Russian Reforms: All Shock and No Therapy
Summary
Presidential economic advisor Andrei Illarionov, an economic
ultraliberal, stated July 15 that Russia's economic competitiveness
had decreased by 30 percent since the beginning of the year,
partially due to rising inflation, according to Segovnaya. Analysts
are estimating Russia's year-end inflation could be as high as 35
percent, almost double the 18 percent upon which Russia's budget
was founded. Wrangles between the administration and the Duma are
significantly reducing the probability of economic growth. The
result will be a stagnant economy beset by inflation.
Analysis
Russian economists are sounding warning bells. According to
Segovnaya, presidential advisor Andrei Illarionov claimed that
Russia's economic competitiveness had decreased by 30 percent since
the beginning of the year. Inflation too, is a problem. In the
first six months of the year inflation jumped 9.33 percent -
tripling in the past two months alone. This inflation burst is
directly linked to many of the reform policies of Russian President
Vladimir Putin and Prime Minister Mikhail Kasyanov.
The reform efforts are half of a two part plan, the other half
being foreign investment. Neither effort will succeed without the
other. Foreigners won't invest in a corrupted economy, and painful
reforms will only hurt the public if that investment fails to
materialize. In the coming months, it is unlikely the reforms will
achieve their goal. Instead, inflation will continue to strengthen,
weakening the already tenuous economic hold of the Russian
population.
Most observers are parroting Putin's June 3 statement faulting
increases in Russia's money supply for the inflation. While the
money supply undoubtedly plays a role, the Kremlin's reforms -
which have directly raised prices - are the true culprit. As the
official argument goes, federal law requires exporters to sell 75
percent of their hard currency earnings to the Central Bank in
exchange for rubles. The immediate result is an increase in the
amount of money in the Russian economy. With more money in
circulation, producers can charge more for their limited number of
goods. The result is demand-pull inflation.
Several of Putin's policies reinforce this demand-pull inflation.
Putin has committed his government to paying up all wage arrears,
and the Duma and Federation Council have already agreed to more
than triple the minimum wage percent over the next 12 months. On
July 10 Putin raised the average pension by one-sixth, the third
raise this year, and set the stage for further increases in 2001.
Like the Central Bank's policy on appropriating hard currency,
these moves increase the amount of cash in the economy without
raising productivity: more demand-pull inflation.
But Russia's Central Bank statistics indicate the money supply has
not kept up with the hype. Exports for the first five months of the
year totaled $39.3 billion, or 1.1 trillion rubles. That means 840
billion rubles should have entered the money supply. However,
according to the Russian Central Bank, from January to June the
money supply only increased by 161 billion rubles.
So if the official line is at best only partly correct, what is
actually causing the inflation? Over the past several months the
Putin/Kasyanov administration has scrapped various subsidies and
enacted broad taxes. The results are increased costs for the basic
consumables in Russian society: Electricity prices have soared 55
percent, natural gas 15 percent to 20 percent, vodka 40 percent and
telephone lines 15 percent. This is cost-push inflation, and it
directly affects all Russians.
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Russia has few tools to deal with its inflation. Russia could use
some of its 48.6 billion ruble budget surplus to pay off some of
the government's debt to the Central Bank. This would both improve
Russia's internal debt and mop up a few billion excess rubles,
partially offsetting the demand-pull inflation.
But the only thing that can alleviate cost-push inflation is
stable, broad-based economic growth. Petroleum sales don't count.
The only way Russia can achieve that growth is by increasing worker
productivity. That requires strong managerial skills, new
technology and abundant capital - three things that Russia lacks,
but foreigners have. Simply put, Russia needs foreign investment.
That investment remains elusive. The 1998 ruble crash, combined
with endemic corruption, burned most foreign investors. To lure
those investors back, Putin is implementing two types of reform:
legal and economic.
Under Putin's firm hand, Russia has already taken the first legal
reforms: getting the government out of business, getting business
out of the government and strengthening the rule of law - albeit
through the implementation of a police state. Putin is knocking the
oligarchs down to size as well. The latest target is Anatoly
Chubais, former privatization minister and Yeltsin chief of staff
and currently head of Unified Energy Systems, Russia's electricity
monopoly.
