by
Johannes F. Linn
Vice President
Europe and Central Asia Region
The World Bank
Fourth Annual U.S. - Russian Investment Symposium
Kyiv, October 5, 2000 Introduction
It is an honor to address this distinguished gathering today, including senior members of the Russian Government, colleagues from the IFIs, and numerous representatives of the Russian and American business community, at this Symposium, hosted by Harvard University’s Kennedy School of Government in conjunction with the US-Russian Business Council, The Conference Board and the Financial Times. Further, I am delighted to be able to do so from Kyiv.
Russia has chalked up an impressive macroeconomic report card after the crisis, taking everyone by surprise. Over the first half of this year, industrial output grew 10 percent, and investment picked up substantially. Current expectations are that GDP will grow 5-7 percent for the year, with the federal government recording its first-ever post-transition fiscal surplus. Both output and the foreign exchange reserves of CBR are on track to eclipse their pre-crisis 1997 levels, and the fiscal situation has enjoyed a remarkable turnaround. Remarkably, the foreign exchange reserve build-up has occurred without the matching increase in debt we saw in 1997.
While good luck in the shape of the oil and gas boom has played a role, so has good government policy. It is easy to forget this, but there were widespread fears in the aftermath of the August 1998 crisis that hyperinflation and serious policy reversals would take over. To the contrary, one of the most impressive accomplishments has been a sharp change in the macroeconomic policy stance. The focus of macroeconomic management is now clearly on re-establishing control over Russia’s public finances and debt dynamics – the root cause of the 1998 crisis. And the criticality of keeping the real exchange rate at a level that helps both the trade surplus and industrial recovery is now recognized.
Notwithstanding this good news, questions about sustainability abound. As Mr. Illarionov, Adviser to President Putin, noted recently, growth is slowing down and could even stop by next summer if present trends persist. Indeed, there are early signs that industrial output growth may be leveling off. And while the oil and gas boom has been a fiscal and BOP blessing, it is inevitably putting upward pressure on the real exchange rate, which has played such a crucial role in the post-crisis industrial rebound. This raises two important and immediate questions: (i) what will make GDP and industrial output growth sustainable? and (ii) what is the “best” response to the oil and gas boom? Should for example, a higher windfall tax be levied with the proceeds used to pre-pay foreign debt and/or help cushion the considerable social costs of transition? These questions are critically important.
There is a third crucial question, linked to the previous two: How to alleviate the substantial level of poverty that exists in Russia today. For us in the World Bank, it is a grave concern that so many Russian citizens today face serious economic difficulties in their every day lives. While statistical difficulties and a large shadow economy make precise measurement difficult, poverty is a problem, especially among single, aged pensioners, children in one-parent homes and the chronically unemployed.
According to official data, the number of people living below the subsistence minimum decreased from 41 percent in the first quarter of this year to 35 percent in the second quarter. The unemployment rate based on the ILO definition fell from 12.1 percent to 11.4 percent during the first six months of this year. Real wages at end-April 2000 were 17 percent above end-1998 levels, but still more than 20 percent below pre-crisis levels. In spite of these encouraging trends, 35 percent of Russians still live below subsistence levels. Hence, sustained, rapid economic growth will be needed to reduce poverty significantly, but is not enough. Steps are also needed to directly address Russia's poverty and social problems.
The preceding questions can be looked at in the context of four immediate challenges that the Russian government faces: (i) ensuring that public finances and public debt are placed on a stable long-run path so that genuine, long-lasting stabilization can be achieved; (ii) completing the implementation of difficult structural reforms to ensure the post-crisis output rebound gets translated into a long-run trend based on new investment and a more competitive and efficient enterprise sector; (iii) social protection and labor market reform to ensure that the truly needy are efficiently served while workers have the necessary information and mobility to get suitable jobs; and (iv) public sector management.
