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THE RUSSIAN ECONOMY- FROM STABILITY TO GROWTH

Hoshino Committee on Economic Reform in Russia
April, 1996

Preface

More than four years have passed since the introduction of fundamental economic reform in Russia. In 1995, with inflation increasingly under control and the decline in production bottoming out, the view strengthened that, for the first time since the reforms, the economy was beginning to stabilize. However, there are many problems which still have to be solved in order to consolidate the stabilization of the economy and shift to a growth path.
Economic Planning Agency in the Japanese Government which has an on-going policy dialogue with Ministry of Economics in the Russian Federal Government, last year commissioned the Japan Research Institute to undertake this study. The Institute established the "Hoshino Committee on Economic Reform in Russia" which produced this report. It is the culmination of a range of activities including reports by individual committee members, survey results, and the contributions of Russian and Japanese experts who attended the Symposium held in March this year. Though there are many issues which require further study, we hope that this Report, together with past reports, will contribute to the process of economic reform in Russia and strengthen relations between Japan and Russia.
I would like to take this opportunity to thank those who, despite their busy schedules, found the time to participate in the Committee. Their generous co-operation and their invaluable opinions are greatly appreciated. I would also like to thank the Japan Research Institute which managed the research project and provided administrative support.

Hoshino, Shinyasu
President of National Institute for Research Advancement


Hoshino Committee on Economic Reform in Russia

Chairman
Hoshino, Shinyasu       President, National Institute for Research Advancement

Member
Araki, Nobuyoshi        Chief Economist, East and West Research Institute
Hakamada, Shigeki       Professor, School of International Politics, Economics and Business, Aoyama Gakuin University 
Iwata, Kazumasa         Professor, faculty of liberal arts, Tokyo University
Nishimura, Yoshiaki     Professor, Institute of Economic Research , Hitotsubashi University
Sakurai, Makoto         Director General and Chief Economist, Mitsui Marine Research Institution Cooperated
Tabata, Shinichiro      Associate Professor of Economics, Slavics Research Center,Hokkaido University
Secretariat
Tanaka, Takafumi        Director, Second Economic Affairs Division, Coordination Bureau, Economic Planning Agency
Sasaki, Tomoko          Deputy Director, Second Economic Affairs Division, Coordination Bureau, Economic Planning Agency
Fukuoka, Hajime         Staff, Second Economic Affairs Division, Coordination Bureau, Economic Planning Agency
Nishifuji, Noboru       President, Japan Research Institute

SUMMARY

INTRODUCTION

CHAPTER 1: THE PRESENT STATE OF THE RUSSIAN ECONOMY AND ISSUES FOR THE FUTURE

Part 1. The Present State of the Russian Economy and Issues for the Future

  1. The Russian Economy in 1995
  2. Problems Facing the Russian Economy
  3. New Issues for the Russian Economy

Part 2. New Medium to Long Term Policy Objectives

  1. The Characteristics and Policy Objectives of Stage One of the Transition Period
  2. The Characteristics and Policy Objectives of Stage Two of the Transition Period
  3. Basic Approach to Achieving the Policy Objectives of Stage Two
  4. The Need to Establish a Growth Foundation

Part 3. Economic Policies to Create a Growth Foundation

  1. Policy Directions
  2. Macroeconomic Policies
  3. Stimulation of Private Economic Activity
  4. Greater Efficiency of the Capital Market
  5. Labor Market Policy

CHAPTER 2. THE PRESENT STATE OF THE RUSSIAN FAR EAST AND ITS FUTURE DIRECTION

Part 1. The Present State of the Russian Far East

  1. Overview of the Russian Far East Economy
  2. Structural Characteristics of the Russian Far East Economy

Part 2. The Asia-Pacific Region and the Russian Far East Economy

  1. Economic Linkages with the Asia-Pacific Region
  2. The Russian Far East in the Asia-Pacific Region

Part 3: The Direction of Russian Far East Policy

  1. Promotion of Investment
  2. The Asia-Pacific Viewpoint

CONCLUSION

Glossary 1. The Stagnation Trap

Glossary 2. Changes to Bankruptcy Procedures

Glossary 3. The Separation of New and Old Accounts

Glossary 4. Financial and Industrial Groups

Reference


Summary

As Russia enters the fifth year of economic reform, we are at last beginning to see signs of stability in the major economic indicators. But the stabilization of the macroeconomy does not automatically translate into economic growth. The Russian economy is at a turning point from which it could move into either sustained growth or the stagnation trap (Figure 15).
The Russian economy has reached the second stage of economic growth and must now build on the achievements of its stabilization policies which were aimed at alleviating the economic confusion immediately following the reforms. It must create a new growth foundation so that it can achieve a new gro wth path based on corporate and household economic activities. In this report, we demonstrate that as well as stabilization of the macroeconomic indicators, autonomous corporate activity which is consistent with the market economy and market adjustment mechanisms in labor and financial markets to support it are also essential to the creation of such a growth foundation. We suggest that, building on this foundation, by promoting investment and achieving structural change in industry and regional economies, the Russian economy should be piloted towards implementation of the next two policy objectives - transition to sustained growth and integration into the world economy (Figure14).
In addition, in Chapter 2, we look at the Russian Far East which is one of the regions which has been most affected by the reforms. Even more than the rest of Russia, the Russian Far East is a prototypical example of the need for structural adjustment and the problems of inadequate investment but, at the same time, because of its particular geographic situation, there is a need to open up new possibilities. As the key to the future direction of the Far East economy, we propose that it should build up economic linkages with the Asia-Pacific region and exploit its comparative advantage in the areas of resources and environment.

Chapter 1: The Present State of the Russian Economy and Issues for the Future


Although there are signs of stability in the major economic indicators such as the rate of price increases, the sharp decline in investment continues and there is still no clear evidence of a shift to a growth path.
  1. The Russian Economy in 1995
    Real GDP has continued to decline since the beginning of the economic reforms and has fallen over 30% from 1991 to 1994. However, since 1995, the rate of decline has slackened (Figure 1).
    Consumer prices finally escaped from the hyperinflation that followed immediately after the reforms and, as a result of tight fiscal and monetary policies, the rate of price increases has continued to decline. Since the autumn of 1995, they have been moving at a monthly rate of about 3-4%, the lowest level since the introduction of price deregulation (Figures 3; Figures 4).
    Since the introduction of the reforms, the exchange rate of the ruble against the dollar has continued to fall almost without pause. However, since the introduction of the target exchange rate band in July, 1995, the exchange rate has stabilized within the target range (Figure 8).
  2. Problems facing the Russian Economy
    On the other hand, there are problems such as the continued inefficiency of corporate activities and stagnation of investment in plant and equipment.
    Currently, the proportion of GDP produced by non-state-owned enterprises is about 70%. However, many of the privatized enterprises are now owned by employee shareholders and so there are no externally imposed incentives to regulate the activities of these companies. This has resulted in a range of problems including lack of progress with restructuring, overemployment, accumulation of unpaid loans, and stagnation of capital investment.
    With respect to investment, we find that the current level has decline to only 30% of the 1990 level in real terms. Because the future of the economy is unclear, the greater part of household savings is held as dollars and in 1995, the funds held by financial institutions were directed towards short-term bonds which offered relatively high returns. Moreover, the financial institutions which sprang up after the reforms do not necessarily have adequate analytical ability. Consequently, household savings have not been channeled into real investment.
  3. New Issues for the Russian Economy
    As seen above, the Russian economy has stabilized at least in terms of macroeconomic indicators. However, stability does not necessarily bring economic growth. Economic growth in market economies (including postwar Japan) is achieved not simply by increasing the inputs of productive factors but rather by means of more efficient allocation of the factors of production through the market mechanism and increased productivity as a result of competition. The biggest difference between a command and a market economy is whether or not growth is achieved through the market mechanism. Having achieved stability, the new challenged for the Russian economy as it enters the second stage of reform is whether it can establish a growth foundation which will enable it to make a shift to a sustained growth path by means of the market mechanism.

Part 2. New Medium to Long Term Policy Objectives

The two major policy objectives of the first stage of the transition were macroeconomic stabilization and the creation of systems and structures required for a market economy.
In the case of the Russian economy, this macroeconomic stabilization and deregulation of the economy have not translated into autonomous, robust corporate activity and so there is a danger that the economy will continue to limp along in the stagnation trap. In other words, corporations continue to choose conservative options while ultimately relying on the government to provide support. The result is a vicious circle in which the government, when faced with economic problems and the magnitude of the associated social cost, must ultimately come to the rescue. This vicious circle constitutes the stagnation trap.
Standing at this crossroads, the principal objective for the second stage of the transition is to prevent the economy from falling into the stagnation trap and ensure the sustained growth of the Russian economy. This requires that the new structures and organizations which were created during the first stage of the transition fulfill the functions expected in a market economy.
The second policy objective is the integration of the Russian economy into the world economy. As the world economy is being swept by a wave of globalization and each countries economic activities are carried out within a network of interdependent trade and investment relations with other countries, it is unrealistic to suppose that Russia alone can remain a closed economy. Moreover, in recent years, it is participation in global trade and investment activities which has contributed to the rapid economic growth experienced by the Asian countries, the Czech Republic and Hungary.
To achieve these two policy objectives, it is necessary to increase the overall efficiency of the economy by expanding investment and by bringing about structural change in industry and regional economies.
Moreover, in moving towards integration into the world economy, a reorientation of both the structure of industry and of regional economies will be required. On the supply side of the Russian economy, under the centrally planned economy, an artificial industrial structure was created centered on resources, energy, heavy and chemical industries and high-tech industries such as military and space technology. The industrial structure of the regional cities was constructed on the premise of transport and energy costs which were held at a low level as a matter of policy under the former regime. There are many cities which are in effect industrial estates dependent on a specific industry.
In order for the Russian economy to move onto a sustained growth path in the second stage of the transition, this former structure of industry and regional economies which would not be viable under market principles must be changed.
In order to achieve such change, a growth foundation which consists of the following three elements must be created: that is, macroeconomic stabilization, corporate activity consistent with the market economy, and the full development of the adjustment function of the markets for the factors of production (labor market, capital market).

