Since mid-August, Russia's economy has been in a meltdown. The ruble, which had been one of the most stable currencies in the world in 1996 and 1997, lost more than 75% of its value by the first week of September. The government announced a forced re-scheduling of domestic debt and a moratorium on payments of foreign debt. The banking system is in crisis, with forced mergers and consolidation. The stock market, which had led all emerging markets in 1997, entered the final phase of a year-long collapse in which it lost more than 90% of its value, brining it to the point where today trade is practically non-existent.

These events took place barely a month after the approval of a $22.6 billion rescue plan organized by the International Monetary Fund (IMF). The pressing question is what has gone wrong. Why has the optimism of 1997 led to the crash of 1998? Why did the July rescue become the August disaster?

Already a search for scapegoats has begun. The most frequently mentioned causes include the spread of the Asian crisis and the decline in the price of oil, Russia's major export. These factors clearly played a role in the timing of the crisis, but the focus on these external events results, in part, from a need to explain away Russia's failure. It is important, however, to distinguish the precipitating events from the fundamental causes.

The collapse of the ruble stems from a fiscal crisis. For the last several years, Russia has had to finance a budget deficit of at least 5% of GDP. This was accomplished primarily by selling domestic debt and through external borrowing (from both the IMF and private capital markets). Heavy reliance on debt to finance budget shortfalls caused investors to demand a large premium to hold Russian assets. The Russian Central Bank's commitment to maintain the ruble caused a precipitous decline in foreign reserves as investors started to do the math. The IMF's rescue package provided the briefest of respites.
 
 

The False Recovery of 1997

Was Russia simply the victim of speculators scared off by the Asian crisis? Even while the Russian stock market flourished in 1997, there were signs that all was not right. Real interest rates were remarkably high, although on a mildly declining path, due to burgeoning fiscal deficits. Capital flight was massive; estimated at anywhere from 4% to 10% of GDP in 1996 and 1997. But it was above all the situation in the core manufacturing sectors that indicated most clearly the lack of success of the reform project.

Throughout the reform period, Russian industrial companies had, with very few exceptions, failed to show progress in converting themselves from Soviet-style enterprises into market-oriented firms. 1997, despite its apparent boom, was no exception: at year-end, the average Russian industrial enterprise had not only fewer profits and more debts, but also more redundant labor and less modern plant and equipment than it did at the beginning of the year. Rather than recording success in the market, the typical industrial enterprise was moving further away from it and less likely to ever change that. Consider the following data from 1997:

• Industrial output in Russia in constant prices rose 1.9% in 1997. But aggregate real profits in industry were down by 5%. The share of manufacturing enterprises that showed no profit at all was nearly 50%, up from less than 27% in 1995.

 
• Russian enterprises still employ far more workers than warranted by their level of output. While officially measured GDP has fallen by more than 40% during the 1990's, employment has fallen by only about 25%. Large and medium-sized industrial enterprises hired 6.6 million new workers in the first 9 months of 1997. As a percentage of payroll this was a higher rate than for the same period in 1996.

 
• Investment continued to decline in 1997, bringing the volume of capital investment for 1997 to less than 24% of its 1990 level. Although some decline in investment-GDP ratio was a necessary response to the excessive rates of the Soviet period, this seems to be an over-correction. This is evident in the aging of the capital stock. In 1980 the average age of plant and equipment in Russia was 9.5 years; in 1995 it was 14.1 years.

 
• As of the beginning of this year, mining and manufacturing enterprises had overdue debts to suppliers (that is, each other) of about $40 billion and to governments of around $35 billion. (Bad debt to banks, meanwhile, was much smaller: only $2.5 billion). Enterprises also had large debts to their own workers, $4.4 billion at the beginning of the year, rising to $5.6 billion by July 1. The average industrial worker was owed over two months' of back wages; in agriculture the average delay was more than four months.