The above challenges form the focal points of our on-going policy dialogue with the government, in the context of proposed new adjustment lending. To be sure, there are numerous critical issues not included in the preceding list when one looks at Russia in a strategic, 10-year context – such as the financial sector; human resource development issues pertaining to education and health; and the environment and natural resource management. However, we believe that the preceding four challenges constitute the immediate priorities, which, once addressed, will create a springboard for addressing the longer-term strategic issues.
But the fundamental question of implementation remains. We have learnt that no matter how cogent the conditionality or frequent the monitoring by IFIs, it is Russian ownership that is ultimately going to drive successful implementation. It is therefore extremely heartening to note that last June, the team headed by Mr. German Gref submitted its long-term draft economic strategy to GOR based on an in-depth analysis of economic problems and objectives. In July, GOR approved both the long-term program, and a blueprint of priority measures for the next 18 months. The thrust of the new strategy is acceleration of market-oriented reform, including reduction of the government intervention in the economy, increase in efficiency of managing public funds, radical tax and social policy reforms, establishing a level playing field for all companies, etc.. Much of this has formed part of past IMF and World Bank-supported programs; but the point is that GOR’s program is home-grown and rooted in the lessons of the transition through the 1990s, of which the 1998 crisis was an eye-opening watershed.
Let me stress that the comprehensive nature of the program will require strong and coordinated efforts on the part of the government, and strong political will to pursue measures that may conflict with vested interests. There is no reason to doubt the ability of the new team to deliver. But we must recognize that the sheer scope of envisaged reform increases risk of slowdowns and partial implementation. Thus, the program of priority actions, with its 18-month horizon, alone comprises over 130 measures, approximately 100 of which will require amending federal legislation by the Duma.
In this respect, it is also heartening to note that the political situation is solidifying, with the erstwhile confrontational stance between the Duma and the President abating after the parliamentary elections late last year. A more cooperative relationship has developing since Mr. Putin was sworn in as the President in May. In this connection, Russia’s long-awaited tax overhaul got under way with Duma passage this August of the first four chapters of Part 2 of the Tax Code relating to personal income tax, social fund contributions, VAT and excises.
Given all this, we can, as asserted by the theme of the symposium, say that the present time in Russia is indeed one of new leadership and new opportunities rooted in the lessons of the past decade. However, as I emphasized earlier, major challenges remain. I shall dwell on the four identified earlier.
First Challenge: Macroeconomic Management
While there has been a concerted attempt to turn the fiscal situation around and address the pre-crisis inconsistency between fiscal and exchange rate policy, Russia remains very vulnerable to economic shocks, especially to reversals in oil and gas prices, and a slowdown in growth.
This is a good time to review the macroeconomic lessons of the past:
Lesson # 1: good macroeconomic management is necessary for sustained economic growth, as post-crisis events have shown.
Lesson # 2: the combination of tight monetary policy, loose fiscal policy, a fixed exchange rate and excessive public borrowing inevitably leads to macroeconomic crisis, as was the case in 1998.
Lesson # 3: Russia's public finance institutions, including its tax administration, the Federal Treasury, budgeting system and public debt management system, need to be urgently strengthened.
The most important lesson, however, is that macroeconomic stabilization itself is not sustainable without deep structural, social and institutional change. Let us therefore turn to the second challenge.
Second Challenge: Structural Transformation for Competition and Productivity Growth
It is fair to say that the size and persistence of the output rebound we are now witnessing were severely underestimated. Nevertheless, genuine concerns about long-run growth remain. While statistical problems prevent crystal clarity, there is a strong suspicion that net investment levels were probably close to zero or negative through much of the 1990s. This would fit in with a picture of uncertain property rights, high marginal tax rates, a tendency towards asset stripping and exceptionally high real interest rates combined with an appreciating real exchange rate over the 1995-mid 1998 stabilization period.
At the same time, the Russian enterprise sector has been marked by pervasive soft budget constraints in the form of hidden subsidies for tax and energy payments channeled through the nonpayments system. A Bank study estimated the size of these implicit subsidies at 7-10 percent of GDP per year during the pre-crisis period. The subsidies from energy alone were of the order of 4 percent of GDP per year.