Part 3. Economic Policies to Create a Growth Foundation

The policies required for the creation of a growth foundation must have the effect of eliminating the factors that produce the stagnation trap and stimulating autonomous economic activity by the respective economic agents. From this point of view, the following three policy directions are important:

  1. elimination of the systems and practices which permit inefficient economic activity dominated by past practices;
  2. creation of an economic environment, particularly the greatest possible reduction of uncertainty, which encourages economic agents to act on the basis of the medium to long term view;
  3. the introduction of structures which increase the incentives for rational economic activity.
  1. Macroeconomic Policies
    Firstly, in order to consolidate the reversal of the dollarization of the economy, it is essential to continue to suppress inflation and maintain confidence in the ruble by continuing with tight budgetary and financial policies and the nominal anchor policy with respect to the exchange rate. In particular, there needs to be even greater effort made to pursue sound budgetary policies. Amid the economic confusion which has continued since the reforms, there has been a rapid increase in income differentials and so particularly with the upcoming presidential election, there is great pressure to expand budget outlays to win favor with the electorate. However, the temptation to rely on populist policies to relieve social tension by the simple device of increasing budget outlays must be resisted and instead, as seen in the 1996 budget, the objective must be an even higher level of economic stability.
  2. Stimulation of Private Economic Activity
    Up until the present in Russia, the principal objective of the accounting function has been to provide the necessary information to the tax office and the concept of managerial accounting has been virtually non-existent. In order to subject corporate activities to hard budget constraints, the financial position of the firm must first be made clear.
    If the bankruptcy or reorganization of the majority of companies which have excess liabilities is not a realistic option, then the approach which was used in Japan immediately after the Second World War should be considered. This involved moving the bad assets onto a special account and keeping them separate from the results of the new activities of the firm. The transfer to new accounts and the monitoring and management advice provided by government, the central bank or independent advisors during the rebuilding process must be carried out by completely transparent procedures. Moreover, if acceptance of such a rebuilding process is made the condition of new investment funding and government guarantees, this can be expected to provide increased incentives for companies to improve their financial position and promote restructuring.
    In addition, housing, medical care, kindergartens and other social services provided by companies should be separated from the true functions of management. As a first step, separate accounts should be set up for each of these services. Then the assets can be valued and the efficiency of management assessed.
  3. Greater Efficiency of the Capital Market
    Since Russia has a surplus on its current account, in terms of the macroeconomic IS balance, it has an excess of savings. However, because much of its capital stock is deteriorating and outdated, the proportion of replacement investment is high and so foreign investment, and particularly the transfer of technology and management methods that direct investment brings, are important. While macroeconomic stabilization is essential, what is also required is the creation of an environment in which foreign investors can invest with confidence. This can be achieved by ensuring the stability of systems relating to foreign investment, by providing clear information about taxation and other systems, and by the active provision of information and complaints settling procedures. Provision of infrastructure is also a major issue. The utilization of foreign investment for the construction of infrastructure through, for example, the BOT system as seen in the Asian countries in recent year should be considered.
    The function of financial and capital markets in bringing together those with excess funds and those with insufficient funds is important for the encouragement of investment. To achieve this, it is necessary to implement all of the policies directed towards reform of the system - including improving the financial position of the banks and strengthening supervision by the central bank - and to strengthen the fundamentals of the financial system. It is also important to consolidate the stabilization of the economy and remove the opportunities for financial institutions to pursue speculative activities.
    Hope has been placed in financial and industrial groups as a means to encourage investment and promote industrial restructuring. These groups consist of a number of companies centered around a central bank which jointly fund the establishment of a new joint stock company. So that the internal transactions of these groups do not become a hotbed of inefficient, non-market activity, the creation of structures which provide incentives for restructuring , the existence of competition from outside the group, and the objectivity and transparency of government assessment for receipt of special treatment will be required.
  4. Labor Market Policy
    Compared to the decrease in production activity, the decrease in employment was small indicating that excess labor is being retained by companies (Figure 12). As a hangover from the old system, companies are not only the place of work, but also the source of such social services as housing and medical care so that, even if real wages decline or wage payments are late, workers find it very difficult to leave their company. On the other hand, there are also incentives on the management side to retain labor. These include the reinforcement of insider control and the strengthening of bargaining power with local government which results from fear of the social consequences of large scale dismissals.
    In order to eliminate excess employment at the corporate level and transfer labor to more productive sectors, the labor market must function more effectively. It is claimed that recently many of the workers who are part of this excess labor force are holding second jobs so it seems that, with the removal of incentives to remain with one's present employer, the ground is being prepared for greater inter-industry and inter-firm mobility. What is required, first of all, is to remove the incentives on the workers' side to remain with the company by separating the provision of social services from the company.
    In order to increase the incentives for workers to transfer to new companies or new industries, positive labor market policies focused on education and training are required.

Chapter 2. The Present State of the Russian Far East and Its Future Direction

The economic linkages which existed under the centrally-planned economy have been disrupted throughout Russia, and the various regions are confronting structural problems. Economic problems of this kind have been particularly apparent in the Russian Far East. This chapter gives an overview of the present state of the Russian Far East economy and, based on its geographic characteristics, also examines the direction of the region's development placing emphasis on linkages with the Asia-Pacific region.

Part 1. The Present State of the Russian Far East Economy

  1. Overview of the Russian Far Eastern Economy
    The Russian Far East is composed of ten federal component entities (regions) including the Primorsk kray and the Khabarovsk kray. It has a population of some 7.63 million (5.1% of the total population of the Russian Federation) and a land area of approximately 6.22 million square kilometers, or 16 times the land area of Japan (Figure 19;Figure 20). The region accounts for roughly 6% of the industrial production of the Russian Federation.
    The progress of reforms in the Russian Federation was accompanied by a deepening of economic problems in the Russian Far East. During the former Soviet period, because of financial assistance from the center and policies to keep transportation costs low under the centrally-planned economy, economic linkages were created with other faraway domestic regions and the region was incorporated as the eastern extremity in the closed domestic distribution of industry.
    With the progress of economic reforms, however, assistance from the center decreased and price deregulation led to a soaring of transportation costs. As a result, the economic linkages of the former Soviet period has collapsed, and the region was plunged into an economic crisis more severe than most other places in Russia. Large decreases in production and investment are continuing at a rate above the average for Russia as a whole and there is still a long road to travel before the regional economy reaches stabilization.
  2. Structural Characteristics of the Russian Far East Economy
    1. An economic space with a low population density
      The population density of the Russian Far East, at 1.2 persons per square kilometer, is much lower than the average of 8.7 for the Russian Federation as a whole. With a small population, economies of scale do not function resulting in the high cost of infrastructure and social amenity in general, as well as to economic inefficiency in production and distribution activities. Due to scarce financial resources, it seems unrealistic to expect that the development of the region as a whole will be achievable, and for the present what is needed is regional development which promotes a concentration of population and industry at selected points such as the major coastal cities of Vladivostok and Khabarovsk, areas along the Siberian Railroad, and places with extractable mining resources.
    2. A narrow industrial base
      The industrial structure of the Russian Far East is concentrated in two major sectors: non-ferrous metals and food. The machinery industry is dominated by military demand and the delay in the conversion from military to civilian production is a major problem.
      In terms of non-ferrous metals, minerals such as diamonds, gold and tin are extracted, mainly in Sakha autonomous republic. The region accounts for a large proportion of total Russian production of such resources. In terms of fuel and energy, the region has large deposits of natural gas, petroleum, and coal, but the development of these resources has been slow. Coal accounts for roughly 10% of total production in Russia, but for natural gas and oil the volumes are insignificant.
    3. Obstacles, including high transportation costs, to price competitiveness
      Some of the major factors contributing to the loss of competitiveness of industry in the Far East include the rising costs of raw materials, including fuel energy, and transportation. This reflects the fact that under the former planned economy, industrial location was determined without regard to the cost efficiency of transportation and distribution between companies, and economic linkages were established to bring energy and agricultural products in particular across the continent from Siberia and Central Asia.
    4. A fiscal structure highly dependent on the federal government
      Because the public finances of the Russian Far East have a high degree of structural dependence on the federal government, the cuts in transfers from the center accompanying the contractionary budget policies of the federal government have led to reductions in public expenditure in the region.
Part 2. The Asia-Pacific Region and the Russian Far East Economy
  1. Economic Linkages with the Asia-Pacific Region
    The hidden potential of the Russian Far East economy can be found in the fact that it borders the Asia-Pacific region, which is both a center of world growth and contains nations at diverse stages of development. We believe the future direction for the Far East will be to develop this hidden potential by exploiting its abundant resources and building an industrial structure based on an international division of labor with the Asia-Pacific region.
    If we look at recent trade statistics for the Russian Far East, we find that the four countries of Japan, China, South Korea and the United States make up 80-90% of its exports and 60-80% of its imports. They are thus its major trading partners, and it is here that we can find the beginnings of new economic linkages. Foreign direct investment also comes mainly from the same four countries, Japan, China, South Korea and the United States. Given the realities of its enormous distance from Moscow and the rest of European Russia and the high costs of transportation from that region, and, on the other hand, its closeness to the fast-growing Asian region, which is one of the world's growth centers, we find that the key for the Russian Far East to overcome the difficulties it now faces will be to integrate into the world economy through economic linkages with the Asia-Pacific region.
  2. The Russian Far East in the Asia-Pacific Region
    When forging economic linkages with the Asia-Pacific region, it is important for the Russian Far East to develop an international division of labor based on its comparative advantage and its complementary with other economies. The debate should focus on what industries the region should develop.
    In the medium to long term, in response to the expected demand for energy in the Asia-Pacific region, the possibility of developing an industrial structure based on the region's comparative advantage, particularly its abundant natural resources and energy, looks promising. The demand for energy will expand rapidly if the current high growth in the Asia-Pacific region continues. For instance, by 2010, energy demand for the big ten APEC Asian economies (excepting Japan) is projected to grow to more than 2.3 times the figure for 1992, but energy supply will only grow by 1.9 times, meaning that the rate of dependence on energy from outside the region is projected to grow from 6.1% to 24.1%. In particular, projections are that reliance on sources outside the region for supplies of natural gas, which has advantages in terms of environmental policy, will grow from 9.0% in 1992 to 26.6% in 2010. It is expected, therefore, that there will be increased demand in the Asian region for the abundant natural gas resources of the Russian Far East.
    However, since the development of energy resources will take time, for the time being, the region will have to rely on industries such as forestry, non-ferrous metals, and fishing and processing of marine products. It will be able to upgrade its industrial structure gradually, by increasing the value-added processing of these export commodities in accordance with the market needs of the Asia-Pacific region. In order to do this, it will have to abandon existing antiquated equipment and processing technology, which will require the promotion of investment. On the other hand, in areas such as grains, vegetables, and light industries, where it is at a comparative disadvantage given environmental factors and the competition of neighboring countries, it should promote imports from neighboring countries. As a result, abundant and low cost imports of foods and daily necessities could raise real wages.
    There is thus a need to begin, in a positive way, to transform the industrial structure of the Russian Far East, and the key to doing this will large-scale investment in natural resource development, investment in processing of natural resources, and investment for conversion from military to civilian production.
Part 3. The Direction of Russian Far East Policy

In the case of the Russian Far East, in addition to the encouragement of investment and structural change in industry, policies which deal with the future of the economy in the context of the Asia-Pacific region will also be required. Further, it will be necessary to pursue comprehensive policies which include the whole of the Russian Far East. In this regard, it is desirable that the Far East Long Term Development Program which is currently being prepared by the Russian Federal Government, be developed from such a standpoint and that it be systematically implemented.
In particular, with respect to the promotion of investment, we see that Vladivostok, which already has a stock market and a foreign currency market, is gradually being developed as a financial center. While this should continue, structures to absorb and utilize the profits and foreign exchange gained from natural resources to promote investment in the Far East should also be explored in the future.
In addition, the introduction of foreign capital is indispensable if the Far East is to build economic linkages with the Asia-Pacific region. In order to do this, conditions must first be put in place to attract and promote investment by foreign companies. In particular, the companies of the major investor countries, America, Japan and Korea, compare the Russian Far East to other possible investments in the Asian region and look at the total picture including profit, cost, risk, and investment environment when they decide whether to invest or not. As the scale of investment needed for resource development projects increases in the future, investment decisions will have to be medium to long term and will only be taken after serious consideration so the creation of an attractive investment environment and the minimization of risk will be of increasing importance. In this situation, efforts to overcome any lack of transparency in systems and procedures will also be important. This will include the provision of accurate and highly transparent information about local companies and the establishment of complaints handling machinery to deal with trade and investment matters.


