01 June 1998
TEXT: THE RUSSIAN ECONOMY: POST-ASIA AND POST-CHERNOMYRDIN
(Treasury's Mark Medish on the Russian Economy) (2630) Washington -- Deputy Assistant Treasury Secretary for International Affairs Mark C. Medish discussed his "unexuberant, balanced bullishness" for the Russian market at a noon discussion at the Woodrow Wilson Center June 1. The talk, sponsored by the Kennan Institute, focused on Russia's economy after tenure of former Prime Minister Viktor Chernomyrdin and in the aftermath of the Asian financial crisis. "A few short years ago," Medish said, "the idea that Russia would turn into a market-oriented democracy was wildly utopian. Today, the many imperfections of its transformation into precisely such a system are concrete issues for negotiation and pragmatic problem-solving." Among the issues Medish discussed were four lessons that Russia might draw from the recent crisis in Asian financial markets. First, Medish noted that Russia has entered a stage in its transition in which "Russia is currently in a second transition, this time from a 'transition economy' to an 'emerging market' (EM)." As such, he said that "all EMs are under heightened scrutiny from investors. In the jungle of international capital markets, investors choose countries, and not the other way around." Second, "No sector is now under greater scrutiny than the financial sector," he said. "We have re-learned the classic lesson of bank runs: namely, that weak banks can bring down strong countries. The safety and soundness of banking systems is crucial. Among other things, this requires effective regulatory frameworks, capital adequacy standards, prudential supervision, international accounting standards, and transparency." Third, he said, "central authorities -- this includes national leadership, finance ministries and central banks -- must do a good job of sharing information with the outside world. In a crisis, nothing fuels doubt more than silence or obfuscation." Finally, Medish recommended, "The dirigiste, statist, insider model of capitalist development has been largely discredited.... If credit decisions cannot be justified on commercial grounds, they are often corrupt or quasi-corrupt. And they usually carry hidden risks that, taken together over time, can lead to financial collapse for banks, enterprises and ultimately a national economy." In sum, Medish said, "To use a basketball metaphor, Team Russia faces a shot clock. There are certain things that Russia needs to do with all due haste. It needs to sink a three pointer, preferably with some foul shots to boot." Nonetheless, he remains optimistic. Following is the text of Medish's speech as prepared for delivery: (Begin text) "The Russian Economy: Post-Asia & Post-Chernomyrdin" Remarks by Mark C. Medish, Deputy Assistant Secretary of the Treasury Kennan Institute, Washington, D.C. June 1, 1998 A Treasury staffer reminded me recently of Keynes's famous observation about the Russian economy in 1925. Keynes wrote: "The economic system of Russia has undergone and is undergoing such rapid changes that it is impossible to obtain a precise and accurate account of it.... Almost everything one can say about the country is true and false at the same time." This observation certainly has some relevance to the contemporary Russian economy, too. Like Schroedinger's cat in the hypothetical physics experiment, the Russian economy at times appears to be both dead and alive. And the current death-defying roller coaster ride of Russian capital markets makes both diagnosis and prognosis all the more difficult. But, notwithstanding these uncertainties, I believe the basic direction of Russian economic development has been fundamentally positive in the post-Soviet era. Russia has shown that it can achieve firm monetary stabilization. It has embraced a modern macroeconomic policy framework. It has implemented many key structural reforms, including large-scale privatization. It has instituted most of the essential legal and regulatory elements of a well functioning market economy. True, the pace of reforms -- and the political will behind them -- have been uneven. The sequence of reforms has not always been ideal. Reform in many key structural areas is still languishing or incomplete. Russia is not yet a nation of shopkeepers, like the other Group of Eight countries. Intermediation of credit is weak, and the level of direct investment is low. Most important, despite an arrest of economic decline in 1997, Russia has yet to achieve robust, sustainable growth -- which is the ultimate measure of successful transition. But Russia is basically doing the right things to get to growth and national vitality. And -- compared with a few easily imaginable alternative political-economic scenarios -- I would submit that the actual path is not that bad at all. This is particularly true if one measures reality against the possible, as opposed to the ideal. A few short years ago, the idea that Russia would turn into a market-oriented democracy was wildly utopian. Today, the many imperfections of its transformation into precisely such a system are concrete issues for negotiation and pragmatic problem-solving. Russia's political modernists like Struve and Witte (whose portrait, by the way, hangs in the office of Finance Minister Zadornov) lived a century too early. Who would have thunk it? In a sense, Russia is currently in a second transition, this time from a "transition economy" to an "emerging market" (EM). (Countries like Poland, Hungary and the Czech Republic graduated quite a while ago.) In terms of portfolio investment, foreigners