 
• Enterprises continue to trade with one another without the use of money--either by not paying each other at all or by using non-monetary means (such as barter or promissory notes, called veksels). Estimates of the share of sales made in the form of barter or other non-monetary forms range as high as 70%. According to the so-called Karpov Commission Report, Russia's 210 largest companies received money for only 27% of their sales; everything else was paid for through barter and other nonmonetary forms of settlement. Most remarkable of all was the way these enterprises dealt with the federal and local tax authorities. To the federal budget they remitted 80% of the taxes they owed--not a terribly bad figure--but the proportion paid in cash was only 8%.

What Happened?

What went wrong? After all, Russia had completed the most massive privatization of industry in the history of world. Russia appeared to have correctly followed the advice of the West to maintain the value of the ruble and keep inflation low. Western advisers to the Russian Government published books with the titles such as How Russia Became a Market Economy and The Coming Russian Boom. Then why do Russian private enterprises behave in ways that differ so remarkably from what is observed elsewhere? This question is critical, and it provides the insight needed to understand the genesis of the crisis.

The first point to make is that the method of privatization matters. This point was ignored by the authors of Russian privatization, who designed a program that was, essentially, a giveaway to insiders. With weak to non-existent corporate governance, this meant that enterprises were captured by those who had plenty to lose if the enterprise were restructured. Meanwhile, the government's remaining packets of shares in valuable state-owned enterprises were given away to the large banks and other political insiders. In short, relatively worthless enterprises--the ones that needed to change the most--were given to those with the least interest in changing them, while truly valuable companies were offered at reduced prices to the most powerful.

Given this environment and the Central Bank's policy of maintaining a fixed exchange rate, the strategy of most banks was clear: borrow in hard currencies to finance the purchase of Russia's prize companies and to purchase high-yielding government securities, or GKO's. Because of weak corporate governance, foreign investors were loath to purchase minority stakes in companies that appeared to offer high prospective returns. The only way to get into the Russian bonanza was to do so indirectly: either by lending to the banks or purchasing GKOs. But this led to no increase in investment or restructuring because the banks that purchased the enterprises were interested in something else: using their privileged position to buy assets low and sell them high.

Notice what this situation produced: an enterprise sector where little restructuring took place, and a banking system that was engaged in one-way bets on the value of the ruble. This was encouraged by the Central Bank's commitment to the ruble, and implicitly by western aid that supported it.

But why didn't the owners of enterprises want to restructure? The answer turns out to be simple: they didn't have to. They found a way to protect themselves. The set of peculiar mechanisms that allowed them to do so is what we have termed Russia's "virtual economy."
 
 

The Virtual Economy

Over the past six or seven years, since 1992, enterprises did indeed adjust their behavior. But they adjusted not so much in order to join the market as to protect themselves from the market. This is contrary to intention, both of economic policy-makers in Russia and international advisers. It seems contrary to economic theory. More pressure did not force change to the market but produced an even stronger defensive reaction within that economy.

The essence of the virtual economy is that the recorded prices and recorded transactions bear little relationship to the actual terms on which enterprises trade. The virtual economy is the result of enterprises' and households' efforts to survive when the market value of the things they produce is smaller than the value of what is needed to produce them.

The phenomena described above are most prevalent in the large enterprise sector. Russia is still dominated by the industrial "dinosaurs" established under the dictates of communist central planning. The average plant size is some ten times what it is in the United States. These enterprises employ millions of people and support entire cities and regions across the country. The political commitment to keeping these entities from collapse is what drives the virtual economy.

In the virtual economy, enterprises are keeping pretty much the same old products that they produced under the Soviet system, producing them in pretty much the same way they did. The enterprises can continue to produce these goods--we call them "soft" goods--because they have a guaranteed set of "buyers" (to use the term loosely) and because they avoid the use of money. Avoiding money, through the mechanisms of barter and other forms of nonmonetary exchange, allows the goods to be arbitrarily priced. They are overpriced, giving the appearance of more value being produced than is actually the case.