INTRODUCTION

As Russia approaches the fifth year of economic reform, we are at last beginning to see signs of stability in the major macroeconomic indicators. But the stabilization of the macroeconomy does not automatically bring economic growth. The Russian economy is at a turning point from which it could move into either sustained growth or the stagnation trap.
The Russian economy has reached the second stage of economic reform and must now build on the achievements of its stabilization policies which were aimed at alleviating the economic confusion immediately following the reforms. It must create a new growth foundation so that it can achieve a sustained growth path based on corporate and household economic activities. In this report, we demonstrate that as well as stabilization of the macroeconomic indicators, corporate activity which is consistent with the market economy and is underpinned by market adjustment mechanisms in labor and financial markets is also essential to the creation of such a growth foundation. We suggest that, building on this base, by promoting investment and achieving structural change in industry and regional economies, the Russian economy should be piloted towards implementation of the next two policy objectives - transition to sustained growth and integration into the world economy.
In addition, in Chapter 2, we look at the Far East which is one of the regions which has been most affected by the reforms. Even more than the rest of Russia, the Russian Far East is a prototypical example of the need for structural adjustment and the problems of inadequate investment but, at the same time, because of its particular geographical situation, there is a need to open up new possibilities. As the key to the future direction of the Far East economy, we propose that it should build up economic linkages with the Asia-Pacific region and exploit its comparative advantage in the areas of energy resources and environment.


CHAPTER 1: THE PRESENT STATE OF THE RUSSIAN ECONOMY AND ISSUES FOR THE FUTURE

Part 1. The Present State of the Russian Economy and Issues for the Future

Although there are signs of stability in the major economic indicators such as the rate of price increases, the sharp decline in investment continues and there is still no clear evidence of a shift to a growth path. The Russian economy is now in an uncertain phase where it is unclear whether it will move into sustained growth or whether economic activity will continue to stagnate.
In this section, we will first review the Russian economy in 1995. On the one hand, while confirming that the major macroeconomic indicators are showing signs of stabilization, we also identify the problems and the fact that the economy has now reached a turning point where it will either move into sustained growth or fall into the stagnation trap. We will then argue that the new challenge for the Russian economy is to go beyond the mere stabilization of economic indicators to create a new foundation for a shift to sustained growth.

  1. The Russian Economy in 1995
    It is now five years since the large-scale deregulation of prices in January, 1992. At the beginning of the reforms in 1992, there was hyper-inflation with prices increasing by 26 times a year. From 1992 to 1994, the economy was in a state of confusion as indicated by, for example, the decline in industrial production of around 20% per annum.
    Recently, however, there are signs of stabilization as production has ceased to decline and inflation has slackened. Also, the surplus in the balance of trade is increasing.
    1. Real GDP
      (Easing in the Rate of Decline)
      Real GDP has continued to decline since the beginning of the economic reforms. From 1991 to 1994, it decreased by more than 30%. However, in 1995, the rate of decline slackened to only △4% for the year - the smallest decrease since the introduction of economic reform. (Figure 1) Similarly, industrial production is now only about half the level of 1991 although, in 1995, this also showed the smallest decrease (△3%) since the beginning of the reforms. (Figure 2)

      One of the reasons for this is the good performance of the export-related sector. As a result of the depreciation of the ruble up until April, 1995, and the increase in exports due to economic recovery in the Eastern European countries, production is recovering in such industries as iron and steel (9%), non-ferrous metals (2%), and chemicals and petrochemicals (8%). On the other hand, this recovery is not uniform and production is declining in industries subject to import competition such as light industry (△31%), food (△9%), machinery (△10%). This could be regarded as an inevitable consequence of the process of change from a closed economy under the former Soviet COMECON system to an opening of the system and integration into the world economy and to a new industrial structure based on comparative advantage.

      (The Problem of GDP Figures)
      The existence of bias in Russia's GDP statistics has frequently been noted but there is no agreement on the direction of the bias.
      For example, it has been claimed that GDP for 1995 is not consistent with the movements in statistics for household consumption and represents an overestimation (Gavrilenkov, 1996). On the other hand, it has been claimed that, because of the under-reporting of enterprise output, GDP figures are an underestimate. This is said to be due to the fact that, whereas before the reforms, there was a tendency for output to be over-reported in order to exaggerate results, after the reforms, the opposite occurred and there is now a widespread tendency to under-report in order to avoid tax and also to demonstrate the firm's difficulties in order to receive subsidies (Leitzel, 1995).
      It has also been pointed out that, during the process of change from the artificial system under the former Soviet regime to a world price system, because the change in investment is smaller than the change in consumption, there is a high likelihood that investment is over-estimated and consumption under-estimated (World Bank, 1995).
      Recently, the Russian Federal Statistics Commission, with the cooperation of the World Bank, revised GDP statistics. A sample survey was undertaken to estimate economic activities such as individual trade (so-called shuttle trade) which had not been included before. (Note that the figures given above are revised figures.) It is desirable for further revisions to be made in the future to bring official statistics into line with international standards and for statisticians to be trained. In this case, the major industrial countries (including Japan) and international organizations could provide assistance in the form of intellectual support.

    2. Prices
      In January, 1992, following a major deregulation of prices, monthly consumer price increases of 245.3% were recorded. The increase for the full year 1992 was approximately 26 times, in other words, hyper-inflation. Under the former planned economy, foreign currency holdings increased out of balance with real transactions (monetary overhang) because of forced savings. This indicated hyperinflation in the process of adjustment to the deregulation of prices.
      The rate of increase fell to approximately 10 times in 1993 and 3.2 times in 1994 and continued to show a gradual month-by-month decline in 1995. By autumn, the monthly rate was 3-4% - the lowest rate since the introduction of price deregulation and inflation has continued to slacken recording a low of 2.8% in February, 1996 (Figure 3). The factors behind this transition were the leveling off in import prices due to tight budgetary and monetary policy , the stabilization of the exchange rate, and the weakening of inflationary expectations of corporations and households as the rate of inflation declined.
      In our report last year, we expressed concern about the apparent emergence of a political cycle which saw fluctuations in macroeconomic policies due to political considerations and the acceleration of inflation the second half of the year. However, in the latter half of 1995, inflation remained steady so it seems that this cycle has disappeared. The introduction of the policy of freezing or controlling public utility charges for electricity, gas and so on in autumn of the same year probably had quite a large impact, but it remains to be seen whether it is possible to continue such price control policies(1) in the medium to long term.

      NOTE (1): A decision was taken to hold price increases in natural monopolies such as energy, telecommunications and railways to less than 70% of the rise in all industrial prices.

    3. Balance of Trade
      Russia's balance of trade has continued to show a surplus since the beginning of the reforms but there was a marked increase in the surplus in 1995. The surplus in non-CIS trade (including individual trade activities) rose from 14.7 billion dollars in 1994 to 22.7 billion in 1995. Exports to non-CIS countries increased by 25% over the previous year due to the good performance of energy (including crude oil, natural gas and coal), iron and steel and chemical and petrochemical products, while imports, particularly machinery and equipment and foodstuffs, increased by 12% over the previous year (Figure 5).
    4. Exchange Rate
      (Target Range and Stability of the Exchange Rate)
      Since the introduction of the reforms, the ruble has continued to fall against the dollar almost without pause. Although it rose for a brief period from May, 1995, with the introduction of the target exchange rate band(1 dollar = 4,300-4,900 rubles) at the beginning of July, the fall in the value of the ruble began to level off in August and has now stabilized within the target range. In the first half of 1996, a new target range of 4,550~5,150 rubles to the dollar was set and at present the ruble is continuing to move within this range (Figure 6).
      The target exchange rate band has been set since July 1995 as part of the policy of non-dollarization of the Russian economy. The dollarization of the economy refers to the shift in private currency holdings and circulation from local currency to a hard currency, particularly the dollar, which is regarded as having a stable value. This shift occurs when high inflation causes the local currency to loses its function as a store of value. Generally speaking, there are three principal motivations for currency holdings - transactional, precautionary, and as a store of value. In Russia, the conversion of rubles to dollars is guaranteed, so there are not very many people who hold dollars for transactional purposes. Rather it appears that as hyperinflation increased, the demand for dollars as a precautionary measure and as a store of value strengthened. The dollarization of the Russian economy increased as inflation worsened. For example, in 1994, 16.1% of household income was spent on acquisition of foreign currency such as the dollar. On the other hand, deposits of rubles in commercial banks amounted to only 6.5% of income and even if so-called savings under the bed (4.7%) are included, this is less than the amount expended on the acquisition of dollars. In other words, in terms of the household economy, dollars were preferred over rubles as a store of value (Figure 7). If the value of the local currency stabilizes, households preferring rubles over dollars as a store of value can be expected to increase. At the moment, it is not possible to confirm statistically the extent to which the stabilization of the ruble as a result of the setting of the target exchange range band has contributed to non-dollarization as intended by the policy-makers. However, if this stability is maintained and people increasingly recognize this, it can be expected to have some effect.

      (The Function of the Target Exchange Rate Band as a Nominal Anchor)
      The setting of the target exchange rate band also functions as a type of nominal anchor policy and can be regarded as having the effect of controlling inflation. The nominal anchor policy refers to the use of the exchange rate as an economic stabilization measure which includes the control of inflation. Specifically, it involves stabilizing the nominal exchange rate by using a fixed exchange rate system or comparable method. The stability of the nominal exchange rate facilitates the determination of prices in the transition toward a new price system following price deregulation. At the same time, it encourages private economic activity, encourages monetary discipline by demonstrating the strength of the central bank's commitment to maintaining the value of the currency, and also acts to suppress inflationary expectations in the private sector. Since the setting of the target exchange rate band in July, 1995, the rate of increase in both consumer and industrial prices has shown a marked decline. It is clear that the policy of stabilizing the exchange rate has acted as a nominal anchor to suppress inflation (Figure 8).

