also built up Central Bank reserves with government budget, trade, and current account surpluses. The FY 2002 Russian Government budget assumes payment of roughly $14 billion in official debt service payments falling due. Large current account surpluses have brought a rapid appreciation of the ruble over the past several years. This has meant that Russia has given back much of the terms-of-trade advantage that it gained when the ruble fell by 60% during the debt crisis. Oil and gas dominate Russian exports, so Russia remains highly dependent upon the price of energy. Loan and deposit rates at or below the inflation rate inhibit the growth of the banking system and make the allocation of capital and risk much less efficient than it would be otherwise.
In 2003, the debt will rise to $19 billion due to higher Ministry of Finance and Eurobond payments. However, $1 billion of this has been prepaid, and some of the private sector debt may already have been repurchased. Russia continues to explore debt swap/exchange opportunities.
In the June 2002 G8 Summit, leaders of the eight nations signed a statement agreeing to explore cancellation of some of Russia's old Soviet debt to use the savings for safeguarding materials in Russia that could be used by terrorists. Under the proposed deal, $10 billion would come from the United States and $10 billion from other G-8 countries over 10 years.
Gross Domestic ProductThis is a chart of trend of gross domestic product of Russia at market prices estimated by the International Monetary Fund with figures in millions of Russian Rubles.
|Year||Gross Domestic Product||US Dollar Exchange|
For purchasing power parity comparisons, the US Dollar is exchanged at 13.63 Rubles only. Russia's GDP, estimated at $287.9 billion at 2002 exchange rates, increased by 4.9% in 2001 compared to 2000. However, this rate slowed compared to the phenomenal 8% growth in 2000. Continued low inflation and strict government budget led to the growth, while lower oil prices and ruble appreciation slowed it. At the end of 2001, the unemployment rate was 9.0%, down from 10.4% at the end of 2000. Combined unemployment and underemployment may exceed those figures. Industrial output in 2001 grew by 4.9% compared to 2000, driven by private consumption demand. The contribution of fixed capital investment, an important contributor to growth in 1999, lost its importance in industrial growth.
The exchange rate stabilized in 1999; after falling from 6.5 rubles/dollar in August 1998 to about 25 rubles/dollar by April 1999, one year later it had further depreciated only to about 28.5 rubles/dollar. As of June 2002, the exchange rate was 31.4 rubles/dollar, down from 29.2 rubles/dollar the year before. After some large spikes in inflation following the August 1998 economic crisis, inflation has declined steadily. Cumulative consumer price inflation for 2001 was 18.6% slightly below the 20.2% inflation rate of the previous year but above the inflation target set in the 2001 budget. The Central Bank's accumulation of foreign reserves drove inflation higher and that trend is expected to continue. The 2002 budget estimates an inflation rate of 12%, but the World Bank predicts inflation will stay above 15% in 2002.
Central and local government expenditures are about equal. Combined they come to about 38% of GDP. Fiscal policy has been very disciplined since the 1998 debt crisis. The overall budget surplus for 2001 was 2.4% of GDP, allowing for the first time in history for the next year's budget to be calculated with a surplus (1.63% of GDP). Much of this growth, which exceeded most expectations for the third consecutive year, was driven by consumption demand. Analysts remain skeptical that high rates of economic growth will continue, particularly since Russia's planned budgets through 2005 assume that oil prices will steadily increase. Low oil prices would mean that the Russian economy would not achieve its projected growth. However, high oil prices also would have negative economic effects, as they would cause the ruble to continue to appreciate and make Russian exports less competitive.
Lack of legislation and, where there is legislation, lack of effective law enforcement, in many areas of economic activity is a pressing issue. During 2000 and 2001, changes in government administration increased the power of the central government to compel localities to enforce laws. Progress has been made on pension reform and reform of the electricity sector. Nonetheless, taxation and business regulations are unpredictable, and legal enforcement of private business agreements is weak. Attitudes left over from the Soviet period will take many years to overcome. Government decisions affecting business have often been arbitrary and inconsistent. Crime has increased costs for both local and foreign businesses. On the positive side, Russian businesses are increasingly turning to the courts to resolve disputes. The passage of an improved bankruptcy code in January 1998 was one of the first steps. In 2001, the Duma passed legislation for positive changes within the business and investment sector; the most critical legislation was a deregulation package. This trend in legislation is continued through 2002, with the new corporate tax code going into effect.
The mineral-packed Ural Mountains and the vast oil, gas, coal, and timber reserves of Siberia and the Russian Far East make Russia rich in natural resources. However, most such resources are located in remote and climatically unfavorable areas that are difficult to develop and far from Russian ports. Oil and gas exports continue to be the main source of hard currency, but declining energy prices have hit Russia hard. Russia is a leading producer and exporter of minerals, gold, and all major fuels. The Russian fishing industry is the world's fourth-largest, behind Japan, the United States, and China. Russia accounts for one-quarter of the world's production of fresh and frozen fish and about one-third of world output of canned fish. Natural resources, especially energy, dominate Russian exports. Ninety percent of Russian exports to the United States are minerals or other raw materials.
Russia is one of the most industrialized of the former Soviet republics. However, years of very low investment have left much of Russian industry antiquated and highly inefficient. Besides its resource-based industries, it has developed large manufacturing capacities, notably in machinery. Russia inherited most of the defense industrial base of the Soviet Union, so armaments are the single-largest manufactured goods export category for Russia. Efforts have been made with varying success over the past few years to convert defense industries to civilian use.
As of 31 December 2005, there were an estimated 1,589,000 broadband lines in Russia. Over 72% of the broadband lines were via cable modems and the rest via DSL.
