REFORM’S PARADOXES

By Elena Chinyaeva

For the second consecutive year the Russian parliament has postponed its summer vacation to deal with legislation designed to become the basis for structural reforms. The cost of implementing these long-overdue reforms, which affect most spheres of economic and public life, will be substantial. Meanwhile, the preliminary parameters of the 2002 budget approved by the government suggest that the budget might not provide a stable financial basis to see the reforms through. Economic strategy, which has always been the weakest point of Russian governments, might once again be sacrificed to satisfy tactical economic and political needs.

AN AMBITIOUS PROGRAM OF LIBERAL REFORMS

During the last two years a number of long-expected economic and public-sector structural reforms have gotten underway in Russia. These include reform of the tax code, the state monopolies, the army, the pension and judicial systems, housing services and land. With a flat income tax of 13 percent, a consolidated social tax, lowered turnover and customs duties, and–the Duma’s latest feat–a 24-percent profit tax, the Russian tax system is turning out to be the most liberal in Europe.

The three biggest monsters of the Soviet economy–the gas monopoly Gazprom, the railways and the electricity producer RAO UES–are to be reformed so as to create competitive markets. Despite great opposition, the concepts of these reforms have been approved and only the details are still being discussed. Rem Vyakhirev, the seemingly untouchable head of Gazprom who was associated with corruption and management inefficiency in the company, which was dubbed the “state within the state,” was sacked. An outsider, Aleksei Miller, one of President Vladimir Putin’s former colleagues from his days in the St. Petersburg mayor office, was appointed to replace Vyakhirev and carry out Gazprom’s restructuring.

The army is to be reduced in size, with another of the president’s men, Sergei Ivanov, a retired intelligence general and former head of the Kremlin’s Security Council, having been appointed as the country’s first civilian defense minister and tasked with completing military reform. Lyubov Kudelina, another civilian–and what is more, a woman, something extraordinary for Russia’s Defense Ministry–was appointed to oversee the army budget. The military’s payment system has already started to change.

The pension system is to be altered to reduce pressure on the state budget. Employees will now be required to accumulate part of their income on special pension accounts.

The most controversial set of reforms is designed to bring the Russian judicial system up to modern standards. Courts are to take over a number of functions from the Prosecutor General’s Office, including issuing search and arrest warrants; extending periods of preliminary detention; authorizing access to any private information, including private bank account information and the seizure of any materials from offices and homes. The courts are expected to become truly independent and acquire a higher social status than before.

Last but not least, communal services will finally undergo reform. This is a very important step, considering that Russia’s Soviet-built infrastructure is crumbling–a problem which last winter led to numerous cuts in electricity and heating all around the country. Instead of being subsidized by the state, the housing services industry, which has in fact been another state monopoly, is to become a competitive market in which consumers will be given the opportunity to choose between suppliers of services. The most difficult part of the reform is that consumers will have to pay for these services themselves, with only the poorest getting subsidies from the state.

All these reforms should produce positive results for the economy in the future. In the short term, however, they will require large-scale financing, which will lead to immediate losses. The big question is whether the state budget for 2002 can cover the cost of the changes.

A DEFICIT OF ECONOMIC POLICY

While reflecting the general situation in a national economy, a state budget can at the same time can be used as an effective instrument of economic policy–provided that such a policy exists. In Russia, economic priorities have varied during different stages of its transition period. At the beginning, fundamental changes had to be made, among them price liberalization, privatization and the creation of an effective financial system, including commercial banking. But there always were fundamental problems whose solution required sacrifices to be made. Unfortunately, it was economic strategy that usually turned out to be the sacrificial lamb.

The first such fundamental problem was to fill the shops with goods, given that in late 1991 there were queues for bread even in Moscow. Price liberalization was applied to consumer markets, while state controls were maintained on natural resources and the products of state monopolies, such as oil and gas. There was no time to create a balanced framework for liberalizing the market, as proper economic policy would demand. As a result, a great disparity emerged between low domestic and high world prices. This, together with the restrictions on foreign trade that remained at the time, created a corrupt system in which those who could bribe their way into being granted export quotas benefited tremendously. The export of resources and the import of cheap goods, which were resold domestically for much higher prices, became the most profitable forms of business.

Another immediate task was to undermine the foundations of the Soviet economy by creating private ownership. Because there was also no time to prepare privatization, state assets were sold to whoever was willing to pay whatever money they had at the time. The new owners, who were often the Soviet-era managers, considered their newly acquired property their lucky chance to get rich quickly and often virtually ruined their companies in the process.

National production fell dramatically during this period, but the ruble printing presses continued to pump up inflation. As the country found itself balancing on the brink of hyperinflation, curbing runaway prices became the most pressing need. There was no time to create a stable financial system, and the newly emerging banking sector went from one crisis to another. In response, a currency corridor was established for the ruble, creating an artificial stability.