      (Decline in Currency Speculation)
      Prior to the introduction of the target exchange rate band, financial institutions were speculating in foreign exchange because it offered the largest profits. Speculation is a natural activity of economic agents and should not of itself be disapproved. However, in Russia, because of the immaturity of financial markets and the continuing instability of the macroeconomy, exchange rate speculation had a significant negative effect on the private sector. After the introduction of the target exchange rate band, this trend declined and financial institutions redirected investment to short-term ruble- denominated bonds. This had the effect of raising the demand for rubles, and contributed to the stabilization of the exchange rate and non-dollarization of the economy.

      (Assessments of the Exchange Rate Level)
      Opinions are divided on the level at which the target exchange rate band was set. The level has been criticized as too high particularly by the export industries. Certainly, one of the problems of a nominal anchor policy is that the attempt to maintain the nominal exchange rate in the face of rising inflation tends to result in the deterioration of the external balance of trade by undermining export price competitiveness. However, at the present time, there is little reason for concern because Russia's trade surplus continues to expand and, because it is a resource rich country, foreign currency can be acquired by exporting resources. Rather it is more likely that setting the exchange rate artificially low would tend to protect domestic producers from the pressures of international competition and ultimately prevent the restructuring of export industries. Moreover, a policy scheme of maintaining the real exchange rate, which reduces the nominal exchange rate in the wake of accelerating inflation, is likely to be conducive to inflation.
      On the other hand, in some quarters, the current ruble exchange rate is considered to be too low in terms of purchasing power parity. At present, Russia's purchasing power parity (taking into consideration changes in the price structure) is moving at a level of around twice that of the actual exchange rate (Figure 9). The gap between purchasing power parity and the actual exchange rate was 9 times in 1993 but just recently it has dropped below 2 times and prices are becoming aligned to world prices. This trend is particularly marked in the case of energy prices. (World Bank (1995), Government of the Russian Federation (1995))

    5. Budget Balance
      The budget deficit of the Russian Federal Government for 1995 was △2.9% of GDP which is a marked improvement compared to △10.4% in 1994 (Figure 10). Revenues as a percentage of GDP increased to 14.9% in 1994 from 12.9% in the previous year, while expenditures decreased from 23.2% in the previous year to 17.8%. Thus the reduction in the budget deficit has been achieved by both expansion of revenues and reduction of spending.
      Also, since 1995, the financing of the budget deficit by direct borrowings from the central bank has been prohibited and is now limited to government bonds and overseas borrowing. This is also considered to have contributed to the slowing of inflation.
      A contractionary budget is again planned for 1996 with the Federal Government deficit to be held at △3.9% of GDP.
    6. Monetary Policy
      1995 saw the continuation of a tight monetary policy. In the second quarter, the money supply showed a large once-off increase. This was due to a major issue of government bonds to finance the budget deficit. Because of the stabilization of the exchange rate, speculative funds which were no longer able to find returns in currency speculation were switched to the buying of bonds as alternative assets. A growing trend towards selling hard currency such as dollars and buying rubles emerged as a result. In response, the Central Bank entered the market to sell rubles to prevent an excessive rise in the ruble rate and consequently the money supply showed only a large, once-off increase. However, because basically a tight money policy was maintained, the increase in the money supply slackened again from the third quarter onwards and this, together with the previously mentioned introduction of price controls in natural monopoly areas such as energy, meant there has been no acceleration in inflation since the second half of the year.
      Because of the maintenance of a tight monetary policy and the stability of the exchange rate, an economic crisis occurred in August when a number of banks were unable to repay call money. The emergency measures taken by the Central Bank prevented this crisis spreading throughout the financial system as a whole. In these circumstances, maintenance of a fundamentally tight monetary policy, can be expected to result in a series of rationalizations and mergers which will remove the weaker financial institutions from the industry.
  2. Problems Facing the Russian Economy

    As seen in (1) above, if we look at the major economic indicators as they relate to macroeconomic policy, the Russian economy appears to be moving towards stabilization. However, if we look at the supply side, we find various problems. For example, even though privatization has proceeded, restructuring still fails to make progress and investment continues to show large declines. We will now explore the problems on the supply side of the Russian economy.

    1. Corporate Activity
      (Progress of Privatization)
      The privatization of state-owned enterprises in Russia began in 1992. The first stage of privatization (achieved through the voucher system) was completed in June, 1994, and was successful in terms of speed and the large scale on which it was conducted. As a result, more than half of GDP was produced by non-state-owned enterprises. The voucher system is a form of privatization suited to an economy in which the accumulation of capital by the general population is inadequate. It involves allocating one voucher to every person free of charge which can be exchanged for shares. Moreover, in this case, a system was introduced which gave the employees of the enterprise being privatized an advantage in the acquisition of shares in their own company.(2) This avoided major conflict with the values of the socialist system according to which "the factory belongs to the workers", thus making it possible to achieve large scale privatization free of political problems.

      NOTE(2): Privatization by voucher in Russia offered three options. (For details, see OECD (1995)). In practice, most of the enterprises were privatized according to the second option which gave the managers and employees of an enterprise preferential treatment to acquire up to 51% of the shares.

      The second round of privatization which began in July, 1994, is being conducted on the basis of the cash purchase of shares and, as a result, the proportion of GDP produced by non-state-owned enterprises is now about 70%.

      (Continuing Insider Control and Inefficiency)
      Nevertheless, because many of the privatized enterprises are now owned by employee shareholders(3), problems of corporate governance have emerged and it is not possible to say that corporate activities are carried out in conformity with the market economy. In the developed countries, putting aside some national variations in systems (Anglo-American, Japanese, etc.), corporate activities (rationalization of management, efficiency of production, capital investment, expansion into or withdrawal from markets) are monitored and regulated by external economic agents such as shareholders or major banks. However, in Russia's privatized companies where the employees hold the majority of the shares and there are no externally imposed incentives to regulate the activities of the company, often the same managers continue to use the management practices they were accustomed to under the socialist system. For example, according to a survey of privatized enterprises, approximately 20% of managers still cited “maximization of employment" as one of the two major objectives of management and more managers cited “maximization of production" than “maximization of profit" (Figure 11). As a result, there are problems such as continuing inefficiency and lack of progress in restructuring which are manifested in over-employment, non-repayment of loans, the stagnation of capital investment and so on.

      NOTE (3): According to the OECD (1995), as a result of share dealing since privatization, insider control of companies through share-holding has decreased somewhat, but, as of December, 1994, in approximately 70% of privatized enterprises, a majority of the shareholders are insiders.

      For example, though hidden unemployment in Russian companies has fallen from a peak of 5.3% of the total labor force (first quarter of 1994), it is still estimated to be about 3.8% (Government of the Russian Federation, 1995). Further, relative to the slump in GDP after the introduction of the reforms, the slump in employment was small suggesting that companies were taking some sort of labor hoarding measures (Figure 12). This could probably be regarded as a hang-over from the socialist period when a larger number of employees was an advantage in terms of political leverage when it came to obtaining subsidies from the federal government. In addition, the problem of outstanding corporate debt which amounts to as much as 1.6~1.7 times GDP, while in part the result tax avoidance by companies holding each others debt, also indicates the inadequacy of financial accounting systems in many companies.
      According to a survey by the Russian Federal Anti-Monopoly Commission, only 1 in 5 of the privatized companies are engaged in activities which are consistent with a market economy in the sense that they are supplying products which meet market needs, cutting costs including wages, concentrating on capital investment and so on (Tselichtchev, 1996). The great majority of companies are lax in their efforts towards restructuring, still seek government subsidies and special treatment for trade and engage in rent-seeking activities. The issue remains as to what extent the activities of these companies can be converted to those of a market economy in the future.

    2. Investment
      In 1995, real fixed investment declined by 13% from the previous year, continuing the trend of a major reduction. The current level has declined to only 30% in real terms of what it was in 1990. In particular, productive investment including investment in machinery and equipment declined by 17 % for the year (Figure 13).
      One of the reasons for this is the failure of household savings to be linked through financial markets to real investment by private corporations. In addition to the fact that the greater part of savings is held as dollars because of the instability and dollarization of the economy, in 1995, the funds held by financial institutions were directed towards short-term bonds which offered relatively high returns thus crowding-out private capital investment. The financial institutions that sprang up after the reforms do not necessarily have adequate investment know-how or analytical ability, so ultimately household savings have not flowed into the real market but remained in financial markets.
      The recovery of investment is a necessary condition for the achievement of sustained growth. In addition to the reorganization of corporate activities as mentioned in above, the solution of structural problems such as reform of financial markets is essential if savings are to be linked to investment in parallel with the stabilization of the macroeconomy by means of contractionary budgetary and financial policies.
  3. New Issues for the Russian Economy

    Thus, although as indicated above, the Russian economy can be judged as in the process of stabilization in terms of the major macroeconomic indicators, corporate activities still do not follow the rules of the market economy, and investment which ought to be the engine of economic growth continues to decline. In other words, problems which have to be resolved continue to mount so that it is impossible to predict whether the Russian economy will be able to achieve sustained growth or not.

    (The Meaning and Limitations of the Stabilization of Macroeconomic Indicators)
    Economic stabilization usually refers to the stability of the economic indicators used in the formulation of economic policy, that is, macroeconomic indicators such as the rate of price increases and the exchange rate. This is not only because they are objective indicators which are readily understood and internationally accepted, but also because they represent a necessary precondition if the various economic agents (both households and corporations), are to be able to engage freely in economic activities including production, consumption and investment. Russia is no exception. Under the direction of international organizations such as the IMF and the developed countries, particularly the G7, the government has pursued contractionary economic policies with the primary objective of stabilizing the macroeconomy. By 1995, this objective had largely been achieved and if the trend continues, could be expected to have a favorable effect on the economic activities of the respective economic agents.
    However, the stability of the macroeconomic indicators does not necessarily bring robust economic activity and economic growth. This is particularly the case in the transition economies. If the market does not function fully and the economic agents do not conduct economic activities in accordance with the principles of a market economy, there is the danger that there will not be a shift to a growth path based on the market mechanism. Instead stagnant economic activity will produce a certain equilibrium and the economy will fall into the stagnation trap.