While subsidies through the tax system have abated after the crisis – because the government has stopped borrowing, and must therefore tighten tax enforcement – the energy subsidy persists, and has grown with the rise in international prices and the sluggish adjustment of energy prices to domestic inflation. Indeed, if price distortions are taken into account, the energy subsidy from gas and electricity will in all likelihood be considerably higher than the 4 percent of GDP estimated from non-payment alone.
At the same time, there are numerous problems with the investment climate, as noted during the excellent seminar organized by the Higher School of Economics and the Center for Strategy development last April in Moscow. These problems have kept new investment levels low, including from FDI, and capital flight has remained at high levels, ranging from $1-to-2 billion per month even in the post crisis period.
This configuration suggests that a cautious interpretation of the present output rebound would characterize it largely as an increase in capacity utilization from very low levels stimulated by the expenditure switch towards domestic goods as a result of the devaluation; while the pick up in investment is probably a re-tooling of capacity that has lain unutilized and dormant for several years.
To be sure, there is much to be happy about. The rebound has shown that Russian managers, like their counterparts elsewhere, respond to incentives, and have chosen to increase output, profits, liquidity and real wages (which are now on the rebound as well) instead of accelerating asset stripping. But the sustainability of growth will be ensured only when enterprise budgets have been hardened and the investment climate improves sufficiently to attract FDI in volumes consistent with the size of Russia’s economy, with capital flight disappearing. This is merely to emphasize that Russia does not face a shortage of potential investment resources.
Much, if not all, of this is recognized in GOR’s own long-term strategic document. But nevertheless, difficult hurdles must be crossed. The hardening of budgets is needed for efficient enterprise restructuring, which, as EBRD’s last Transition Report carefully documented, is the foundation for a sustainable resumption of growth. For Russia, this means that local governments have to stop impeding the exit of unviable enterprises, and reduce the red-tape for establishing SMEs that can benefit from the down-sizing and unbundling of unviable, large enterprises – a factor that has proved decisive for growth in the Central European transition countries.
It also means transparency in privatization auctions, and in the awarding of telecommunications licenses, as well as more aggressive action to address existing monopolies, especially in infrastructure and those created by poorly regulated acquisitions and mergers; and fostering competition. Government must be seen as fair, transparent and applying a clear set of rules uniformly to all investors, domestic and foreign. It also means more mundane, but nevertheless, important things such as IAS for banks and enterprises. And it also means laying the foundation quickly for a solid financial sector, which if not addressed will become a binding constraint to the mobilization and efficient allocation of resources over the medium-term.
The above is a daunting list. We believe, based on experience so far, that the immediate priority is a hardening of budgets constraints based on fully eliminating non-payments for energy and taxes, and eventually, on rational pricing for energy based on long-run marginal costs. A natural concern on the part of regional governors is how to deal with the possible social fall-out. This is an area of great concern to the World Bank, and it brings us to the next challenge.
Third Challenge: Social Protection Policies and Institutions
A social protection system based on avoiding enterprise exit through explicit and implicit subsidies is costly and eventually unsustainable. It is costly because it is a disincentive to enterprise restructuring, which in turn impedes new job creation and growth. It is unsustainable because implicit subsidies based on arbitrary, partial payment of tax and energy bills will lead ultimately to a debt crisis (as in 1998) or to the de-capitalization of companies such as Gazprom and RAO UES. Moreover, the untargeted, implicit nature of the subsidies is a recipe for corruption and asset stripping.
This means a difficult choice between: (i) preserving a system based on implicit subsidies that temporarily, but very inefficiently, minimizes the social costs of transition and does not offer any long-run upside; and (ii) hardening budget constraints to achieve enterprise restructuring, and combining this with lowered entry barriers for SMEs and other new investment, which could lead to a temporary worsening of the social costs that are already being incurred, but with the hope of an upside in terms of better jobs and long-run growth. The second is clearly better when viewed in a strategic, long-run context, but calls for a more effective, better targeted social safety net that will help the truly needy during the transition and after.