With the government acting like a fire brigade in an oil field where everyone was smoking, there was no time for structural reforms and the economy continued to fall, with the budget deficit rising. To finance that deficit, the government created a financial pyramid of state bonds with returns first as high as 180 percent but never lower than 30 percent. Money that had been accumulated by whatever means in previous years, along with foreign portfolio investments, rushed to get a part of the budget pie. Production continued to fall while some analysts cried out that the ruble needed to be devalued before it was too late. There was, however, as usual, no time to conduct a controlled devaluation, so in August 1998, Russia defaulted on all its obligations and the ruble’s value dropped by a factor of four.

Those events marked the end of the most dramatic period in Russia’s economic transition. It was as if a run-away train had finally come to a halt. The passengers gasped for air, realized they were still alive and went about their business. Following the crisis, the new government of Yevgeny Primakov did nothing in terms of economic policy–which was the best anybody could hope for while people started clearing the rubble. A half a year later the economy began to show signs of growth as domestic production benefited from the ruble’s devaluation and abrupt decrease in imports. Russia was also lucky for a change, as world oil prices went up. Before long, however, the lack of a clear economic policy began to be felt.

Primakov was sacked, but that did not automatically bring about new economic thinking. The following year was marked by frantic changes of prime ministers. Following Vladimir Putin’s accession as president, observers wondered what he was after in terms of economic policy, and received something of an answer when his government, headed by Prime Minister Mikhail Kasyanov, presented the first nondeficit budget in the history of Russia’s transition. For the first time, economic policy seemed to coincide with pressing tactical needs. The 2000 budget was austere and–its most impressive merit–realistic. Oil prices continued to skyrocket, giving the government additional leverage to implement its goals. The results were impressive: in 2000, GNP rose 7.6 percent, industrial production–9 percent, agriculture, for the first time in many years, showed a 3 percent growth, wages rose approximately 20 percent, investment in the real sector–17.6 percent, while inflation was slightly over 20 percent and unemployment–10.4 percent. At last the macroeconomic results Russian governments had unsuccessfully strived for in all previous years were achieved and, to top it off, these results were made on the basis of the economy’s natural development.

WHO WILL PAY FOR THE REFORMS?

Now it was finally the right moment for structural reforms. But just as there was no time to carry them out before, now there was no time to postpone any of them. Perfectly in keeping with the Russian tradition of extremism in everything, the reforms were launched in many spheres virtually simultaneously. On June 7 of this year, the Russian government approved the key parameters for the 2002 state budget. Despite the fact that it has no deficit, a relatively low inflation level of 12 percent and a stable currency prognosis–the new budget hardly seems a solid financial basis for a number of the pressing reforms launched during the last two years.

Indeed, the restructuring of the state electricity producer and the communal services will result in at least a twofold rise in prices for their services. Ticket prices on Russia’s railways, which are heavily subsidized by cargo transportation, rose 30 percent at the beginning of the summer season and will continue to grow. Not to mention the cost of military reform and of preparing new qualified cadres of judges–a key element in judicial reform. Given that the yearly inflation rate is already running at 14 percent, it is unlikely to drop to 12 percent next year, when the most costly reforms are set to begin. Similarly, a zero budget deficit is a wonderful macroeconomic achievement after years of deficits, but with economic growth starting to stall, it starts to look like proof of the government’s lack of priorities

Russian governments have been struggling for so long to achieve “proper” macroeconomic targets as defined by international financial bodies like the IMF, that now the cabinet is afraid to set more realistic ones. In fact, countries with transitional economies in Eastern Europe achieve are only required to cut budget deficits to 2-3 percent in order to qualify for European Union membership, while in a number of developing countries, such as Turkey, economic growth has continued with inflation running as high as 50 percent. Why shouldn’t Russia adopt a less rigorous standard vis-a-vis the budget if this would help it to iron out the difficulties of the period between the start of reforms and the time they begin produce first results?

The new wave of long-awaited structural reforms is threatening to collide with the previous one, which was aimed at achieving stabilization on a macroeconomic level. The government is once again neglecting the priorities of economic strategy in favor of tactical goals. Its new budget, while liberal in appearance, is a reaction to the most pressing needs rather than a strategy-setting guide for development. While during the last decade the government’s failures in the sphere of economic policy were often blamed on the sabotage by the Communist-dominated Duma, the fact the Duma is now dominated by Kremlin loyalists means that this excuse can no longer be used.

The paradoxes of reform require a fresh look at what constitutes a proper economic policy. It is obvious that, depending on the situation, economic priorities fluctuate between the need to achieve macroeconomic stabilization and to facilitate changes at the microeconomic level. The current Russian government has yet to find the right balance as it prepares its 2002 budget for the Duma’s autumn session.

Elena Chinyaeva, who holds a doctorate in modern history from Oxford University, is a writer with the leading Russian political weekly Kommersant-Vlast.