The process of economic transformation in Russia has been marked by a prolonged transitional depression and macroeconomic instability: seven years of continuing decline resulted in a cumulative drop of GDP by more than 40% between 1989 and 1996; in that period there were also several outbursts of near- hyperinflation. The first radical effort to tackle inflation was the IMF-supported stabilization program of 1995. It focused on tight monetary control and nominal exchange rate targets; subsequently, direct central bank financing of the budget was discontinued and the exchange rate was placed under control.
In the years that followed, Russia made marked progress towards price and exchange rate stability and this prompted positive expectations in the West and a widespread perception that the country was pursuing the right course of reforms. It is important to point out that the 1995 stabilization effort was not supported by deep structural and institutional reforms. Russia inherited from the past an over-industrialized economy, dominated by highly inefficient heavy industry (including the military-industrial complex).
The liberalization of prices and the discontinuation of subsidies resulted de facto in the destruction of a large share of the existing capital stock. Restructuring these industries is a serious policy task: simply closing down the large number of inefficient enterprises would not be socially and politically tolerable, but unfortunately that was the way of Russian development during 1990s. In these circumstances the Russian authorities started speedy, give-away mass privatization program which was carried out during 1992-1994.
However, this resulted in most cases in the concentration of effective property rights in the hands of insiders (company managers) who had neither the willing nor the capital to perform the necessary deep restructuring of the enterprises. The newly emerging system of private ownership was not conducive to effective corporate governance and was in fact another obstacle to the process of enterprise restructuring. Moreover, the loopholes in law system seem to have incited a continued stripping of the assets of the privatized enterprises rather than their market-oriented restructuring.
Thus, the progress in institutional and legislative reforms in Russia in the 1990s has been modest and the emerging market infrastructure in the country is extremely poor. This is especially so in the areas of commercial and corporate law. The execution of agreements most often relies on the goodwill of the parties, while contract enforcement is often impossible by legal means. Very little was done to reform the functioning of Russian public administration whose lack of transparency is well known.
It gave birth to widespread rent seeking which resulted in the de facto concentration of wealth in a relatively small group of oligarchs. This distorted socio-political environment, and the presence of a mistakes in public administration has created a vicious circle which is a major obstacle to reforms and to social justice. One frequent characteristic of the Russian nouveaux-riches is that the wealth of numerous members of the new class was not acquired as a result of entrepreneurial success; it was simply “easy money”, obtained in some cases from illegal or semi-legal activity.
Huge amounts of capital left Russia and were spent on luxury goods or just placed in safe havens instead of being put to productive use within the country. The unprecedentedly rapid stratification of society and the lack of social justice eroded initial public support for the reforms and strengthened the opposition to the reform process. It was in this economic and institutional environment that the Russian government launched the 1995 stabilization program. The climate for productive investment in Russia remained hostile, mostly due to the negative impact of this environment.
The persistent lack of investor confidence leaded to further decapitalization of the economy. In real terms, gross fixed investment in 1997 was a quarter of its 1991 level. The prolonged financial pressure on manufactories provoked a credit crunch and the emergence of various monetary surrogates (acting as an alternative to money) and widespread barter (closely related to the diffusion of loss-making activity) which eroded further the tax base. Wage arrears kept mounting not only in the public domain but also in the corporate sector: in 1996 the arrears were, on average, for about 85% of total wage.
The escalation of this situation was in May 1998, when doctors, workers and coal miners went on a massive strike over unpaid wages, blocking the Trans-Siberian Railway. After a short recovery in 1997, the economic situation started to getting worse in early 1998. Russia depends heavily on exports of energy resources and other primary commodities which make up 80% of merchandise exports, and the weakening of global demand and the unprecedented fall in their prices in the aftermath of the Asian crisis had a significant negative impact on its economy.