    (The Importance of Growth through the Market Mechanism)
    It is generally recognized that the high economic growth at the beginning of the socialist period was achieved by utilizing large amounts of productive factors, that is, large amounts of labor and capital (Krugman, 1994). In contrast, rather than increasing the amount of productive resources, it is improved productivity through competition and the efficient allocation of resources via the market mechanism which plays a major role in achieving high economic growth in a market economy. For example, if we analyze the factors behind post-war economic growth in Japan, we find that it cannot be explained in terms of the amount of labor and capital but rather in terms of rising productivity and the technological improvement. (for example, Maddison, 1987). In other words, the biggest difference between a command and a market economy, is whether or not growth is achieved through the market mechanism. In the former socialist countries, even if they achieve macroeconomic stability, it is difficult to achieve sustained growth if the market mechanism does not function.
    Having achieved the first stage of reform - macroeconomic stability, the major remaining issue for the Russian economy is whether it can establish a growth foundation which will enable it to go on to fully develop the market mechanism and reach a sustained growth path.


Part 2. New Medium to Long Term Policy Objectives

As seen in the previous section, Russia has largely achieved the objectives of the first stage of the transition to a market economy - that is, macroeconomic stability. In this section, we will look at the medium to long term policy objectives which are required for the next stage and the basic approach to the construction of the necessary policy framework.
In order to debate the policies for this second stage of the transition, we first need to review the characteristics and policy objectives of the first stage. Then, after discussing the definition and meaning of the second stage of the transition, we will demonstrate that the policy objectives should be the transition to a sustained growth path by means of the market mechanism and integration into the world economy. In order to achieve these two policy objectives, the encouragement of investment and structural change in industry and regional economies will be necessary. This, in turn, will require that a growth foundation be established to stimulate autonomous economic activity by households and corporations which is consistent with the market economy (Figure 14).

  1. The Characteristics and Policy Objectives of Stage One of the Transition Period

    Russia's transition to a market economy brought about 1) hyperinflation caused by monetary overhang; 2) a drop in production due to the collapse of the centrally-planned economy; and 3) internationally, a breakdown of former trade relations due to the collapse of COMECON. These outcomes were also evident to a greater or lesser extent in the transitional economies of Central and Eastern Europe and elsewhere so they can be regarded as characteristics of the first stage of the transition to a market economy.
    At the first stage of the transition, the principal policy objectives were macroeconomic stabilization and establishment of the structures required for a market economy. Specifically, this involved macroeconomic stabilization (including the control of hyperinflation by means of contractionary budgetary and financial policies), and the creation of structures such as the establishment of a currency system, privatization of government enterprises, the introduction of the right of private ownership, and the introduction of a civil code (including laws of contract and bankruptcy), which is indispensable to the smooth operation of a market economy.
    Despite some differences between countries, the above policies were generally successful in the countries of central and eastern Europe. With the disappearance of the negative aspects of the first stage of the transition, most of these countries began to show positive growth in GDP from about 1994 onwards. Between 1995 and 1996, the Czech Republic and Hungary joined the OECD.
    As seen in the Part 1, the phenomena associated with the first stage of the transition are also coming to an end in Russia and signs of macroeconomic stability indicate that Russia is entering the second stage of the transition. Many systems have been changed in the past few years and although there has been some degree of disorder, it seems that the systemic change necessary for the creation of a market economy is in the process of consolidation. However, the development of some systems, such as the law of contract, are still incomplete, while others, such as the law of bankruptcy, have been introduced but are not functioning adequately. In other words, at this stage, the construction of new systems is far from complete.

  2. The Characteristics and Policy Objectives of Stage Two of the Transition Period

    Stage two of the transition period is that in which the economy is stabilized at the macroeconomic level (as seen in the disappearance of the hyperinflation characteristic of stage one and the bottoming-out of the decline in production), the basis of the market economy begins to be established and the economy enters a period of sustained expansion. On the other hand, it is also a turning point which, depending on the appropriateness of the policy mix, will see either the transition to a growth path or a decline into the stagnation trap. The Russian economy is now at this critical turning point (Figure 15) (4).

    NOTE (4): In his Annual Address in February, 1996, President Yeltsin identified the stimulation of production and investment, the raising of economic efficiency, and structural change in the economy as the issues for the third stage : the first stage being deregulation of the economy and the second stage financial stabilization. However, if financial stabilization refers to decline in inflation and stabilization of the exchange rate, then our stage one is largely equivalent to Yeltin's stages one and two. As seen below, the issues for what we call stage two in this report correspond closely to the issues which Yeltsin associates with stage three in his address.

    (The Danger of the Stagnation Trap)
    So far, macroeconomic stabilization and the deregulation of the economy in Russia have failed to automatically bring about autonomous and robust economic activity by households and corporations which is consistent with a market economy. Each of these economic agents, rather than pursuing efficient economic activity based on a medium to long term perspective, is pursing immediate profit or is seeking current profits by choosing conservative options while ultimately relying on the government to provide support. The result is a vicious circle in which the government, when faced with economic problems and the magnitude of the associated social cost, must ultimately come to the rescue. This, in broad outline, is the stagnation trap (5), the danger which is latent in the present Russian economy. To put it another way, it is the failure of the system in which the negative effects of the various contributing factors are mutually reinforcing. These factors include the deficiencies of the new structures, the continuation of customary practices from the old system, the fact that the activities of the economic agents continue to rely on these practices, the reaction of the government and so on.

    NOTE (5): For one interpretation of the stagnation trap, see Glossary 1.

    (Sustained Growth and Integration into the World Economy)
    Standing at this cross-roads, the principal objective for the second stage of the transition is to prevent the economy from falling into the stagnation trap and ensure that it achieves sustained expansion. This must be a 'transition to a sustained economic growth path via the market mechanism'. In other words, it must not be economic growth on the socialist model with full mobilization of the labor force and allocation of capital by the government, but market-driven economic growth generated by the autonomous activities of corporations and households.
    This means making it possible for the new structures and organizations which were created during the first stage of the transition to fulfill the functions expected in a market economy. However, a market economy does not spontaneously come into existence as a result of economic deregulation or stability. A considerable policy effort is also required.
    Secondly, in order to achieve growth, the Russian economy must be integrated into the world economy. As the world economy is being swept by a wave of globalization and each country's economic activities are carried out within a network of interdependent trade and investment relations with other countries, it is unrealistic to suppose that Russia alone can remain a closed economy. Moreover, international trade and investment will provide the maximum possible increase in economic welfare. In recent years, participation in global trade and investment activities has contributed to the economic growth experienced by Asian countries and the transition economies such as the Czech Republic and Hungary which have joined the OECD. In the context of increasing globalization, integration into the world economy is an indispensable policy objective for the transition to sustained economic growth.

  3. Basic Approach to Achieving the Policy Objectives of Stage Two

    To achieve the two policy objectives of the second stage of the transition period, it is necessary to increase the efficiency of the economy as a whole by expanding investment and by bringing about structural change in industry and regional economies. Moreover, a multiplier effect can be expected by pursuing these objectives simultaneously.

    1. Promoting Investment
      The role of investment includes the demand effect, the production capacity expansion effect, and the new technology effect. Investment not only produces short term demand but also expands demand through the multiplier effect. In addition, on the supply side, potential productive capacity is increased by investment in plant and equipment. Moreover, since new production technology is usually embodied in new machinery, an increase in productivity due to the introduction of new technology can also be expected.
      The effects of increased investment on economic growth via both the demand and supply side go without saying but, in the case of Russia, the importance of the technology effect in particular should not be underestimated. In many companies, old machinery and equipment has not been upgraded or replaced. As integration into the world economy proceeds, it will be necessary to improve competitiveness in terms of both product quality and price in order to compete with imported goods in the domestic market or foreign products in overseas markets. This will involve encouraging investment in new technology particularly by means of investment in capital goods which embody the technology of the advanced Western countries. The promotion of investment is a necessary condition to achieve sustained growth and integration into the world economy.
    2. Structural Change in Industry and Region Economies.
      On the supply side, the Russian economy was artificially structured artificially under the centrally-planned economy on the premise of a closed economic environment within the COMECON system of the former Soviet regime. This resulted in an industrial structure centered on military demand and overindustrialization, particularly in resources and energy, the heavy and chemical industries and high-tech industries such as military and space technology. When we look at the regional structure, we find an artificial distribution of industry which ignored natural economic regions because the objective was to achieve a complete international division of labor within the COMECON system. For example, although the Russian Far East is geographically close to the Asia-Pacific region, as part of the COMECON system, its industry was structured by its relations with European Russia in the Moscow region more than 6,000 km away. Under the socialist system, a range of policies were adopted to make this possible.
      Moreover, the industrial structure of the regional industrial cities was constructed on the premise of transport and energy costs which were held at a low level as a matter of policy under the socialist economy. There are many cities which are in effect industrial estates dependent a specific industry. In particular, in the vast expanses of Siberia, industrial towns with populations of 1-1.5 million are dotted along the Siberian railway around latitude 55°North.
      For example, the industrial structure of Krasnoyarsk, a city of about 1 million situated in the center of Siberia, is centered on large enterprises in the machinery industry serving military demand and the processing of non-ferrous metals, particularly aluminum refining. But these industries, in terms of bringing in raw materials and shipping out product, depended on the policy of low transport costs under the centrally-planned economy. As a result of price deregulation and the sudden large increase in transport costs, they have lost their competitiveness in terms of both acquisition of raw materials and marketing of product and are now facing a crisis. However, since the companies in these industries are large corporations which are responsible for providing social services such as housing, kindergartens, hospitals and so on, the problems of a particular industry become the problems of the local community.
      In order for the Russian economy to move onto a sustained growth path in the second stage of the transition, it is necessary for these industries and local economies which would not be viable under market principles to be restructured with a view to integration into the world economy. While it is highly likely that this will result initially in large scale unemployment, we can expect this to be absorbed by existing industries moving into new business areas and by new enterprises which establish as a result of the promotion of investment mentioned earlier.
  4. The Need to Establish a Growth Foundation

    In order to achieve the necessary promotion of investment and structural change in industry and regional economies, as mentioned in Part 1. above, a growth foundation which takes full advantage of the market mechanism must be created.

    (The Three Foundations of Growth)
    In view of the present state of the Russian economy, the foundations of growth which are particularly important are 1) macroeconomic stabilization, 2)corporate activity consistent with the market economy; and 3) development of the adjustment function of the markets for the factors of production (labor market, capital market). In order to promote investment, it is necessary for corporations as agents of the market economy to pursue economically rational activities, that is, management must eliminate excess manpower to reduce costs so that excess capital can be redirected to needed investment. Moreover, unless the capital market functions properly and capital is supplied to investments with the highest expected returns, investment will not grow. In order to encourage structural change (industry, regional), the capital and labor markets must function to transfer the factors of production from declining industries to growth industries.
    In the medium to long term, given the twin objectives of sustained growth and integration into the world economy, the creation of a growth foundation will provide the environment for investment and structural change thereby avoiding the stagnation trap and moving the Russian economy from stability to growth.

