8 Trans2

Commonwealth of Independent States12 Former USSR Republics

3 groups of countries

Russia

UkraineBelarus Moldova

ArmeniaGeorgia

Azerbaijan

Kazakhstan Uzbekistan Kyrgyzstan

TurkmenistanTajikistan

China vs Russia

Transition Recession: Why?• Subsidies to state enterprises cut (Credit crunch)

•Decline in population income•Decline in trade within CIS and with CEE•Russia’s energy subsidies to other countries cut – 1990: $40 bl to union republics, $18 bl to CMEA– Dependent: Ukraine’s imports 85% of its natural gas from Russia

•Disorganization of production– Transaction costs: New borders, tariffs, new currencies, check

points – Informal links between enterprises broke down– Integrated power grids and water systems collapsed– Rail transportation to/from remote areas deteriorated– Telecommunication sector under-developed – Putin on disintegration of USSR: “national tragedy of an enormous

scale”•Wars, refugees, resettlement– 3 mil Russians returned from other republics

•High interest rate (contractionary) monetary policy

• Lack of financial markets• Restructuring shock, no entrepreneurial experience•Defense spending cut– “bad” output– Defense spending as share of GDP

USSR 1987: 17% 1990: 12%

Russia 1992: 5.5% 1997: 3.8%

•Welfare higher even if output is lower?– Production shifted to“good” output – No lines to purchase goods –high income consumers better off

•Official data overstates collapse – Informal sector– Over-valued output at old prices• USSR reported higher than actual growth

• Smaller recession – in countries that integrated in world economy faster – In non-reformers, Uzbekistan and Belarus

Transition Recession: Why?

Informal Economy• Unreported activities, not measured• 50% of GDP, 40% of cash turnover• Moonlighting, barter, unofficial production• Household food production• “Shuttle trading“ by 5-10 million entrepreneurs – transport and sale of consumer goods – 1995: some US$11 billion worth of goods

• Why useful to know size of shadow economy? – Tax collection: informal economy erodes tax base and leads to higher

government debt– Official data underestimates household income– Formulating policyMeasuring Informal Economy

• Direct estimates of income or household expenditure by survey– not reliable, people conceal revenues

• Indirect methods– demand for cash relative to broader monetary aggregates – electricity consumption - high correlation with GDP

Employment and Wages

• Large-scale privatization of money-losing state owned enterprises should increase unemployment– East Germany and Poland: 16% in

1994• Russia: low unemployment rates – 1994: 6.3%

• High under-employment– "hidden" unemployment – workers on administrative leave, part-

time– labor hoarding– workers attached to enterprises by

wage arrears

Health in Transition

Virtual Economy by Gaddy and Ickes

• Workers, managers, regional governments adapt to environment that threatens their survival• 2 sectors of Russian economy:–Export-oriented (oil and gas)

• value-adding, cash-based –Domestic (other sectors)

• value-subtracting, non-cash• inefficient, same output & technology as under central planning• average age of plant and equipment

1980: 9.5 years, 1995: 14.1 years• Gazprom supplies gas to domestic

economy at low $28 / ‘000 cubic meters –gets paid with arrears– in exchange for the right to keep export

profits• Corruption, looting, barter, offsets• Stable equilibrium–Participants pretend it’s not

happening

“Lawless Capitalism Grips Russian Business”

The Washington Post November 7, 2000

-

•Moscow - center of banking and foreign investment

often to exclusion of other regions

Russian Business Environment, mid

90s

• Organized crime, protection rackets, contract murders, kickbacks, bribes– Most businesses not able to function without

paying for mafia protection– violence to enforce contracts

• State dependent on criminal structures– enterprises did not have money to pay taxes– government borrowed at high interest rates

from commercial banks – banks lend to the government government’s

own money

Ineffective financial intermediaries• Adverse selection effect of high interest rates

– Only high risk individuals borrow– Default if high risk project not successful – Low risk – low return projects not undertaken– Bad loans for banks, low public confidence in banks – Government intervention possible - Interest rate subsidies, deposit

insurance• Bank runs, failures:

– Latvia, Lithuania : 1995– Czech Republic, Bulgaria, Romania : 1996-97– Russia: 1992 - savings in Sberbank frozen and destroyed by hyperinflation

1996-98 - bank runs, withdrawal of deposits, failures

• Financial scandals– Russia, Albania, Romania, 1994-94 - Collapse of financial pyramids

