CHRONOLOGY OF THE MELTDOWN

Russia's stock market had performed spectacularly well, rising 150 percent during the period June 1996-June 1997. In the fall of 1997, however, the Asian economic flu caused a bout of pneumonia on the Russian stock exchange. Moscow's financial markets went into a tailspin, and foreign investors began to withdraw. The poor economic situation in Russia was exacerbated by falling oil prices (oil and gas are responsible for up to 75 percent of Russia's foreign currency earnings); a government deficit in excess of 7 percent of the GDP; a punitively high tax rate combined with an inefficient and ineffective tax collection system; and crime, corruption, and crony capitalism.

The situation deteriorated in late May 1998. The economy almost collapsed on May 27, when foreign and domestic investors panicked and began to sell government bonds, corporate stocks, and rubles. In a desperate attempt to defend the ruble and offset the mass exodus of foreign investors, the Russian Central Bank hiked the interest rates on government bonds to an astronomical 200 percent per year and expended large amounts of Russia's foreign exchange reserves in purchasing rubles. To support the ruble, the Central Bank sold $1 billion in one day, causing its hard currency reserves to dwindle to $14 billion. It became obvious that the Central Bank could not support the currency forever and that it was only a matter of time until the government had to borrow even more funds to support the ruble.

Some economists, such as Andrei Illarionov, the Director of the Moscow-based Institute of Economic Analysis,³ predicted the ruble's devaluation and called for measures to manage this inevitable development in an orderly fashion. They were not heeded.⁴ Instead, then-Prime Minister Kirienko called upon former First Deputy Prime Minister Anatoly Chubais to negotiate yet another bailout package with the IMF.

Several factors contributed to the drop in foreign investor confidence in the spring and early summer of 1998. The communist-dominated State Duma passed legislation prohibiting foreign ownership of more than 25 percent of the stock of Unified Energy Systems (UES), the national electrical monopoly, at a time when foreign ownership already was over 28 percent. Foreign investors also became jittery when a huge government-owned oil company with oil reserves worth tens of billions of dollars that was slated to be privatized failed to attract any buyers at the asking price of $2.1 billion.

Oil prices dropped approximately 30 percent between 1997 and 1998, severely decreasing the earnings of Russia-based companies as well as government receipts. Investors also began to take serious notice of the rampant corruption and nepotism in Russia. For example, highly lucrative short-term government bonds (the so-called GKOs) were snapped up by several well-connected Russian banks, while the broad masses of Russians had no opportunity to purchase them.

THE IMF TO THE RESCUE

The Russian government and the Clinton Administration intensively lobbied the IMF Board to approve new funds to bail out Russia. The IMF had approved an $11 billion package for Russia in 1996.

On July 13, the IMF Board announced "in principle" a $22.5 billion dollar international bailout, which included the previously committed funding from the IMF as well as funds from the World Bank and the government of Japan. On July 20, the IMF Executive Board approved its portion ($11.2 billion) of the $22.5 billion dollar loan. The intention was to provide foreign currency reserves that would enable Russia to defend the ruble long enough to implement the reforms needed to achieve long-term stability.

Indeed, the IMF plan--detailed in an IMF press release--specifically stated that the "exchange rate policy should remain broadly unchanged during the remainder of 1998."⁵ Many doubted it would work. In fact, the lull in the Russian market turmoil purchased with IMF credits lasted only two weeks.

On August 17, just three days after President Yeltsin stated unequivocally that the ruble would not be devalued, Prime Minister Kirienko announced that the government would allow the ruble to devalue by 34 percent by the end of the year. He also declared a 90-day foreign debt moratorium and announced a de-facto default on the government's domestic bond obligations. On August 23, Kirienko was fired and his predecessor, Viktor Chernomyrdin, was brought back on the scene. He subsequently failed to win confirmation by the Duma.

On August 26, the Russian Central Bank announced that it would not be able to support the ruble any longer. In less than a month, it collapsed 300 percent, from 6.2 rubles to the dollar to over 20. Inflation shot up to15 percent a month in August from 0.2 percent in July and reached 30 percent in the first week of September. On September 7, the Chairman of the Russian Central Bank, Professor Sergei Dubinin, who with Chernomyrdin was the architect of the recent economic policy, resigned.