today hold approximately 25 percent of the outstanding stock of $60 billion in Russian government paper (GKOs and OFZs). It is a sign of the progress Russia has made on this path that Russian capital markets have been seriously affected by "contagion" from turmoil in Asia. At the same time, the virulence of the contagion Russia has felt is also a measure of the shortcomings of Russia's domestic reforms: Russia has to do more to strengthen its economy to withstand outside shocks. Among emerging markets, the weaker ones tend to get hit hardest. In other words, exogenous shocks tend to reveal endogenous weaknesses. We are currently witnessing the third round of EM shock. The first two rounds occurred in November-December 1997 and January-February 1998. Each time Russia has been battered. Central authorities have responded with increasing alacrity, primarily by raising key money rates. But Russia's financial and economic vulnerabilities are being exposed -- much as Indonesia's, Thailand's, Korea's and Brazil's have been. The price of slower reform is deeper contagion, higher interest rates, greater systemic risks, etc. Russia has had a great deal of advice -- some good, some less so -- on reform over the past few years. First, the advice came largely from bilateral foreign aid agencies. More recently, it has been coming from the International Monetary Fund, the World Bank and other international financial institutions (IFIs) especially in the form of conditionality on loans. Now the advice is coming in stark terms from international capital markets. This is what one might call "capital discipline" or the wages of globalization. It is part of the admissions package for membership in the global financial and trading systems dominated by private flows and transactional decisions by consenting adults. Indeed, the major regional and global financial crises of the 1990s -- first in Mexico, now in East Asia -- have carried lessons for all advanced economies and emerging markets alike. It seems that the myth of economic exceptionalism has been all but shattered by recent events, even for mighty economies like Japan. Put crudely: If you want to play, you must obey. Let me summarize the four general "lessons" I take from the crisis in East Asia. All of them are worth Russia's close attention: First, all EMs are under heightened scrutiny from investors. In the jungle of international capital markets, investors choose countries, and not the other way around. EMs are still highly desirable for yield-hungry investors, but as an asset class they are more suspicious than they used to be. Old risk factors (macroeconomic indicators such as fiscal deficit, balance of payments, and debt service ratios) are looked at much more closely. Furthermore, there is recognition of new risk factors, especially in the private financial sector as well as legal risks. The second lesson is closely related. No sector is now under greater scrutiny than the financial sector. We have re-learned the classic lesson of bank runs, namely, that weak banks can bring down strong countries. The safety and soundness of banking systems is crucial. Among other things, this requires effective regulatory frameworks, capital adequacy standards, prudential supervision, international accounting standards, and transparency. Third, central authorities -- this includes national leadership, finance ministries and central banks -- must do a good job of sharing information with the outside world. In a crisis, nothing fuels doubt more than silence or obfuscation. If authorities cannot be trusted to share bad news, they will not be trusted when they try to report good news. Part of this is just PR [public relations] common sense. Lying and hiding things tend to drive up spreads. Fourth, the East Asian crises have exposed the perils of "crony capitalism" in its various forms (zaibatsu, keiretsu, amakudari, chaebol, etc.). The dirigiste, statist, insider model of capitalist development has been largely discredited. The state-banking-industrial triangle seen in some economies is particularly risky. Allocative efficiencies are sacrificed with potentially dangerous consequences in the long run. If credit decisions cannot be justified on commercial grounds, they are often corrupt or quasi-corrupt. And they usually carry hidden risks that, taken together over time, can lead to financial collapse for banks, enterprises and ultimately a national economy. This is an argument for transparency and arms-length transactions. It is an argument for institutions rather than "Diktat," contract rather than kinship, and competition rather than monopoly or oligopoly as a basis of commercial life. So it's a scary world, with lots of risks. Is globalization worth it? Yes. (And I do not wish to mythologize the virtues of free capital flows and open markets. There are things markets don't do well. There are risks associated with the caprices of capital and the phenomenology of markets -- what George Soros brilliantly calls "the alchemy of finance.") Russia, like other EMs, remains committed to globalizing out of rational self-interest, precisely because the benefits of economic and financial integration with the world far outweigh the costs. The key is to manage the risks -- systematically, preemptively. For countries like Russia that means more reform, sooner. Russian equities were down 15 percent last week, and 51 percent on the year. (The stock market is back to late 1996 levels.) The refinancing rate was at 150 percent last Friday. GKOs are trading at 70-80 percent, compared with 30 percent a few weeks ago. The Central Bank has