Russia comprises roughly three-quarters of the territory of the former Soviet Union but has relatively little area suited for agriculture because of its arid climate and inconsistent rainfall. Northern areas concentrate mainly on livestock, and the southern parts and western Siberia produce grain. Restructuring of former state farms has been an extremely slow process. The new land code passed by the Duma in 2002 should speed restructuring and attract new domestic investment to Russian agriculture. Private farms and garden plots of individuals account for over one-half of all agricultural production.
In 1999, investment increased by 4.5%, the first such growth since 1990. Investment growth has continued at high rates from a very low base, with an almost 30% increase in total foreign investments in 2001 compared to the previous year. Higher retained earnings, increased cash transactions, the positive outlook for sales, and political stability have contributed to these favorable trends. Foreign investment in Russia is very low. Cumulative investment from U.S. sources of about $4 billion are about the same as U.S. investment in Costa Rica. Over the medium-to-long term, Russian companies that do not invest to increase their competitiveness will find it harder either to expand exports or protect their recent domestic market gains from higher quality imports.
Foreign direct investment, which includes contributions to starting capital and credits extended by foreign co-owners of enterprises, rose slightly in 1999 and 2000, but decreased in 2001 by about 10%. Foreign portfolio investment, which includes shares and securities, decreased dramatically in 1999, but has experienced significant growth since then. In 2001, foreign portfolio investment was $451 million, more than twice the amount from the previous year. Inward foreign investment during the 1990s was dwarfed by Russian capital flight, estimated at about $15 billion annually. During the years of recovery following the 1998 debt crisis, capital flight seems to have slowed. Inward investment from Cyprus and Gibraltar, two important channels for capital flight from Russia in recent years, suggest that some Russian money is returning home.
A significant drawback for investment is the banking sector, which lacks the resources, the capability, and the trust of the population that it would need to attract substantial savings and direct it toward productive investments. Russia's banks contribute only about 3% of overall investment in Russia. While ruble lending has increased since the October 1998 financial crisis, loans are still only 40% of total bank assets. The Central Bank of Russia reduced its refinancing rate five times in 2000, from 55% to 25%, signaling its interest in lower lending rates. Interest on deposits and loans are often below the inflation rate. The poorly developed banking system makes it difficult for entrepreneurs to raise capital and to diversify risk. Banks still perceive commercial lending as risky, and some banks are inexperienced with assessing credit risk.
Money on deposit with Russian banks represents only 7% of GDP. Sberbank receives preferential treatment from the state and holds 73% of all bank deposits. It also is the only Russian bank that has a federal deposit insurance guarantee. Sergei Ignatiev recently replaced Viktor Gerashchenko as Chairman of the Russian Central Bank. Under his leadership, necessary banking reforms, including stricter accounting procedures and federal deposit insurance, are likely to be implemented.
In 1999, exports were up slightly, while imports slumped by 30.5%. As a consequence, the trade surplus ballooned to $33.2 billion, more than double the previous year's level. In 2001, the trend shifted, as exports declined while imports increased. World prices continue to have a major effect on export performance, since commodities, particularly oil, natural gas, metals, and timber comprise 80% of Russian exports. Ferrous metals exports suffered the most in 2001, declining 7.5%. On the import side, steel and grains dropped by 11% and 61%, respectively.
Most analysts predict these trade trends will continue to some extent in 2002. In the first quarter of 2002, import expenditures were up 12%, increased by goods and a rapid rise of travel expenditure. The combination of import duties, a 20% value-added tax and excise taxes on imported goods (especially automobiles, alcoholic beverages, and aircraft) and an import licensing regime for alcohol still restrain demand for imports. Frequent and unpredictable changes in customs regulations also have created problems for foreign and domestic traders and investors. In March 2002, Russia placed a ban on poultry from the United States. In the first quarter of 2002, exports were down 10% as falling income from goods exports was partly compensated for by rising services exports, a trend since 2000. The trade surplus decreased to $7 billion from well over $11 billion the same period last year.
Foreign trade rose 34% to $151.5 billion in the first half of 2005, mainly due to the increase in oil and gas prices which now form 64% of all exports by value. Trade with CIS countries is up 13.2% to $23.3 billion. Trade with the EU forms 52.9%, with the CIS 15.4%, Eurasian Economic Community 7.8% and Asia-Pacific Economic Community 15.9%.
Trade volume between China and Russia reached $29.1 billion in 2005, an increase of 37.1% compared with 2004. China’s export of machinery and electronic goods to Russia grew 70%, which is 24% of China’s total export to Russia in the first 11 months of 2005. During the same time, China’s export of high-tech products to Russia increased by 58%, and that is 7% of China’s total exports to Russia. Also in this time period border trade between the two countries reached $5.13 billion, growing 35% and accounting for nearly 20% of the total trade. Most of China’s exports to Russia remain apparel and footwear.
Russia is China’s eighth largest trade partner and China is now Russia’s fourth largest trade partner, and China now has over 750 investment projects in Russia, involving $1.05 billion. China’s contracted investment in Russia totaled $368 million during January-September of 2005, twice that in 2004. Chinese imports from Russia are mainly those of energy sources, such as crude oil, which is mostly transported by rail, and electricity exports from neighboring Siberian and Far Eastern regions. In the near future, exports of both of these commodities are set to increase, as Russia is building a giant pipeline to Pacific Ocean with a branch to Chinese border, and Russian power grid monopoly UES is building some of its hydropower stations with a view of future exports to China.
The mafia remains a significant force in Russia. The drugs (narcotics) industry alone has a turnover of $8-9bn a year, compared to a state budget of $20bn. More generally, the shadow economy remains large, and tax evasion and corruption pervasive.
Source - Wikipedia