There was a sharp fall in export earnings (about 12% in the first half of 1998) and this had a major impact on Russia’s external and fiscal balances. The fiscal problem There is wide agreement that the Russian fiscal crisis is itself just the expression of the overall crisis of the Russian transformation. Fundamental institutional reform of both taxation and expenditure has been repeatedly set back by political conflicts, such as constitutional crisis in 1993 and the problem of regional separatism. For the first half of 1998, the consolidated budget deficit (federal, regional and local) stood at 4. % of GDP, according to the lowest official figures. The overall position was considerably worse than this, particularly because the major extra-budgetary fund, the Pension Fund, had also a large deficit. These figures must also be seen in the context of wage arrears throughout all sectors of the economy. In the first quarter of 1998 debt service was fully one-third of federal spending. This visible strain was in itself another factor that destibilized confidence in the ability of the government to correct the situation.
The growing burden of interest payments was built into the measures taken in 1995: while Russian official figures continue to record the 1995 budget deficit at 3. 0% of GDP, interest payments on the growing stock of GKO (Government Short-Term Commitments) were actually adding nearly the same amount to the financing needs in that year. The first issues of GKOs were available only to residents, and offered very high interest rates. In 1996, and in part as a result of International Monetary Fund insistence, the market was opened to non-residents.
This did eventually succeed in lowering the interest rates, but it also clearly meant that the dangerous accumulation of debt could be continued. Until the first major crisis of confidence, this is what, in fact, occurred in 1998. The financial crisis of summer 1998 As part of the efforts to achieve macroeconomic stabilization, the federal government had made increasing use of Government Short-Term Commitments. But the situation remained dangerous: of the government deficit as much as 50% was due to interest payments.
As Russia’s current account deteriorated from a position of surplus in 1997 to a deficit forecast at 1. 5-2% of GDP for 1998 as a whole, the rouble came under pressure and monetary policy was tightened with the result that the interest rates on GKOs reached levels of more than 100%. The consequent decline in the value of government securities led to calls by the foreign creditors of Russian banks for addition a repo loans. Thus, russian banks came under pressure to raise additional funds at just the time when the central bank was draining liquidity from the market as part of its attempt to defend the exchange rate.
Due to the falls in the value of government securities, banks’ efforts to borrow were transferred to the interbank market that eventually couldn’t function. These difficulties signaled the liquidity squeeze on Russian banks to international lenders, and increased their fears of becoming a bankrupt. At the same time the government faced increasing difficulties over borrowing to meet the interest obligations on its debt. The package of international loans from the IMF, the World Bank and Japan arranged in July was to provide Russia with funding of $17 billion during the 1998 and 1999.
However, the attempt to defend the exchange rate which followed, was eventually abandoned, and a wider band for the rouble/dollar exchange rate was introduced in the third week in August that leaded to a rouble depreciation of more than 25%. On 2 September 1998 the Central Bank of the Russian Federation decided to abandon the “floating peg” policy and float the ruble freely. By 21 September 1998 the exchange rate had reached 21 rubles for one US dollar, meaning it had lost two thirds of its value of less than a month earlier.
The moratorium on government debt caused large losses to foreign banks. For Russian banks the losses associated with the crisis are estimated at 40% of their assets. Despite the small scale of international exposure to Russia, the emergency measures taken by its government were accompanied by significant declines in prices in international financial markets and important downward revisions in forecast of capital inflows to developing and transition economies. Recovery Russia bounced back from the August 1998 financial crash with surprising speed.
Much of the reason for the recovery is that world oil prices rapidly rose during 1999–2000 (just as falling energy prices helped to deepen Russia’s troubles), so that Russia ran a large trade surplus in 1999 and 2000. Another reason is that domestic industries, such as food producing, had benefited from the devaluation, which caused a steep increase in the prices of imported goods. Also, since Russia’s economy was operating to such a large extent on other non-monetary instruments of exchange, the financial collapse had far less of an impact on many producers.
Finally, the economy had been helped by an infusion of cash. As enterprises were able to pay all debts on wages, consumer demand for goods and services produced by the Russian industry began to rise. For the first time in many years, in 2000 unemployment fell as enterprises added workers. Since the 1998 crisis, the Russian government has managed to keep social and political pressures under control, and this has played a essential role in recovery during the early 2000s.
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