In other words, hard budgets and competition must be complemented by policies and institutions of social protection meeting four criteria:
1) support structural change in enterprises and labor markets, 2) address poverty, and especially deep poverty, head-on, 3) apply the resources currently used in social protection much more efficiently, 4) build social protection institutions (pension system, unemployment insurance and basic welfare support) that are sustainable in the long term.
The current social protection system in Russia does not meet these criteria. Some of the early corrective actions that could be taken include the following:
a) Protect the poor through a targeted, proxy-means tested, simple poverty benefit scheme, while eliminating many of the current social protection programs. b) Flatten the benefit structure in the pension system, while raising minimum pension levels. c) Institute financial discipline and realign coverage and benefits in the Pension Fund, Employment Fund and Social Insurance Fund for better targeting and greater efficiency. A first step towards this has already been taken with the consolidation of the social funds tax into one tax to be centrally collected by the Ministry of Taxes and Fees, although at up to 35 percent of the payroll, this tax continues to be high. d) Monetize current in-kind benefits, especially housing subsidies. This is a major issue, as it will give ordinary Russians choice in their housing expenditures, improve management of the existing housing stock and encourage construction. e) Support (sub)sectoral downsizing and restructuring of declining industrial sectors and regions (similar to the coal sector program), with comprehensive sub-sectoral restructuring packages, including liquidation and privatization, changes in ministerial responsibilities that focus on regulation in support of competition (not protection or promotion), and social support measures for affected employees and communities.
Fourth Challenge: Public Sector Management
Lasting progress in macroeconomic, structural and social transformation is possible only if supported by an effective, efficient, transparent public sector that increases people's confidence in the state and sharply reduces the scope for corruption. Four key areas deserve early attention:
1) Realigning a complex and duplicative government structure, by simplifying the current structure, eliminating remaining commercial and service obligations of ministries that are best left to the private sector, while strengthening their regulatory functions. 2) Strengthening the civil service, by improving the currently uncompetitive pay structure, reducing the excessive number of civil servants in some areas, and upgrading the skills base through training and renewal of the civil service. 3) Strengthening the judiciary, by improving its financial condition (low or unpaid salaries, lack of adequate facilities, technology and logistical support). 4) Rationalizing the complex and unclear intergovernmental relations between federal and sub-national authorities, by clarifying the revenue and expenditure authority of different levels of government, strengthening the effective control of federal tax authorities over federal tax collection in the regions, providing incentives to sub-national authorities to introduce efficient administration and a competitive environment for investment and productivity growth, and eliminating the reliance on ad-hoc negotiated deals between the federal and oblast governments.
Conclusion
Everyone has been talking about the window of opportunity -- “okno vozmozhnostei” – for Russia. It means different things to different people. To short-term portfolio investors, it might mean a play on the exchange rate. To long-term investors, domestic and foreign, an anxious time of waiting to see whether resolute steps will be taken to improve the investment climate. To older Russians, the hope for better prospects for their children even if they have had to make sacrifices. To the Government, a unique opportunity to accelerate reform based on the lessons of the 1990s, and organized around the four challenges identified above. To the IFIs, a chance to continue a “live” policy dialogue, based on a clearer understanding of how the Russian economy works, and a better reading of the priorities.
But there is also a downside scenario: If oil and gas prices fall significantly, and if macroeconomic and structural reforms are not accelerated while the window lasts, and if in the meanwhile, public borrowing resumes, then Russia could once again face a serious downturn with a set-back to the manufacturing sector. To be sure, there are many “ifs” in this statement, but one should guard against history repeating itself.
The way to do so is for Russia to build on the recent favorable economic developments to create the sustained growth that is so clearly possible, and which is the essential ingredient for the greater prosperity of ordinary Russians. The Bank is working closely with the Government to meet the challenges that undoubtedly lie ahead. We have made clear to the Russian authorities our willingness to continue to provide strong support to Russia’s economic reform efforts, and look forward to a continued fruitful partnership.
Thank you for your attention. Cpasibo
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