recently spent over a $1 billion of its depleted reserves defending the ruble. Rumors of a forced devaluation are rife. Markets are getting spooked. To use a basketball metaphor, Team Russia faces a shot clock. There are certain things that Russia needs to do with all due haste. It needs to sink a three pointer, preferably with some foul shots to boot. The government of Prime Minister Kiriyenko is well positioned to do it. The new team is full of youthful reformers, with a great deal of managerial competence. (I would note that by dismissing Chernomyrdin as PM, President Yeltsin has begun to effect a generational shift within Russia's body politic, albeit by decree, as is his constitutional prerogative. This shift is a good thing. After all, through most of its history, Russia has been ruled -- and ruined -- by fathers, not by sons.) What the Kiriyenko government lacks in clout, it generally makes up for in energy and shrewdness. The agreement reached with the IMF last Friday was a major step forward. It will reinvigorate Russia's $9.2 billion Extended Fund Facility with the IMF and will unfreeze a $670 million quarterly tranche on hold since January. Under this new agreement, the Russian government must continue to cut expenditures (RUR 74 billion-20 percent of non-interest spending) and ramp up lagging tax collections. It must cut civil servant rolls. It must reinvigorate privatization of key firms including Rosneft and Svyaz'invest. Furthermore, as President Clinton stated on Sunday, the United States would endorse additional conditional financial resources for Russia from the IMF, World Bank and other international financial institutions, as necessary, to support currency stability, reform and growth. But, ultimately, Russian reform also faces a game clock. Markets will be volatile in the short term. To keep them bullish in the longer term, Russia needs to get its house in better order. Furthermore, the election season for both the Duma (December 1999) and the presidency (June 2000) are not too distant. Let me enumerate several inter-related areas of good economic housekeeping that require further attention: 1. Fiscal dynamics -- primary surplus, but overall gaping budget deficit -- downward pressure on revenues from falling commodities price -- need full control on spending through treasury system -- strengthen fiscal federalism 2. Taxation -- chronically low tax collection (federal = 10 percent of GDP) -- no tax code, poor tax administration -- tax evasion by large companies: crack down, seize assets 3. Financial sector -- Central Bank transparency -- introduce international accounting standards for all banks -- Basel capital standards and close prudential supervision -- prevent another TokoBank episode -- continue to strengthen capital markets regulatory framework -- improve clearing and settlements mechanisms 4. Public debt dynamic -- external debt to GDP not too high, but domestic debt mounting -- get interest rates down on government paper -- rebalance debt in favor of longer-term and external debt 5. Public administration -- "reinvent government" -- downsize, rationalize -- good governance: bureaucracy for a market economy -- from "weak state" to "smart state" -- training 6. Privatization -- re-start Rosneft tender -- continue with Svyaz'invest, LUKOil, etc. -- ensure transparency 7. De-monopolization, especially in energy sector -- trust busting: protect markets from oligarchs 8. Land and housing reform -- resolve land code issues with Duma -- create real estate and mortgage -- create housing market 9. Pension reform -- implement three-pillar pension reform for fiscal sustainability -- achieve synergy with capital markets (mutual funds, etc.) 10. Legal Issues -- strengthen rule of law, judicial institutions -- judicial and legal training -- strengthen corporate governance, shareholder rights -- implement the new bankruptcy law -- ensure enforceability of contracts, including forex forward contracts -- fight crime and corruption. This list is long, but unsurprising. Russia already has initiatives in most of these areas. It receives IFI (& other multilateral) and USAID (& other bilateral) assistance in many of them. In view of all the recent market turbulence within Russia and the risk of further cross-border contagion -- and in view of the need to achieve solid growth before the political season ripens -- a sense of heightened urgency would not be undue. The game clock is long, but not indefinite. Let me close this brief examination of Russia's current economic challenges by underscoring my unexuberant, balanced bullishness. (Yes: I am bullish about the Russian Bear.) I am prudently bullish, mindful that the history of economic Kremlinology is already littered with the wreckage of collective hallucinations. In my assessment, Free Russia has every objective reason to succeed -- but this does not mean that Free Russia will not at times find subjective ways to fail. Therefore, I fully expect that we Russia-watchers will remain riveted to our seats for some time to come -- until the final buzzer. To quote Russia's greatest liberal, the great nineteenth century critic Alexander Herzen (who was attacking the socialists of 1848): "If history followed a set libretto, it would lose all interest, become unnecessary, boring, ludicrous ... History is all improvisation, all will, all extempore -- there are no frontiers, no itineraries." (To be sure, the IMF offers some very useful librettos and itineraries.) What the Russian government needs to do is to improvise a little faster. (End text)
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