On September 6, Foreign Minister Evgeny Primakov was offered the job of Prime Minister. He is the former head of Soviet and Russian external espionage and was a member of the last Soviet Politburo. Primakov immediately appointed the former chief of Soviet Central Planning (the GosPlan), Yurii Maslyukov, as First Deputy Prime Minister in charge of economic policy, and the former Chairman of the USSR's and Russia's Central Bank, Viktor Gerashchenko, as Chairman of the Central Bank.⁶ This "dream team" won the immediate and enthusiastic endorsement of the Duma.

IMF officials apparently had little, if any, knowledge of what was coming:

• During a press conference in Moscow on May 29, the top Fund official with line responsibility for Russia, Director of the European II Department John Odling-Smee, stated, "The IMF management and staff believe that...a devaluation of the ruble can and should be avoided. With the reestablishment of confidence in the currency, we hope to see stability return to the financial markets."⁷

• Asked at a July 13 press conference why the IMF intervened to prevent the devaluation of the ruble, IMF First Deputy Managing Director Stanley Fischer responded, "[T]he problem with the devaluation is more than anything else that it doesn't solve the underlying problem. The underlying problem is the budget and the financing needs. So if you devalue, you sort of relieve the pressure on the markets for a while, causing difficulties, but unless you get the budget in shape, and the devaluation wasn't going to do anything for the budget, you would be back in this situation."⁸

• In a July 20 press release, Fischer said, "The enhanced policy package represents a strong and appropriate response to overcome Russia's current difficulties."⁹

• Commenting on the Russian devaluation and debt moratorium on August 17, Michel Camdessus, the Fund's Managing Director, stated, "Implementation of [Russia's economic] program has been satisfactory. Despite this, confidence in financial markets has not been re-established and as a result Russia has continued to lose reserves, and asset prices have fallen sharply."¹⁰ It is unclear how a devaluation of this scope can be termed "satisfactory."

It is, however, now painfully clear that the IMF and its $22.5 billion bailout failed to rescue Russia. Investor confidence was not bolstered, the stock market continued its free-fall, and interest rates on government bonds again climbed above 200 percent.

If the goal of the bailout was to support economic reform in Russia, a new infusion of funds was the worst way to achieve it. Although it has the dubious honor of being one of the IMF's largest borrowers, Russia remains economically weak because it refuses to implement the fundamental reforms which are the only cure for its economic ills. Prior to the decision to go ahead with the $22.5 million bailout, both the IMF and the G-7 governments were aware of the problems and repeatedly (and unsuccessfully) demanded the implementation of reforms. There was no reason to assume that providing additional loans would have proven any more effective in spurring reforms than it had in the past.

THE CAUSES OF RUSSIA'S ECONOMIC FAILURE

The causes for pessimism about Russia run deep. The country's economic woes are the result of 74 years of communist mismanagement and almost eight years of half-hearted reforms under the post-communist regime. A number of interconnected problems combined to generate the current systemic failure of the Russian economy.

The first problem Russia faces is fiscal and budgetary. The country has been running up large budget deficits (7.5 percent of the GDP). It has a complex, punitive, and arbitrary tax system. To make matters worse, the tax collection system is failing; it is mismanaged, corruption is rampant, and the tax base is extremely narrow.

Moreover, the government fiscal and disbursement process is corrupt as well. According to former Prime Minister Chernomyrdin and reports in the most reliable Russian media, $250 million in World Bank credits provided to Russia to restructure its coal industry disappeared without a trace. Hundreds of millions of dollars allocated for restoring Chechnya after the civil war of 1994-1996 reportedly have also disappeared. Finally, the government has lagged behind on disbursing salaries and pensions because local officials postponed payments while utilizing state funds for their personal gain in commercial and short-term banking operations.

The second problem is structural. Russia's GDP has declined for six years since 1992, and the country has yet to experience meaningful economic growth in the post-communist era. Its industrial base is obsolete; it is not uncommon to find machinery in Russian factories dating as far back as the 1920s, while equipment from the 1970s is considered modern. Russian finished goods are of such low quality that they often are not competitive in the domestic market, let alone on the global scene.

