Colloquium 1996 Panel I : Balance Sheet of Economic Performance and Reforms in Cooperation Partner Countries

The Russian Economy: Stabilization Prospects And Reform Priorities Igor Y. Volossov Head of Section, Russia's Institute for Strategic Studies, Moscow Major Results of 1992-1995 Reform Period In January 1992, the Gaidar Government launched its radical economic reform program based on IMF "shock therapy" prescriptions. Though later some insignificant changes were made to improve the reform strategy, the Government followed the main guidelines of the initial reconstruction program. Regarding major macroeconomic results, the reform was a severe blow to Russia's economic, scientific, technological and labour potential (See Table I). Table I Russia's Economic Performance of 1992-1995 1989 1992 1994 1995 in percent Industrial Production 100 74.5 47.0 43.2 Agricultural Production 100 84.6 75.0 72.2 Investment 100 46.5 32.0 27.2 Source: "Voprosy Economiki", 1996, N3, p. 77

Despite such devastating effects on the Russian economy and social sphere, the reform succeeded in pushing Russia towards a market economy. Up to now Russia has undergone some vital changes that seem to be irreversible. The most important are the following: the economy is not dominated by state property, as the private sector has become an independent factor of economic development; total state control, exercised through central planning and distribution, has practically vanished, though the state continues to be the principal force of economic regulation; entrepreneurship is flourishing and there is an evident move of the population towards market-oriented behaviour. In the second half of 1995 the Russian economy seemed to be dragging bottom. According to Government estimates, in May-December 1995 seasonally adjusted industrial production was close to a stablization trend. There was also an evident reduction in the inflation rate on a monthly basis: from 17.8% in January to 3.2% in December 1995. The ruble/dollar exchange rate remained rather stable. Nevertheless, on the whole the Russian economic performance in 1995 was not so bright, though the production fall was much lower than in 1992-1994 (see Table II). Table II Russian Economic Indicators 1992 1993 1994 1995 in percent to the previous year Gross Domestic Product 85.5 91.3 87.4 96.0 Industrial Production 82.0 86.0 79.0 97.0 Agricultural Production 91.0 96.0 88.0 92.0 Investment 60.0 88.0 76.0 87.0 Consumer Price Index 2610 840 220 130 Source: Goskomstat RF Russia's GDP fall was much lower (4% in 1995) than in the three previous years. The private sector reinforced its position as the main driving force of economic development and now accounts for 50% of GDP production. The Russian GDP structure continued to change towards an increasing role of services (its share in GDP production reached 51.5% in 1995). That could be treated as a positive trend. Nevertheless, this trend resulted mainly from rapid growth of services tariffs as well as recession in major industries. The official statistics do not reflect some serious shortcomings of Russian economic performance in 1995. For example, though overall industrial production declined by 3% in 1995, the output of large and medium enterprises, usually providing more adequate data, fell by 4.7%. Seasonally adjusted figures showed a 7.7% reduction in December 1995 in comparison with December 1994. (1) The decline in the inflation rate doesn't seem to be irreversible as well. In January-August 1995 inflation followed the same trend as in the corresponding period of 1994. Thought the inflation rate dropped to 131% on an annual basis, the figure was several times greater than the Government goal of 27-30%, set for 1995. Average monthly inflation of 7.2% also remained rather high for an economy that is going to stabilize. Since a 40% annual inflation rate could be a criteria of financial stablization, the Government failed to achieve its main goal for 1995. Despite evident progress in Russia's macroeconomic performance, the economy remains in a state of "unstable equilibrium", as Minister of Economy E. Yasin puts it. Russian Industry Performance The development of Russian industry was still very uneven in 1995. Exports remained the main "locomotive" that helped a number of key industries to bottom out. With 1995 production growth shown in brackets, pulp and paper (23%), the chemical and petrochemical (8%), and the ferrous (9%) and non-ferrous (2%) metallurgy industries were the top performers. Weak demand and increased foreign competition in the domestic market hampered the development of other industries that were mainly internally oriented. Recession continued in the engineering (minus 10%), the food processing (minus 9%), and the light (minus 31%) industries (See Table III). Table III Russian Industrial Production in 1995 1995 1 quarter 2 quarter 3 quarter 4 quarter Dec. Year to Year in percent to corresponding period of 1994 