On the economic front, Putin is revamping the tax system and
dismantling price controls. Yet, the economic reforms must be
approved and implemented quickly in order to work without
triggering hyperinflation.
It is difficult to understate the obstacles to progress. While
currently on the run, the oligarchs still control vast tracts of
the economy. Russian culture, traumatized by decades of communism
and previous rounds of shock therapy, lacks the ingrained civic
responsibility - not to mention corruption-free law enforcers -
needed to ground an advanced economy. And regional governors, along
with corrupt government bureaucrats at all levels, are fighting
tooth-and-nail to slow or deflect almost the entire Putin/Kasyanov
reform package.
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The regional governors have met with some recent success. After
vetoing a law in the Federation Council that would reduce their
power, regional governors managed to convince Duma deputies to
water down many of Kasyanov's new taxes that would shift the burden
away from Russia's beleaguered producers (and onto its beleaguered
consumers). For example, Kasyanov proposed 20, 200 and 600 percent
increases on alcohol, tobacco and gasoline taxes, but the Duma only
approved 5, 50 and 300 percent increases, respectively, according
to the Moscow Times. More importantly, the Duma also voted to keep
one of Russia's odious turnover taxes.
Turnover taxes are perhaps the single most damaging feature of the
Russian economic system. First of all, they apply to every
transaction a business makes: salaries, advertising, sales, rent,
utilities, phone lines, equipment rental, etc. Second, they are
applied cumulatively with all other taxes: payroll, excise, fuel,
profit, etc. Turnover taxes encourage dishonest bookkeeping and
barter trade, which in turn pushes the economy toward the
corruption-prone black market. After all, if there is no
transaction to record and no cash to trace, there is no tax to pay.
Furthermore, the Duma chose to keep the worst of a bad lot: the
road tax. Unlike many other taxes, this one pays into the regions -
not the federal government. According to Putin in an Izvestia
interview, the tax has raised more than $30 billion since 1994, yet
the country has experienced no meaningful road improvement,
implying road tax revenues are going toward the regional governors'
slush funds. The Duma's insistence on the continued existence of an
onerous tax that encourages such widespread, high-level corruption
is exactly the type of action that will discourage essential
foreign investment.
Facing this type of hostility to economic reform, few foreign
companies are returning to Russia. Foreign direct investment in
Russia for the first quarter of 2000 is a mere $853 million. While
this is a 40 percent increase when compared to a year earlier, it
amounts to a paltry $5.80 a person. On a per capita basis, Estonia
garnered 10 times that amount. Most firms view Putin's reforms
favorably, but are adopting a wait-and-see policy before diving
back in, according to the U.S.-Russia Business Council.
If Russia fails to attract foreign investment and continues reforms
that produce inflation, Putin and Kasyanov will have achieved the
worst of both worlds: growth-free inflation. This will erode
Russia's remaining competitiveness while further impoverishing its
citizens. Sadly, this seems to be the direction in which Russia is
heading. Having already signed decrees that will further boost
pensions and the minimum wage - moves that will trigger more
demand-pull inflation - Putin will find it difficult to backtrack.
Meanwhile, reductions in housing subsidies and new taxes on
automobiles are already in the pipe - causes of cost-push
inflation. Russia is brewing a deadly concoction of across-the-
board price increases and chronic inflation that will further lower
the average Russian's already abysmal standard of living.
For the investment to flow, Putin must simultaneously root out
corruption, liberalize prices, rationalize the tax system and slash
government spending. But the Duma's rejection of some of Kasyanov's
tax plans all too vividly shows just how deep the resistance to
change is rooted in the country's financial bedrock. The
Putin/Kasyanov legal and economic reforms threaten almost every
Russian power group on multiple levels. Putin and Kasyanov have
made impressive progress with few tools, but unless they can
destroy the corruption at the heart of Russia's business community,
their reforms are destined to be all shock and no therapy.
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