This overpricing is important when these goods are delivered to the government in lieu of taxes, or to value-adders, mainly energy suppliers, in lieu of payment. Overpricing of manufactured output becomes the primary mechanism for continued subsidization of unprofitable, even value-destroying, production in the Russian economy. This mechanism is a key motive for the use of barter and other types of nonmonetary exchange. As much as 70% of transactions among industrial enterprises avoid the use of money. Similarly, offsets, barter, and the like account for 80-90% of tax payments by these major industrial enterprises.
 
 

The Soviet Roots of the Problem

The notion that much of Russian industry destroys value is hard for many people to accept. How can it be that six years after reform has started, Russian enterprises continue to produce goods that have less value than the inputs used in their production. Some of the key ingredients have been mentioned above: weak corporate governance, lack of the rule of law, impotence of bankruptcy laws. But this cannot be a complete explanation. If industry destroys value, resources must be obtained from somewhere else. Where?

To answer this we must recognize a fundamental feature of the Soviet economy and the Russian economy. This economy is, and has been, primarily an economy driven by resource industries. Although the Soviet economy produced missiles and cars, and planes and space stations, the bulk of value added was produced in the energy and other resource sectors. Little has changed today. Russia's natural gas monopoly, Gazprom, is one of the major producers of value in the economy, and certainly the single largest. In exchange for the rights to keep what it earns from exports, Gazprom pumps value into the system by supplying gas without being paid for it. Arrears to Gazprom, which then leads to arrears to the government, are the primary way in which unprofitable activity is subsidized today in Russia.

This system survives because so many people have few alternatives. The survival constraint has been met. Russians produce more potatoes on their dachas (90% of consumption) than is produced in all farms in the US, Canada, Australia, Italy, and France combined. With low opportunities workers accept delays in wages (real wage cuts) and enterprises accept late payments.

The Road to Ruin

To sum up, the essence of the virtual economy is two things: (1) Much of the economy is not creating value, but destroying it, and (2 ) most of the participants in the system pretend this is not happening. Value-subtraction and pretense are core elements of this peculiar system. The barter, veksels, and tax offsets are merely mechanisms to make this happen.

It is especially important to underscore the pretense. Because of the pretense that there is more value being produced than there actually is, there are exaggerated claims on the value that is produced. The pretense is what causes all the nonpayments difficulties. There is less value produced than there are claims on it. In particular, this is the problem of Russia's budgets. The apparent low rate of tax collection on the revenue side and the failure of the government to meet its spending obligations on the outlays side, most notably the unpaid wages and pensions, both result.

"Too little value and too many claims" generated the need to borrow to cover the gap. But with the borrowed funds just being used to compensate for value destroyed, not for laying the basis for value creation, the debt became a pyramid. This was compounded, fairly massively, by the rampant corruption and looting which we have characterized as "leakage of value" from the virtual economy.

Taken together, Russia thus had all that was needed for a crisis: (1) destruction of value within the system, in combination with (2) "leakage" of value out of the system (corruption and looting), leading to (3) the continuous necessity to infuse value from the outside--i.e., borrowing. But borrowing while destroying the ability to repay guaranteed one outcome: a debt trap. The crisis was inevitable. Only its timing was uncertain. That was the contribution of Asia and the decline in oil prices.

Now that conventional policy prescriptions have failed to pull Russia out of crisis, what can be done to avoid a further downward spiral? It is crucial to remember the root causes of Russia's economic problems: (1) destruction of value within the system, and (2) "leakage" of value out of the system (corruption and looting), which in combination lead to (3) the necessity to infuse value from the outside--i.e., borrowing. But borrowing while destroying the ability to repay guarantees only one outcome: a debt trap.

These considerations suggest policies that target the root causes.

The Pretense: Abandon It.

Russian leaders must lay bare the reality of the economy. Now is the time to do it. In contrast to the recent past, they now have no reason to fear that "telling the truth will only make things worse."

Step one, therefore, is to stop concealing the fact of value destruction. In fact, try to quantify it, if possible. By all means, also speak openly about the benefits of continuing the value-destroying enterprises (social, political stability, etc.). But admit the costs. Then people can decide. Stop the Byzantine maneuvers and the pretense.