Large and Medium Enterprises 95 97 100.3 94 90 95 Ferrous Metallurgy 110 114 108 105 106 109 Non-Ferrous Metallurgy 101 100.5 105 104 95 102 Chemical and Petrochemical 108 111 118 97 90 108 Engineering 99 93 94 82 77 90 Light 60 65 89 74 60 69 Food Processing 85 96 93 87 100.1 91 Source: "Vestnik Economiki", The Ministry of Economy of RF, N3-4, 1996, p.8. The industrial production trends caused a further deterioration in the structure of the Russian economy. The share of manufacturing in overall industrial production continued to diminish while the share of the fuel and raw materials industries, as well as the intermediate product industries, increased. At the same time in the second half of 1995 the chemical and petrochemical industries and non-ferrous metallurgy slowed down. There were two main causes for the trend: weakening of external demand and the Government policy of setting limits to ruble/dollar exchange rate fluctuations. The latter made exports of a number of products less profitable or even unprofitable, since the ruble/dollar exchange rate remained practically fixed while energy and transportation costs continued to grow. In 1995 Russian industrial production failed to drag bottom. Since internal demand remained weak, its prospects continued to depend to a great extent upon external demand and monetary regulation. State Finances The Russian Government financial policy remained the main instrument that helped to curb inflation. In 1995 there were several bright spots that contributed to a significant reduction of the inflation rate. The Government succeeded in bringing down the federal budget deficit, from 10.7% of GDP in 1994 to 2.5% of GDP in 1995 (2). It managed to increase the budget receipts and to prune the expenditures. Nevertheless, more detailed analysis of the Government financial policy shows that the federal budget deficit reduction was not ensured by true amelioration of the state finances. Though the budget receipts were increased to 14.6% of GDP in 1995 from 13.4% of GDP in 1994, the structure deteriorated. Receipts from taxes declined from 11.54% of GDP in 1994 to 10.28% of GDP in 1995. This trend was mainly caused by a dramatic fall in receipts from foreign trade taxation (from 3.11% of GDP in 1994 to 1.46% of GDP in 1995), owing to numerous tax exemptions, granted to Russian companies. A reduction of receipts from profits tax (from 2.81% of GDP in 1994 to 2.47% of GDP in 1995) also contributed to the trend. The fall in tax payments reflected some serious problems of the State tax system that couldn't provide adequate tax collection and exercise control of numerous tax exemptions and allowances. It also failed to curb a widely spread practice of tax evasion. The budget receipts growth was ensured by non-tax payments (incomes from state property and privatization). These receipts accounted for 2.43% of GDP in 1995 against 0.98% of GDP in 1994. The bulk of these receipts was ensured by speeding up privatization in the second half of 1995 through the bizarre shares-for-loans scheme. (Investors are to make bids for the right to manage parcels of shares that are put up for auction. The winner is to make payment in the form of loans and is to receive some management control. At a later date, the winners are to sell their shares to the state, getting repayment on their loans, interest and a 30% slice of any capital gains realized under their management.) The Government succeeded in pruning budget expenditures from 23.4% of GDP in 1994 to 17.2% of GDP in 1995. It managed to cut expenditures on the economy (mainly subventions), defence, social sphere, and research and development. There was also a dramatic decline in transfers to local budgets (from 6.14% of GDP in 1994 to 1.76% of GDP in 1995). Nevertheless, these cuts of budget expenditures did not result from a radical amelioration in state finances. The Government pruned the expenditures mostly on its own and even postponed urgent payments that provoked serious social discontent. A significant reduction of the budget deficit enabled the Government to finance it by using non-inflationary instruments: state bonds and international loans. State short term bonds, Federal float rate coupon bonds and Internal currency bonds were among the most "popular" instruments. By issuing these bonds the Government managed to raise a sum equivalent to 1.75% of GDP in 1995 against 1.13% of GDP in 1994. International loans amounted to 2.34% of GDP in 1995 in comparison with 0.99% of GDP in 1994. Financing of the budget deficit contributed to a further growth of Russia's debts and servicing payments. Internal state debt increased nearly three times to 202.9 trillion rubles in 1995, while Russia's international debt grew to 124.0 bn dollars US in 1995 (119.9 bn dollars US in 1994). Though Russia's state finances seemed to improve in 1995, this trend towards stabilization was not stable and well grounded. Possible changes in the economic