• Causes of bank runs and financial scandals– non-performing loans to state-owned enterprises– quick financial liberalization allowed too many new banks– inexperience of bank management with risk assessment– deposit rates below inflation rate– no deposit insurance

Exchange Rate Regimes• Float (Flexible Rate):

– value of national currency determined by market

• Peg (Fixed Rate): – central bank buys and sells domestic currency to maintain

exchange rate against a foreign currency– possible only if central bank has enough foreign exchange reserves

to defend the peg– helps fight inflation– currency boards: Latvia, Estonia, Bulgaria

• Managed (“dirty”) floats• Adjustable (“crawling band”) pegs

– Poland, Hungary– Russia: “crawling band" started at 4,300-4,900 Rb = $1

Slowly depreciating due to inflation1997: 6,000 Rb = $11998 currency reform: 1 new Rb= 6,000 old Rb

Success of transition is not crucially dependent on exchange rate regime

Russian Financial Crisis ‘98• 1997:

– Low inflation rate– Stable convertible ruble– Budget deficits (G-T) 7-8% of GDP– Deficit financed with short-term ruble-

denominated government debt• Annual interest rates >140%• Russian banks borrow from foreign banks to

invest into government debt – Asian financial crisis

• IMF loan $22.5 billion in July ’98, with conditions– Contractionary fiscal policy • cut spending, high taxes, tight credit

– Keep strict exchange rate band • Russian government ran out of reserves

buying rubles to support exchange rate• August 1998 default:– Devaluation of Rb by 34%– Unilateral restructuring of Rb-denom.

government debt due btw 8/19/98- 12/99– 90-day moratorium on private sector

payments on external liabilities

1998: Appeal of Devaluation• Oil prices fell in 1998 to $11 from $23 in 1997

• Example

Year ExRate Oil barrel Oil barrel

p=$20 p=$10

1997 $1 = Rb 5 Rb 100 Rb 50

1998 $1 = Rb 10 Rb 200 Rb 100

•Real Effects of Devaluation –Cheaper Rb domestic exports increase, imports decrease

–good for exporters – import-substituting domestic production increases

–Leads to a recovery and output growth –Lower trade deficit (Exports < Imports) or higher trade surplus

Devaluation• Economist, August 1998: • “Devaluation will not do

much to create jobs in industry, because Russia’s miserable output of manufactured exports— chiefly clunky cars, vodka and weapons —is not very price-sensitive.

• Although imports will become dearer, those relatively affluent consumers who favor French cosmetics and German cars are unlikely to find Russian goods acceptable substitutes.”

Who made money on the default?• Raw material exporters + local economies based on them

– did nothing different but earned 4 times as much cash• Bankers charged clients up to 50% withdrawal fees• Medium size banks and insurance companies

– did not hold much government debt– charged clients higher service fees for ‘safer’ transactions

• Money changers: demand for $ increased, so did fees• Medium size companies, bank clients with idle money

– Have Rb1,000 sitting in your account for some time?– Buy $$ at Rb5=$1 ($200)– 30 days later, sell $$ at Rb10=$1 (Rb2,000)– Do not show this transactions in the books- as if still Rb1,000– Convert extra Rb1,000 into $$

• Borrowers who took out loans before banks went bankrupt• Buyers shortly after devaluation paying old ruble prices

– eg. Car for $300 at new exchange rate• State

– Did not return $60 billion worth of debt– Wage, pension and tax arrears fell in $$$ terms

Consequences• Collapse of the banking system

– Most of 1,600 banks made insolvent overnight

• Temporary contraction in output and trade – payments system paralyzed for

over a month • Inflation 138%

– wiped out household savings– reduced private wealth

• Incomes fell– Poverty rate rose by 50%

• Capital outflow – in 2000 $18.4 billion, 18% of

GDP, higher than in 1999• Central Asia

– competitiveness and living standards declined

• Brazil– re-evaluation of risks lead to

crisis in in 1999

Could Have Avoided Crisis with Right Policies?

• Gradual ruble depreciation: print rubles to pay off debts, stop convertibility for a while– Inflation better that massive bankruptcies, loss of savings

• Capital controls to stop capital flight• Public infrastructure investment

– transportation, power, communication, railways, public buildings • Pay back wages to stimulate demand for Russian output• Attract investment, domestic and foreign, for

modernization– Political instability – Functional legal system – Low cost credit for domestic production

• Renationalize enterprises that were sold at less true value • More public spending on science, technology, education• Temporary protection of selected industries and agriculture• Export less raw materials and energy, redirect more to

domestic production – diversify economic base