In the same spirit, be more realistic about the potential of the Russian economy. It is much lower than has been acknowledged. This makes it clear that the cost of sustaining the value-subtractors is high in the long run.
 
 

2. Value Destruction: Begin to Reduce It.

It is important to note the phrase, "begin to reduce ...." This means that it will not be done suddenly and comprehensively. But there has to be a systematic effort. The mechanics are simple: enforce bankruptcy, etc. But the political will is the key issue. Step one--disclosure of the costs of maintaining the virtual ecnomy--is a precondition to gaining support for a reasonable program to reduce value destruction.
 
 

Leakage: Eliminate It..

Stop the sweetheart deals. [Distinguish between good and bad leakage.] Tighten government; reduce waste. Improve the tax code. Perhaps go as far as nationalizing Gazprom. Impose exchange controls.

Some of these points are already demanded by the IMF. Others may challenge the standard recommendations.
 
 

4. The Debt: Write It Off.

To give the country the breathing space to make steps (1)-(3) meaningful, Russia's $70-plus billion [?] of post-Soviet era debt must be radically restructured. The model will be the agreements Russia finally reached with the London and Paris Clubs of creditors with respect to its Soviet-era debt. In those cases, the debt was stretched out over a period of 20 years and a grace period of 6-7 years was granted on repayments of principal.

It is vital to recognize that it is only the combination of these four policies that might work. If not done all in combination, and consistently, they will not work, and indeed may be counterproductive. Clearly, step (2)--reducing value subtraction--cannot be carried out without the foundation laid by (1). Step (3)--stopping leakage--only makes sense if done in conjunction with step (2). Otherwise, it only makes the virtual economy (or its more transparent variant) more sustainable (as we outline in "Beyond the Bailout..."). Step (2), as vital as it is, will not be able to save Russia unless the country can be extracted from the debt trap it is in --step (4).⁽¹⁾ And yet, conversely, the West should not grant debt forgiveness unless it knows that both the destruction of value and the leakage of value are going to stop.

The likelihood that this set of policies will be implemented and implemented correctly is very small. It must be immediately apparent that eliminating the virtual economy is a much greater task than stabilizing the currency. The real question is whether such a program is at all politically viable. The real cost of the recent crisis is the dissipation of political capital which is necessary to undertake the real reforms that are necessary. The real deceit perpetrated against the middle class was not the devaluation itself, but the false promise that the market had arrived and real market growth was driving the economy.

The central element of any policy must be elimination of the virtual economy. Only then can real reform begin. But it must be immediately apparent that eliminating the virtual economy is a much greater task than stabilizing the currency. It will involve a greater Western financial commitment to reform and greater intrusion into the affairs of Russia than the West has hitherto considered.

The real question is whether such a program is at all politically viable. The real cost of the recent crisis is the dissipation of political capital which is necessary to undertake the real reforms that are necessary. The real deceit perpetrated against the middle class was not the devaluation itself, but the false promise that the market had arrived and real market growth was driving the economy.

1. Debt forgiveness will certainly be a difficult pill for the West to swallow. But we have to realize that the only real choice we have is between debt forgiveness (a cooperative solution) and unilateral debt repudiation. Russia can not and will not pay back its debt. By now it should be clear that any arguments along the lines of "they wouldn't dare, because they would be frozen out of world capital markets forever" carry little weight. Not only will Russia be forced to repudiate its debt, no matter what the consequences. Politicians are emerging on the Russian scene who are likely to view unilateral debt repudiation as a good and popular thing to do. It is much better for us that we arrive at a cooperative solution, as costly as it may seem to us.

After that, there would be no more loans, at least not for "bailouts" and "economic reform." The West can still give money for helping to solve problems inside Russia. Those funds should be concentrated on solving problems that concern our own safety and security. Examples include nuclear (both military and civilian) safety, elimination and disposal of weapons of mass destruction and environmental cleanup, public health dangers (e.g., the dangerous new strain of multi-drug resistant tuberculosis emerging from Russia)