and political environment could cause a significant deterioration of state finances with a serious impact on inflation. Investment The Russian economy has failed to overcome a deep investment crisis. In 1995 the investment volume was 73% lower than in 1989 and there was no evidence of recovery to come (3). the share of investment in GDP continued to decline: from 22.4% in 1990 to 17.3% in 1994 and 15.1% in 1995 (4). There remain several major factors behind the investment crisis in Russia. First of all, in 1992-1995 the state had to withdraw from active investment policy due to lack of financial resources. Even in 1995 the share of state-financed investment declined to 13% of budget expenditures from 15% in 1994. The Program of Encouraging of National and Foreign Investment in the Russian Economy, adopted by the Government in 1995, hasn't changed the situation for the better. A possible volume of additional investment was estimated by Russian commercial banks at 2 trillion rubles (less than 1% of overall investment in 1995). Russian enterprises could not ensure adequate investment because of serious financial problems. In the middle of 1995 about 32% of all national enterprises were in the red (5). Moreover, lack of current assets made the bulk of the national enterprises use their investment funds to finance current activity. Russian commercial banks also failed to become a major investor in the national economy. According to some estimates, since 1992 their real assets have evidenced a three fold decline (6). The banking crisis of August 1995, as well as a number of financial frauds, discouraged the population from further deposits of their savings, which remained the main investment source (approximate amount of the population savings was estimated at 25-30 bn dollars and 30-40 trillion rubles). Foreign investment doesn't play an important role in the Russian economic restructuring. Russia continues to lag behind Hungary, Poland and the Czech Republic in attracting foreign capital. Its impact on Russia's economic development is more serious in the stock market, especially in operations with shares and T-bills. Economic Reform Priorities In the 1st quarter of 1996 the socio-economic situation in Russia tended to deteriorate once again. GDP declined by 3%. In fact, the economy failed to adjust to the economic environment set by tight monetary policy. Several major factors contributed to the trend: weak internal demand, a non-payment crisis in the economy, a fall in investment, the lack of Government financing, a low level of the average population purchasing power, and a deterioration of the country's export performance. The top industry performers of 1995 suffered a decline in output: ferrous metallurgy fell by 2% in the 1st quarter of 1996, the pulp and paper industry by 13%, the chemical and petrochemical industry by 14% (7). The industrial production declined by 4% in the 1st quarter of 1996. This trend could result in a 6% fall for the whole year and would crush the official forecast of zero growth. A declining inflation rate is the only bright spot in Russia's economic performance in the first months of 1996. In the 1st quarter of 1996 the consumer price index was 110, which turned out to be lower than in the forecast. Under the circumstances there is an urgent need to seek an optimum balance between macroeconomic stabilization and encouraging of internal demand, especially through recovery in investment. At the same time the Government has to encourage exports and hamper imports expansion, as well as to give much more attention to increasing the population's purchasing power and solving social problems. All these reform priorities have been emerging recently in Government policy. Nowadays there are two main approaches in defining the reform priorities in Russia. The first presumes following the current policy of achieving macroeconomic stabilization with special emphasis on monetary regulation. The second one calls for a significant increase of the role of the state in pushing the economy out of recession. The presidential elections could be the turning point in Russia's reform policy. Nevertheless, dramatic changes are unlikely. Any Government will have to follow the main guidelines set by the current economic environment. After the elections, a new economic program could appear. But it is to be a sort of compromise between these two approaches. Footnotes A. Illarionov, "Lost chance. Why Financial Stabilization of 1995 failed", "Voprosi Economiki", 1996, N3,, p. 86. "Vestnik Economiki", The Ministry of Economy of RF, N3-4, 1996, p. 7. N. Petrakov, V. Perlamutrov, "Russia is a Zone of Economic Collapse", "Voprosi Economiki", 1996, N3, p. 77. "Vestnik Economiki", The Ministry of Economy of RF, N3-4, 1996, p. 31. "Bulletin of Bank Statistics", Central Bank RF, 1995, N6, p. 4. "Kommersant Daily", 29.03.1996, p. 6. "Vestnik Economiki", The Ministry of Economy of RF, N8-9, 1996, p. 1.