Soviet industry was oriented toward military production, having manufactured huge amounts of every kind of military hardware--from intercontinental ballistic missiles to tanks to rifles--often surpassing the United States and its allies in quantities of hardware. Over 30 percent of the Soviet GDP was in the military-industrial sector, and Russia has found it very difficult to make the transition to a peacetime economy. The IMF's Stanley Fischer wrote in January 1998 that "a major constraint to Russia attaining satisfactory rates of growth is that the process of structural reform has not gone far enough."¹¹

The third problem is the lack of bank financing and venture capital needed for economic growth. With property rights insecure, and operations with government bonds and hard currency extremely lucrative, the Russian banks have invested little in industry. Russian entrepreneurs preferred the high returns of short term export-import operations, as well as the security of off-shore bank accounts and investments in real estate in the French Riviera, London, and Florida. Estimates of post-communist capital flight from Russia range from $80 billion to $300 billion--more than all the Western assistance to date combined.

In addition, rampant corruption at all levels of government made Russia an inhospitable land for investment. Rampant crime also contributed to keeping domestic and foreign capital away from Russia. According to some estimates, 25 percent of business expenses in Russia were allocated for "security" payments and outright bribes. Thus, Western investors as a group remained lukewarm at best.

The fourth problem is the lack of governance and management expertise necessary to run a modern market economy and a democratic society. It is no surprise that after seven decades of communism, Russian leaders and high-level officials do not have training in economics or public finance, or that many businessmen and managers have no background in finance, marketing, or management. If one tried to fly a plane designed by a baker, or eat bread baked by a stonemason, the results could be similar to what happened when former communist apparatchiks and underground entrepreneurs tried to run a market economy.

The fifth problem is the lack of a functioning legal system and mechanism to enforce dispute resolution. The legal system is still unfinished; the judges are undertrained and often incompetent; the court system is corrupt. There are anecdotal reports of judges being on retainer to law offices; of judges setting their bribe amount as a percentage of the claim; of lawyers paying for judges' office supplies because the government would not do so.

The courts, moreover, lack the support structures to enforce their decisions and collect fines. Filling the vacuum left by the state, organized crime has come to play a major role in commercial dispute resolution and the enforcement of court rulings. Again, this was an important cause for the low level of foreign and domestic investment, as well as being a contributing factor in capital flight.

Finally, there is the issue of the business culture and the lack of a business ethic. There are numerous cases of Russian partners forcing foreign investors out of joint ventures--even going so far as to use force. Several Western companies have abandoned multimillion-dollar investments because of the deteriorating business environment. IMF officials and financial experts agree that a competitive business culture must be established before Russia can increase its economic efficiency and capital accumulation.

DEEP MARKET-BASED REFORMS NEEDED

Before the most recent $22.5 billion bailout, the IMF already had loaned Russia over $18 billion since 1992. In each case, the IMF demanded that Russia adopt the necessary economic reforms. But despite defaulting on its promises, Russia has continued to receive tranche after tranche. In other words, the cheap credits allowed Russia to delay reforms, while the IMF was effectively rewarding Moscow for not reforming.

Before Russia takes out huge IMF loans that it has no hope of repaying in the near future, it must undertake drastic reform of the national economy and its institutional and legal frameworks. Among the most urgently needed measures:

• Faster, more transparent privatization. Allegations of massive corruption in the privatization process have been aired in the Russian media, the parliament, and the law enforcement structures. The criminal element is very strong; key privatization officials, such as Michael Manevich in St. Petersburg, have even been murdered. The privatization process should be competitive and open to all investors, foreign and domestic.

• Restructuring and breaking up the monopolistic utilities (gas, electric power, district heating, and railways). Similar to PEMEX, the Mexican oil monopoly, the Russian gas giant Gazprom is a state-dominated enterprise. Its financial statements are opaque, and top management is not responsible to the shareholders. The same goes for the national electric utility; the railroads, which are run by a government ministry; and other enterprises. Only further privatization, as well as passing and enforcing anti-monopoly laws and opening up to foreign investment, can make these sectors efficient and competitive.

• Urban land and real estate reform and agricultural privatization. A hundred years ago, Russia was an agricultural superpower, competing efficiently with the United States. In 1897, 50 percent of Western Europe's grain and 25 percent of its egg consumption were produced in Russia. Russian agriculture, which could have developed from there to become one of the strongest sectors of its kind in the world, is instead currently a drain on the country's budget. The reason: The steps needed to begin correcting the disastrous collectivization policies implemented during the Soviet regime have yet to be taken. Instead, the current Duma is blocking a market-oriented land code. Fully functioning land and mortgage markets need to be created. The privatization of agriculture and land, and the creation of an agricultural credit system, could become a powerful engine of economic growth.