    (Issues for the Future - Growth Strategies)
    In integrating into the world economy, the issues likely to concern the policy-makers in the future are those relating to the pattern of development that the Russian economy will follow, and the policies which should be adopted in relation to trade and investment. Given the spectacular growth of the Asian countries, there is plenty of support for an export-led growth strategy such as that employed by the Asian NIEs or China. On the other hand, there is also the view that Russia should utilize its natural advantage as a resource-rich country and pursue the merits of an import replacement growth strategy such as was adopted by Central and South America and Australia. Of course, because of differences in the stage of economic growth, the endowment of resources, and the international environment, none of these approaches should be applied to the Russian economy in a simplistic manner(6). In the future, with the cooperation of economists from around the world (including Japan), hopefully there will be widespread debate and discussion about the direction which Russia's economic development should take.

    NOTE (6): The Asian NIEs achieved high rates of growth in the process of the industrialization starting from a low base built on agriculture but Russia has already industrialized. Indeed, it is probably over-industrialized particularly with respect to the heavy and chemical industries. The existing industrial structure centered on the heavy and chemical industries must be reorganized as part of the conversion to a market economy. Compared to the process of economic growth in China for example, this will be a much more difficult task. Further, unlike the Asian NIEs which have scarce resources and abundant labor, though Russia is rich in natural resources, labor is relatively scarce and is regionally maldistributed. Therefore, assuming perfect competition, in terms of Heckscher-Ohlin type static international trade theory, the structure of comparative advantage in Russia and the Asian NIEs is completely different. If, for example, the emphasis is placed on export of resources in which Russia can be regarded as having a comparative advantage in static terms, Russia will suffer the so-called Dutch disease, much of manufacturing industry will be neglected, structural adjustment will not occur, and the possibility that economic performance will decline in the medium to long term cannot be denied.


Part 3. Economic Policies to Create a Growth Foundation

In this section, we will discuss the policies needed to create a growth foundation which will put the Russian economy on a sustained growth path. First we will point out the general thrust of policy - the elimination of the factors that create the stagnation trap and the stimulation of autonomous activity by the respective economic agents. Then, against the background of the current state of the Russian economy, we will contend that: (1) the stability of the macroeconomy needs to be consolidated and confidence in the ruble raised; (2) as a precondition to achieving a change to corporate activity which is regulated by hard budget constraints, measures need to put in place to clarify the financial position of individual corporations and to promote the retirement of bad debts; (3) in order to encourage investment, action needs to be taken to minimize the factors which increase investment risk within the context of macroeconomic stability; (4) to promote structural change in industry, labor market flexibility should be promoted by removing the incentives which encourage workers to remain with a company. Finally, we discuss the policies which ought to be adopted.

  1. Policy Directions
    If sustained economic growth is to be maintained, the efficiency of the economy as a whole must be improved through the expansion of investment, and structural change in industry and regional economies. In order for this to happen, (1) corporate activity must be conducted in accordance with the principles of the market economy; and (2) the factors of production, capital and labor, must be redistributed to more efficient uses by means of the market mechanism. However, as already mentioned, the Russian economy is in real danger of falling into the stagnation trap.
    Accordingly, what is required to achieve sustained growth, is to remove the factors which give rise to the stagnation trap and to stimulate autonomous activity by the respective economic agents. From this point of view, the key policy directions can be summarized as follows:
    1. elimination of the systems and practices which permit inefficient economic activity dominated by past practices;
    2. creation of an economic environment, particularly, the greatest possible reduction of uncertainty, which encourages economic agents to act on the basis of the medium to long term view;
    3. the introduction of structures which increase the incentives for rational economic activity.

    What is important in this instance is not the individual policies but the combination of policies across different sectors such that the possibility of multiple failure of interrelated systems is overcome.
    Below, on the basis of the three directions mentioned above, we will discuss the policies which should be adopted in relation to the three foundations of growth outlined in the previous section - that is, macroeconomic stability, reform of corporate activity, and improved responsiveness of factor markets (labor, capital).
  2. Macroeconomic Policies
    (The Need to Consolidate Confidence in the Ruble)
    The shift from the dollar to the ruble in 1995 may be seen as the first step towards extricating the economy from dollarization, but it is still difficult to say whether the shift will be permanent. This shift to the ruble occurred firstly, because the government's firm anti-inflationary stance, beginning with the target exchange rate band, finally undermined expectations of continued decline in the value of the ruble. Therefore, in order to consolidate the reversal of the dollarization of the economy, it is essential to maintain confidence in the ruble by keeping inflation under control.
    Secondly, the fact that the funds which shifted to the ruble went into government bonds is significant for a number of reasons. Government bonds offer a valuable alternative to currency speculation because of their high yield and the government guarantee which backs them. However, as we shall see later, this has already had an impact on the budget through an increase in the interest burden. In order to avoid budget rigidity, or even insolvency, as a result of an increasing interest burden, every effort must be made to maintain a healthy budget position.

    (Postponing of Settlement of Debts)
    The change from money financing to bond financing of the budget deficit in 1995 is clearly a step forward from the point of view of anti-inflationary policy. However, at the same time, whereas money financing increases the burden on the present population in the form of an inflationary tax, the fact that the financing of the budget through government bonds passes on the burden to future generations must be given careful consideration. If budget outlays are not being used to raise the productivity of the national economy, either directly or indirectly, or to contribute to national assets in the long term, financing an increasing budget deficit by issuing government bonds will increase the bias towards consumption and increase the burden on future generations by lowering the growth potential of the economy in the medium to long term. Even though interest payments on government bonds are still very small, because of the major issue in 1995, interest payments are expected to leap sharply in 1996. In order to ensure the continued stability of the economy, it is essential to avoid expansion of the budget deficit (7).

    (Unpaid Government Debt)
    As already noted, the 1995 Federal budget deficit was 3% of GDP. This was due in part to increased tax revenue, but tight control of budget outlays due to the reduction in government investment and similar expenditures also made a major contribution. Though not large in terms of amount, part of this expenditure restraint was in the form of non-payment of wages (8). Since this damages public trust in the budget process, it must be treated with great caution. If the government itself behaves as if it does not have to fulfill its contractual obligations which are fundamental to a market economy, it will reinforce the tendency which is already evident for private economic agents to treat contractual obligations lightly.

    NOTE (8): According to the Ministry of Finance, in January of this year, the amount of unpaid wages related to the federal budget was about 700 billion rubles.

    (Avoiding the Expansion of Populist Budget Expenditures)
    Protests against non-payment of wages were the direct cause of the strikes held by educationalists and miners this year. Amid the economic confusion which has continued since the reforms, public dissatisfaction with those reforms has been increasing, particularly among the economically weak. This has occurred as a result of rapidly increasing differentials in incomes and the rapidly decreasing value of social welfare payments, especially pensions, due to high inflation. These have become a major cause of social tension. Under these circumstance, especially with the forthcoming presidential election, there is great pressure to expand budget outlays to win favor with the electorate.
    It is essential that the social welfare system, beginning with the pension system, be reformed and reorganized in order to avoid the danger of rising social tension due to income polarization and the possibility of this becoming linked to the movement to reject the reforms altogether. But if the relief of social tension relies only on the simple device of increasing budget outlays, the results of the reforms achieved so far will be lost. The 1996 budget which has been adopted has been assessed as aiming for a higher level of economic stability, but this stance must be maintained if it is to be effective.

    (Consolidation of Tax Revenue by Improved Collection Capability)
    As pointed out in last year's report, one of the biggest problems with the Russian budget, particularly on the revenue side, is the need to check the erosion of the tax base by various special tax reductions and exemptions and to improve tax collecting capability. In the 1996 budget, the government aimed to strengthen tax collection powers by abolishing various special rights and simplifying the tax system for small businesses and the self-employed. Hopefully, these efforts will result in the consolidation of the tax base.

    (Macroeconomic Management and Increased Stability) As mentioned above, the present macroeconomic policies must be aimed fundamentally at reversing the dollarization of the economy by reducing the budget deficit and implementing appropriate management of the money supply to further reduce inflation and strengthen confidence in the ruble. There is also the view that the negative effect on the real economy (including exports) of the increasing value of the real exchange rate, which follows from the stabilization of the nominal exchange rate, needs to be watched carefully. However, the swing in demand from hard currency to the ruble in 1995, conversely indicates that the fostering of expectations of a decline in the exchange rate is directly connected to dumping of the ruble and that, particularly in an economy with such an extreme degree of dollarization as the Russian economy, the raising of confidence in the local currency by means of a nominal anchor has particular merit.

    (The Medium Term Objective of Macroeconomic Policy)
    In order to reinforce the confidence of private economic agents in economic stability, it is important for the government to show a firm policy commitment to economic stability by controlling inflation in the medium to long term. Of course, if such a commitment is repeatedly broken, confidence in economic stability will be lost. In other words, there is the danger that it will become a double-edged sword. However, if reduction of the budget deficit and a realistic target for inflation can be achieved, there will be a dramatic reduction in the uncertainty surrounding private economic activity.

  3. Stimulation of Private Economic Activity
    (Postponing Settlement)
    In last year's report, recognizing that it was the structures which allow companies to operate according to soft budget constraints that were obstructing activities consistent with a market economy, we emphasized the need for policies which would require corporations to operate according to hard budget constraints. Specifically, through the introduction of rules and systems relating to the survival of enterprises, including reform of the bankruptcy law and improvements to the financial system, we expected that, on the one hand, market competition would open up opportunities for increased profits for efficient companies and on the other, inefficient companies would be forced into bankruptcy and so the economy as a whole would become more efficient. We also advocated the transfer of social services, which were a hangover from the former system, from corporations to local government so that corporations could concentrate on their core management activities.
    However, changes are not necessarily moving in the directions we advocated. Certainly, the bankruptcy procedures have been simplified and mechanisms to declare inefficient enterprises bankrupt were introduced on the government's initiative, but because of the high social cost of bankruptcy, it has not been possible to proceed with the bankruptcy process (9). It was also hoped that the restriction of finance available through the central bank would result in improved corporate discipline but instead the result was that, by utilizing loop-holes such as the cross-holding of debt (10), corporations attempt to postpone settling of accounts indefinitely. In other words, we are seeing a marked trend towards the emergence of pyramid money - lending scheme.

