Hobson's Choice

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Is Russia recovering?

July 12, 2004

(OECD-Economic Survey - Russian Federation 2004)

Communism, a disaster for most people who lived under it, also ended disastrously. In most countries, the collapse of that system led not only to massive economic hardship, but a loss of sovereignty and control over the future. Much of the blame for this has been laid at the door of foreign "helpers" (with excellent reason); a lot more, in my opinion, is the inevitable lot of medium-level development countries under the present currency regime, of CGD traps.¹ Since the collapse of Communism, most affected countries entered a depression (GDP fell 33-60%) accompanied by inflation; in the case of Russia and Ukraine, this was accompanied by hyperinflation, disastrous health problems, a collapse in agriculture, and a crime wave. Then, following the experiences of Central European countries, Russia's economy recovered gradually. The OECD has a report on this recovery that is worth skimming.

Since 1998, the GDP of Russia—the crudest possible measure of economic health—has grown at an average rate of 6.7%. The OECD report linked above discusses the effects of Russia's 40% growth spell.

Sustaining growth: The post-crisis recovery has been faster and more sustained than most observers believed possible in late 1998, with real GDP growing by an average of 6.7 per cent per year during [...] Recovery ...relatively broad-based....However, growth has been driven primarily by export-oriented industries, particularly the oil industry, which has made by far the most important contribution to growth in recent years. In addition, rapidly growing oil exports - together with favourable terms of trade - have also been the main factor enabling the current consumption boom to unfold without putting the external balance in danger so far. However, significant increases in productivity have also been crucial, as they have helped Russian industry to stay competitive in the face of rising wages and a strengthening real exchange rate.
[...]
By 2004, real wages and real disposable incomes were well above their pre-crisis peaks, while the unemployment rate had fallen from over 13 per cent in 1998 to around 8 per cent.
As a result, the proportion of the population living on incomes below the officially defined subsistence minimum has fallen by roughly one-third since 1999.

But there's a reason why GDP growth should be regarded as an extremely crude, almost useless, measure of economic health:

Until recently, however, demographic and health indicators have continued to deteriorate, despite the resumption of economic growth. Life expectancy for both men and women remains below pre-crisis levels, and the incidence of many ‘poverty-related’ illnesses has increased. Thus far, growth alone has proved insufficient to bring major improvements in health and other social indicators. This points to an urgent need for reform of the health system, which is likely to require additional expenditure, not least in order to ensure adequate treatment for the less well off.

Partly this is because oil and gas, the main exports of Russia and the key bright spots, are capital intensive. They are driven in large measure by the influx of investment capital into Russia, and bypass completely the great majority of Russians.

The OECD gives Russia high marks for fiscal prudence (chart); on the other hand, regional governments have a spotty record, as indeed most are facing impossible conditions. I should mention that the OECD is mildly concerned that Russia's real exchange rate will grow too fast, since inflation at home is not reflected in nominal exchange rates.² My own anxiety is that another crisis like the one affecting Yukos could trigger a meltdown in the value of the new ruble, and with it, a flight of capital. The OECD report was published 7 July, just as the Yukos deadline approached. The OECD report has a lot of prescriptive advice—reform the oil & gas sector so those sectors won't turn into speculative bubbles, enhance industrial competitiveness by reforming the tax system, and so on; but those are things any Washington consensus-failthful analyst would have to assume are in the hands of the market anyway. More feasible, it seems, is the call for a reform of the banking secotr, which is heavily regulated in most countries.

Banking reform: The most important reform initiatives of the last two years have included deposit insurance legislation, a major reform of the framework for prudential supervision, steps to increase transparency in the sector, and measures to facilitate the development of specific banking activities. [...] Even more important is the ‘fit’ between them: the various strands of reform complement each other well, which reflects the coherence of the authorities’ overall strategy.

I agree: preventing runs is job one for the Russian monetary authorities. In 1998, assets of the Russian banking system fell 61%, and did not recover to their former level until 2002. Since then, they've exploded to a level 46% highter than before the crash. Is this just a reflection of greater liquidity in the Russian economy?

Russia’s largest banks continue to be controlled by the state. [...] State ownership and state intervention in credit allocation tend to distort competition, to aggravate moral hazard by encouraging the expectation of a bailout, and to undermine the efficiency of intermediation, as banks often pursue policies that reflect the non-commercial requirements of the authorities rather than good commercial sense. The short history of Russia’s banking sector exemplifies many of these problems, particularly with respect to competition and the imposition of hard budget constraints on banks. Official policy is that state-owned banks should exist, if at all, to correct market failures: their activities should be specialised in sectoral and other niches which the market will not address on its own. In practice, however, the major state-owned banks in Russia have tended to operate as universal banks, with Sberbank, in particular, exploiting its protected retail monopoly to extend its business in other directions.

Sberbank holds 68% both of household deposits and government securities. This seems to be a classic role of many pre-WW1 industrializing nations, like Japan (with Mitsui) and Germany (with Deutsche Bank) where the lead bank—as opposed to the central bank—is responsible for monetizing huge amounts of debt in exchange for institutional deference.

NOTES: "with excellent reason": Unfortunately, the Stalinist system was replaced by something nightmarish for most Soviet citizens: hyperinflation, capital flight, the seizure of national wealth by a tiny nomenklatura, and an unimaginable crime wave. The country's economy did not privatize; rather, it was liquidated under circumstances that were anything but transparent. A department of Harvard University, the Harvard Institute for International Development (HIID), was retained to effectively manage all of America's foreign aid to the Russian Federation and the Ukraine.

The U.S. assistance program was driven by the desire to support reformers whose agenda was consistent with U.S. objectives. Between December 1992 and September 1995, USAID, through a noncompetitive cooperative agreement and amendments to the agreement, provided HIID with $40.4 million to undertake a number of activities in Russia. These activities included providing assistance in privatizing Russian companies, developing a capital market, instituting legal reform, and overseeing U.S. contractors’ delivery of over $285 million of technical assistance to Russian institutions and private companies.
(GAO, Foreign Assistance: HIID’s Work in Russia and Ukraine, 1997—PDF)

Readers would be correct in interpreting this to mean that the US government retained a department of the privately endowed Harvard University to assist the former USSR in administering reform. This policy was introduced by the first Bush Administration and continued under the Clinton Administration as well. The object was, of course, to ensure that the exceptionally complex and urgent decisions associated with the creation of a modern capital economy were made by experts. Instead, HIID and the group of Russian "reformers" engineered a scheme for plundering Russia of its wealth. Since the dissolution of Soviet Communism is not the topic of this post, readers are urged to review Janine R. Wedel's "Tainted Transactions," The Common Interest, Spring, 2000.

1 CGD trap: currency, growth, debt. It's explained here: "Market Discipline under Systemic Risk: Evidence from Bank Runs in Emerging Economies" (PDF), p. 8:

By December 1999, however, the Argentine economy was caught in a currency-growth-debt (CGD) trap. The currency was overvalued, growth was faltering, and the debt was hard to service [...]. The macroeconomic stance deteriorated sharply in 2001. Doubts about the one-to-one peg to the dollar soared [...] At the same time, uncertainty about the debt component of the CGD trap grew as the government, instead of attempting an orderly debt reduction, postponed the impending crisis temporarily by absorbing the liquidity of banks and pension funds, rendering the banking system less liquid and more exposed to a government default. As financing sources run out, the threat of money printing became a growing concern, and ultimately a reality through the issuance of small denomination government bonds that differed from currency only formally. This, in turn, added to the misgivings about the margin to preserve the currency board. In the process, debt sustainability and bank solvency became intimately linked to the fate of the currency. The elements of this CGD trap (continued economic contraction, increasing default risk, and uncertainty about the exchange rate) reinforced each other. This led to a massive run on bank deposits.

The CGD trap is actually an old problem, in which a slowdown in growth causes a run on the banks, then a run on the national currency; it caused several depressions in the USA during the 19th century.

2 Within Russia, inflation is a historically low 12%; but the ruble's exchange rate against the USD has actually increased, from US$1:31.8 in January '03 to 1:29.1 today. That's an increase in the REER of around 27% in 18 months. Russia has little control over this; in essence, the recent increase of oil prices led to a flow of capital to Russia's oil and gas industry; since Russia's central bank has limited options for sterilizating increases in reserves, the money supply increased at an annualized rate of 57%. An diversified country like the USA never experiences inflows of capital like this, with the result that unsterilized capital flows don't wreak havoc like this. Fortunately for Russia, the mean velocity of M2 slowed. BUt of course this has drastically increased the country's REER. As the capital flows reverse, as they must, the central bank will need to defend a peg. Saying they won't allow the ruble's REER to fall faster than, say, 5% annually, has been a historically unsuccessful strategy—as anyone in finance would expect it to be.