    NOTE (9): Concerning improvements to the system of bankruptcy, see Glossary 2. NOTE (10): Although corporate receivables showed a slightly decreasing trend through 1995, in November of that year they still amounted to 157% of GDP, and the proportion overdue has risen to 79% of GDP. (Source: Russian Economic Trends 1995 Vol. 4 No. 4)

    Certainly a proper assessment would reveal that the majority of companies are bankrupt, so the processes of bankruptcy and reorganization alone cannot provide a solution to the problem of industry restructuring. On the other hand, there are also problems with the soft landing scenario which allows companies to continue in business while trying to gradually improve their financial position. Firstly, this method does not generate any incentives within the company for the pursuit of greater efficiency and, secondly, it provides no means to encourage investment that will produce economic growth. In our opinion, companies must be forced to submit to hard budget constraints and details of the financial position of companies must be publicly available in order to stimulate the trend towards injection of external investment funding.

    (Availability of Key Financial Information)
    In a market economy, the success or failure of an enterprise is basically judged on its financial position. The company's results for a given accounting period are clearly revealed in the profit and loss statement and its market value is indicated by its net assets (capital) as shown on the balance sheet. Financial institutions carry out monitoring in part to regulate the activities of companies but this cannot be effective either if it is not possible to grasp the financial position of the company accurately. But above all, without accurate information about a company's earnings and current value (net assets), investors cannot make investment decisions and a capital market cannot develop. By comparison, in Russia, it is said that the accounting function only exists to provide the necessary information to the tax office. The concept of managerial accounting is either weak or does not exist at all (11). Moreover, in a situation of escalating inflation, the problem of assessing assets arises and it is highly likely that financial statements do not provide meaningful financial information. (For this reason too, we can say that the control of inflation is fundamental to all economic activities.) However, the financial position of the company must first be clear before its activities can be subjected to hard budget constraints.

    NOTE (11): See Miyabe, et.al., (1994). This survey was conducted in 1993. Since then, financial management in companies in advanced regions, beginning with Moscow, has improved, but in the case of companies in regional areas, company finances are not properly managed and managers do not have adequate knowledge or know-how about financial management.

    (The Separation of Old and New Accounts)
    The present situation is that companies have accumulated bad assets and, while in accounting terms they are bankrupt, they can avoid the punishment of bankruptcy because of concerns about the social cost. In these circumstances, managers have no incentive for effective management and cannot break free of the funding networks which enable them to postpone settlement of accounts indefinitely. Similarly, an injection of funds from outside the company - that is, new investment which could produce economic growth - is unlikely to occur.
    In order to break this negative cycle, it is necessary to construct a mechanism by which the responsible and efficient activities of a company and their consequences can be separated from past bad assets and other inefficient activities and assessed correctly. In the case of new companies which have not inherited any bad debts, this can be achieved by simply instituting proper accounting practices. If the reorganization or closure of most of the companies which have excess liabilities is not a practical option, then the approach which was used in Japan immediately after the Second World War should be tried. This involved moving the bad assets onto a special account and keeping them separate from the results of the new activities of the firm.(12) The monitoring and management advice provided by government, the central bank or independent advisors in the course of the transfer to new accounts and the rebuilding process, must be carried out by completely transparent procedures. If acceptance of such a rebuilding program is made the condition of new investment funding and government guarantees, this will provide increased incentives for companies to restructure and improve their financial position. Finally, through the process of subjecting to external monitoring and leadership, the problem which insider control poses for corporate governance can also be resolved. Of course, the question of how the society should bear the burden of the redemption of all bad assets is a political one which should be subject to public debate. However, unless the accumulation of bad assets is dealt with, the Russian economy will not be able to escape from the stagnation trap.

    NOTE (12): Concerning the experience of separating old and new accounts in Japan after the War, see Glossary 3.

    (Separation of Social Services Starting with Separation of Accounts)
    In our report last year, we advocated the transfer of responsibility for social services from companies to local government but in fact, local governments have not bee able, or willing, to take over these services. This remains as one of the factors which is obstructing the implementation of the bankruptcy process. It has been suggested that, in the present situation where productive investment is stagnating and the relative weight of investment in social services is increasing, social services may be being used to strengthen insider control. So it seems that the incentives for the separation of social services are not having an impact on the corporate management side either.
    We have emphasized that, in principle, social services should not be a part of company management. As a first step, separate accounts should be set up for each of the services (medical, residential, etc.). Once this has been done, the assets can be valued, the flow of funds to and from the companies own business accounts checked and the efficiency of management assessed. The services should then be divided into salable assets, leasable assets, and assets which would be viable as a separate business. Further, even in the case of services which should rightly be supplied as social welfare and which could not be self-supporting, the extent to which it is possible for the beneficiaries to bear a part of the cost should be investigated. The creation and evaluation of separate accounts for social services should be included as part of the separation of old and new accounts mentioned above. Further, the setting of rules for the government contribution to basic social services, such as medical services, will provide the incentive to remove them from company responsibility and at the same time, lighten the burden on the local governments which will take over provision of the services.

    (Corporate Reform and the Provision of a Social Safety Net)
    If the removal of social services from company responsibility is not carried out in parallel with the provision of a social safety net by local government, corporate reform will meet with strong opposition from employees. The social services provided by companies cover a wide range from those which should normally be supplied by the market (e.g., the provision of consumer goods) to those which would be provided by government in developed Western countries as part of the social welfare system (e.g., medical services). In-between there are also many areas in which services are provided in various forms by both the public and private sectors (for example, public housing, creches and kindergartens, nursing homes for the aged). The process of removing responsibility for social services from corporations and deciding whether a particular service should be provided by companies or local government can also be the process by which the actual services are put in place. Moreover, in the course of this process, a consensus can be created about the extent of the social safety net that local government should provide.
    Funding is being established for each of the basic social services such as pensions, unemployment insurance, health and medical services and social assistance, and the framework for the social safety net is being put in place. However, there are problems of the low level or even deterioration of services, so an even greater effort needs to be put into the provision of services.

  4. Greater Efficiency of the Capital Market
    We have already noted that capital investment is essential if the Russian economy is to achieve sustained growth. Below we will explore the question of what changes need to be made to the supply side of the Russian economy to remove the obstacles to capital formation. This question will be examined from three perspectives: (1) sources of investment (savings, foreign capital), (2) asset choice (real investment versus financial investment, (3) the financial mechanisms which link savings and investment.

    (Utilization of Foreign Capital)
    Investment in Russia has suffered large declines since 1991. If real GDP for 1991 is 100, in 1995, it had declined to 66 but real fixed investment contracted at an even faster rate - from 100 in 1991 to 35 in 1995 (Figure 16).

    By comparison, the level of Russia's gross savings is high (13) and it implies no lack of funds which could be going to investment. Therefore, there is the view that the introduction of foreign capital is not necessarily an important issue for the promotion of investment. Certainly, the Russian economy continues to record a current surplus of a few percent (relative to GDP) and, in macroeconomic terms of IS balance, has a surplus of savings. However, there are several problems with this interpretation. Firstly, because a large part of the capital stock is deteriorating and out-dated, the proportion of replacement investment is high and so a much larger amount of investment than would otherwise be expected is required to achieve a net increase in capacity. Secondly, as mentioned above, there is the large decline in the level of real GDP and real fixed investment since 1991. Since the modernization of the Russian economy will require vast amounts of investment, particularly investment in infrastructure, it cannot be argued that foreign capital will be unnecessary on the grounds of the balance between savings and investment because there has been such a large decline in the level of both. Thirdly, because foreign investment, particularly direct investment has a large effect in terms of transferring technology and management methods from the host country, it can be expected to be a very great advantage to Russia in the process of its transition to a market economy. However, the level of foreign investment in Russia is quite low compared to the other transition economies such as the Czech Republic and Hungary (Figures 17,18). We believe that it is not necessary for foreign investment to be given special treatment but that an environment needs to be established in which foreigners can invest with confidence according to non-discriminatory rules for both domestic and foreign investment. From this point of view, what is required of Russia at this point is not only macroeconomic stability but also to reduce as far as possible the uncertainty which surrounds investment as seen by foreign investors. This can be done by ensuring the stability of the systems relating to foreign investment and by actively providing clear information about the taxation and other systems.

    NOTE (13): Afanasiev (1996) gives the figure of 22% for gross national savings as a proportion of GDP in 1995.

    The stimulation of private sector investment activity and the provision of infrastructure are major current issues for the Russian economy but there is also room to consider the utilization of foreign investment for the construction of infrastructure using, for example, the BOT (Build, Operate and Transfer) system as has been seen in the Asian countries in recent years.

    (Promotion of Real Investment)
    In terms of the balance of the real economy, if we reject the view that the Russian economy is suffering from excessive consumption, then increasing holdings of foreign assets are consistent with the slump in investment and the surplus on the external account. As mentioned above, the Russian economy has strong tendencies towards dollarization ranging from the primitive such as hoarding of dollars by households to speculation in foreign exchange by export industries and financial institutions and even the illicit flight of capital. In order to promote real domestic investment, it is necessary to reduce the uncertainty that both domestic and foreign economic agents feel about the future of the Russian economy and decrease the opportunity cost of holding ruble assets in the long term. This will require stabilizing the macroeconomy, including consolidating control of inflation and stabilizing the exchange rate. The shift to the ruble in 1995 suggests that this has actually been happening.
    As one would expect, the low level of confidence in the ruble results in a low level of confidence in ruble-denominated assets beginning with savings and consequently, the creation of credit by financial institutions is inadequate (= financial deepening does not occur) and results in the inefficiency of the economic system. In this respect too, economic stabilization, and particularly the control of inflation, are fundamental to the encouragement of real investment. Above it was argued that the risk of holding ruble-denominated assets is reduced by macroeconomic stability but it goes without saying that the risk of investment opportunities themselves must also be clear and efforts must be made to reduce the risk as much as possible. While risk is an inevitable part of investment, the various obstacles posed by the systems and practices of the Russian economy have made the risks of real investment unnecessarily high. Firstly, because a firm moral base for the fulfillment of loan contracts has not been established and the financial circumstances of firms are not transparent, the risk related to expected return on investment is extremely high. Moreover, because of the strong tendency to insider control in the structure of corporate governance, the risk of profit squeezing by insiders is further increased. Therefore, the reform of corporate behavior discussed in the previous section is a necessary condition for the encouragement of real investment.
    Measures, such as special tax treatment for long term funds (including bank debentures) and accelerated depreciation for capital investment, are considered to have functioned effectively to promote real investment in Japan after the War. This is because these policies are effective in increasing the returns to real investment relative to financial investment and long term funds relative to short term. However, the important point is that these measures will only be effective when they are combined with policies to minimize the risk of real investment in terms of the macroeconomic and systemic and behavioral aspects mentioned above.

    (Strengthening of the Financial System)
    It goes without saying that the function of financial and capital markets in bringing together those with excess funds and those with insufficient funds is important for the encouragement of investment. We pointed out in detail in last year's report that financial and capital markets are still not functioning adequately.
    In fact, Russian financial institutions have not been fulfilling their proper functions of selecting investments and risk taking. Instead, they have been engaged in currency speculation, speculative activities such as rolling over funds in the inter-bank (call) market and function as little more than the finance branch of a parent company (pocket bank). As mentioned before, despite the fact that the 1995 stabilization of the exchange rate made the pursuit of profit through exchange speculation difficult and institutions switched to government bonds, they still have not moved to support productive investment by the private sector.(14)

    NOTE(14): Although the data is a little out-of-date, according to Tselichtchev (1995), “According to a survey of 60 commercial banks conducted in May, 1993, by the Russian Economic Monitor, about 80% of banks were not providing any funds at all for investment in plant and equipment ...
    only about 25% of banks saw funds for mining and manufacturing industry as a priority".

    In order to strengthen the function of Russian financial and capital markets, the implementation of all of the policies directed towards reform of the system - beginning with the improvement of the financial position of the banks and strengthening supervision by the central bank - which were mentioned in last year's report is fundamental but it is equally important to consolidate the stabilization of the economy and remove the opportunities for financial institutions to pursue speculative activities. It is also necessary to weed out inefficient financial institutions by promoting competition among institutions while tight monetary policies continue to be maintained.

    (The Potential Role of Financial and Industrial Groups)
    The potential of financial and industrial groups (15) is attracting considerable attention as an attempt to improve the present situation in which the financial system does not function adequately and there tends to be a shortage of investment funds for industry. The idea is to form corporate groups centered around a commercial bank by having manufactures, trading companies, insurance and transport companies jointly finance the creation of a new joint-stock company. The central objective of the formation of these financial and industrial groups is to channel bank investment funds into production and ensure long term funding for real investment by brining together financial institutions and manufacturing companies. However, various secondary effects, such as improvement in the credit standing of companies and the more effective utilization of group resources, can also be expected. The formation of such groups has been adopted as one of the major directions of industrial policy and mechanisms have been put in place which accord special treatment in the form of an injection of funding by the government and a government guarantee for group investment to groups which are recognized by the government and registered.

    NOTE (15): For an outline of financial and industrial groups, see Glossary 4.

    As in the case of Japanese industrial groupings or main bank system, one could argue for the effectiveness of the formation of such groups in terms of the logic which explains the economic rationality of organized transactions between corporations (that is the avoidance of market failure because of the asymmetry of information, etc.). In reality, as has already been emphasized many times, at the present stage where the systems and behaviors which are the basis of market transactions have not been firmly established, the risk and cost of undertaking investment through market transactions is extremely high so converting to organized transactions is a practical way to promote investment.
    However, consideration must be given to the fact that inter-group transactions will not automatically result in greater economic efficiency unless all of the following conditions are met. Firstly, the group must be structured so that there are incentives for companies to restructure and the organization needs to be operated in such a way that these incentives are increased. Specifically, as was the case with the Japanese main banks, the meeting of top executives or the central financial institution should be the headquarters of the group and must have the ability to adjust the activities of all the companies in the group by such means as monitoring results and supplying capital. Secondly, and most importantly, there must be strong, effective competition from outside the group in order to increase incentives for restructuring by companies inside the group. In Russia, in many cases, the industry monopolies which existed before the transition to a market economy, managed to acquire political power as industry lobbies after the collapse of the old system. Consequently, if the formation of these financial and industrial groups is encouraged without strict attention to the abolition of monopoly, it will simply have the same effect as reverting to the old system. Thirdly, the basis of assessment of eligibility to receive special treatment from the government must be objective and transparent, otherwise there is the danger that these groups will boost for rent-seeking activities. If appropriate measures are not taken in this regard, there is a real danger that these financial and industrial groups will turn into a hotbed of non-market, inefficient activity - contrary to what was intended.
    These financial and industrial groups have so far shown a high level of performance(16) but since they are still new, is too early to make a proper assessment.

    NOTE (16): According to Afanasiev(1996), whereas mining and manufacturing industry production for the whole of Russia in 1994 declined by over 20%, production by the financial and industrial groups increased by 3.9%

    (Government Finance - Necessary? Possible?)
    Should a system of the type used in Japan - that is, postal savings and fiscal investment and loans - be recommended as a policy to promote investment? This is a system by which low interest funds are supplied to particular strategic industries through policy-directed investment. In fact, unlike the Japanese postal savings system, the Sber Banks were converted to joint-stock companies in the process of the reforms in Russia though they still have a close association with the central bank. The Sber Banks absorbed quite a large part of personal savings (particularly in regional areas). These banks seem to be giving some substance to the implementation of such policy-directed investment.

    NOTE (17): According to 'The Present State of Russia's Financial Industry" in the Monthly Bulletin of Trade with Russia and Central-Eastern Europe (December, 1995), the Sber Banks' share of personal savings is over 60% which places them first in the industry, head-and-shoulders above the rest.

    However, in order for policy-directed investment of the postal savings and fiscal investment type to work, the following two are the minimum necessary conditions. First, there is the question of whether it is possible in the present situation of global financial deregulation, to maintain an artificially low interest policy as was done in Japan after the War. In Japan, there was tight control of foreign exchange and until the Foreign Exchange Law was revised as part of deregulation in the 1980s, it was not possible for individuals or private companies to access high interest savings and investment opportunities overseas. By contrast, in the present situation of extreme dollarization (both legal and illegal) of the economy in Russia, trying to accumulate financial resources at low interest rates for low interest policy-directed investment is likely to be extremely difficult. In any case, unless inflation declines and nominal domestic interest rates decrease to a normal level, the conditions for effective policy-directed investment do not exist.
    Two, the formation of a consensus about the strategic sectors to which capital should be provided is proving difficult. Actually, the Russian Government has put quite a lot of effort into choosing strategic sectors but, because of the interference of various lobby groups, a stalemate has arisen. If a consensus cannot be reached about the long term direction of the Russian economy, including the role of strategic industries, and public acceptance obtained, there is the possibility that the designation of strategic industries will also become a hotbed of rent-seeking activities.

  5. Labor Market Policy
    (Excess Employment in Companies)
    Despite the continuing decline in production activities, as of December, 1995, the unemployment rate in Russia was 3.2% according to official government statistics collected by employment offices. According to IMF statistics which include other unemployed job seekers, the rate was estimated at 8.2%. Although the number of employed is continuing to decrease as shown in Figure 12, the rate of decrease is much smaller than that of real GDP. Needless to say, this is the result of companies retaining labor in excess of their needs.
    We pointed out in last year's report, that because, as a hangover from the old system, companies are not only the place of work but also provide social services including housing and medical care, even if real wages decline or wage payments are late, workers find it very difficult to leave the company.
    However, the factors behind the retention of excess labor are not all on the workers' side. According to a survey of managers by the OECD (1995), there is very little attempt on the management side either to reduce excess employment. The reinforcing of insider control and the strengthening of bargaining power with local governments which results from the fear of large scale dismissals have been given as reasons for this.(18)

    NOTE (18): To be precise, OECD (1995) gives the following four reasons. (1) The strengthening of insider control: most of the voucher-type privatization in Russia was carried out by a system which allowed managers and employees to hold more than 51% of the shares, so if employees leave the company and relinquish their shares, this will reduce insider control. (2) Economic rationality: in the case of dismissal, the need for the payment of an allowance and so on. (3) Socio-economic traditions: in other words, paternalism. (4) Negotiating power with local government, etc.

    Although contrary to economic rationality, the accepted view that it is the responsibility of companies (= the place of work) to also supply other social services is especially strong in regional areas and employees have a very strong psychological fear of leaving their present workplace (Tselichtchev, 1995).

    (Flexibility of the Labor Market)
    In order to achieve sustained growth, as well as eliminating excess employment and restructuring at the company level, it is essential to transfer labor into productive sectors. The tendency on the side of both management and labor to hang-on to existing employment gives the impression of an inflexible labor market. On the other hand, however, recent survey data points to the dynamism and flexibility of the labor market. That is, while, on the one hand, since the beginning of the reforms, the rate of leaving has risen, the rate of hiring has also risen (although there are large differentials between industries) so that unemployment in Russia is not resulting in the creation of a pool of long term unemployed as we see in many of the European countries (OECD, 1995). It is said that many of the workers who are being retained as excess labor by companies have second jobs so, with the removal of the incentives to remain with one's present company, the ground is being prepared for the promotion of inter-industry and inter-firm labor mobility.

    (Policies to Facilitate Labor Mobility)
    Labor demand is derivative demand. The elimination of excess labor and the resulting productive use of that labor is achieved fundamentally by employment creation generated by the development of new industries and companies. Therefore, promotion of structural change in industry is a necessary precondition of labor market policy. Change in the industrial structure is already evident in the rapid expansion of the tertiary sector(19) but it is necessary to encourage structural change in a direction which expands employment opportunities with the highest possible value-added.

    A distinctive feature of the Russian economy is the existence of incentives for both employers and employees to maintain the existing employment situation. These incentives must be broken down. Through the reforms already mentioned in the section on Stimulation of Corporate Activity, managers must be instilled with a sense of the discipline required of managers in a market economy and the incentives for workers to remain with a particular company must be reduced by removing social services from companies. In this sense, flexibility of the labor market and corporate reform are opposite sides of the same coin.
    The objective of the pressure applied by management using workers as bargaining chips is to extract investment or subsidies from the government. However, since the government ceased providing investment via the central bank in 1994, it has been reported that this trend has disappeared (OECD, 1995). In the future, it will be important for the government to take a firm stand on reform.
    Thirdly, in parallel with the breaking down of incentives to remain with a particular company, measures are also needed to increase incentives for workers to transfer to new industries and new occupations. Various steps have already been taken to put in place a framework of active labor market policies(20) but, particularly in Russia where the average education level is quite high, it is important that measures be taken which focus on the provision of education and training to facilitate employment in new areas of production while the labor force is gradually shifted into the market economy.

    NOTE (20): According to Lehmann (1995), active labor market policies (ALMP) include a. job placement/matching, b. education and training, c. youth employment policies, d. employment subsidies, e. employment policies for the physically handicapped and, in fact, these policy measures have been adopted in Russia. But he claims that, in Russia, where there is a marked tendency towards employment preservation, the introduction of employment subsidies is not appropriate.

    (Employment Policy for Structurally Depressed Areas)
    Another feature of the Russian employment situation is the marked imbalances between regions. This is an effect of the distortion caused by artificial, mono-cultural industrial location policies, especially of military-related industries, under the former regime. Employment creation and labor market restructuring in these structurally depressed areas must be carried out as part of comprehensive regional development planning (as stressed in last year's report). In this respect, the Far East Long Term Development Program which is currently being prepared by the Russian Federal Government draws attention.

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