Other reforms include further capital market development, improvements in the banking system, opening the economy to foreign investment, development of a working legal and dispute resolution system, and the eradication of crime and corruption.¹² The governments of Prime Ministers Chernomyrdin and Kirienko were fully aware of this priority list. In the case of Kirienko, it might be argued that he did not get a chance to implement the necessary measures.

The problem is that the IMF continued to distribute funds to the Chernomyrdin government despite institutional resistance and the government's apparent inability to implement the reforms necessary for financial recovery and growth. Now there is a real danger that the IMF will continue to subsidize the communist "dream team." Prime Minister Primakov has already started consultations with the IMF and World Bank officials for that purpose.¹³

NATIONAL SECURITY AND INTERNATIONAL AID TO RUSSIA

The Clinton Administration has attempted to decouple national security issues involving Russia and IMF assistance to that country. Officials claim that IMF lending to Russia is a strictly economic issue and should not be influenced by foreign policy and national security considerations. However, the Administration has supported lending to Russia more eagerly than it has supported lending to other countries in similar predicaments, such as Ukraine; and the reason that the Administration put pressure on the IMF to bail out Russia is indeed national security. There are 20,000 nuclear weapons, over 6,000 missiles, chemical and biological weapons, and the technology and experts to manufacture them located in Russia. If the country collapses or becomes anti-Western, these weapons may be used to threaten or harm U.S. interests--either directly or by being sold to rogue regimes.

But this is not the only problem the United States faces with Russia. Moscow is involved in strategic cooperation with Iran and is supplying it with ballistic missile and nuclear technology. It supports international rogues like Iraq's Saddam Hussein and Serbia's Slobodan Milosevic. It has refused to ratify the START II arms control treaty yet insists on U.S. compliance with the obsolete Anti-Ballistic Missile (ABM) Treaty, which denies America the ability to defend itself against ballistic missiles.

This anti-Western policy package, termed "the Primakov Doctrine,"¹⁴ is irreconcilable with Russia's repeated calls for financial bailouts. Moreover, the combination of pursuing nuclear modernization, maintaining its huge military, and pursuing anti-American policies is costing both the Russian and Western taxpayers who pay taxes and support the IMF billions of dollars a year. These wasteful policies make very little sense for a country in such dire economic straits as Russia.

For Russia to continue to receive support and co-operation from the West, it must take several important actions:

• Reduce military expenditures and size. Almost ten years after the end of the Cold War, Russia still is attempting to retain the trappings of a superpower and on occasion is trying to behave like one. In its current economic predicament, this could become suicidal. Russia's military, estimated at 1.5 million persons, is far beyond what a country with a GDP equivalent to the Netherlands or Indonesia can afford.

• Abandon nuclear modernization. The Kremlin is implementing an expensive nuclear modernization program, including construction and deployment of the next generation of intercontinental ballistic missiles, the SS-27; building new Borei-class nuclear subs; modernizing its submarine-launched ballistic missiles; and launching the nuclear-powered missile cruiser Peter the Great (formerly the Yurii Andropov). Moscow is also building the largest bunker facility in the world at the Yaman Tau mountain in the Urals region, believed to be necessary for the prosecution of nuclear war.

• Stop ballistic missile and nuclear technology transfer to Iran. Despite numerous promises by Yeltsin and Chernomyrdin to the contrary, Russian companies have supplied vital components for the Iranian ballistic missile programs. Russian technology is vital for the recently tested Iranian Shahab-3 missile and the new Shahab-4 intermediate range ballistic missile, which is capable of hitting targets as far as 1,300 miles away. Prime Minister Primakov is the architect of the Russian-Iranian rapprochement. Russia also has supplied two civilian nuclear reactors which have potential military uses. Thousands of Russian engineers are working in Iran.

• Abandon support of Saddam Hussein. Russian help and support in the United Nations Security Council are vital to Saddam Hussein's continued arrogance and bullying. This support stems from the decades-long personal friendship between Saddam and Primakov.

Other important foreign policy concerns include Russia's help in arming China, supporting Serbian nationalist/socialist leader Milosevic, and supplying advanced anti-air missiles to the Greek side of the tinderbox of the Cyprus conflict. The U.S. and G-7 should insist that in order to ensure Western support and cooperation, Russia must behave responsibly both in the economic and national security spheres. The Administration will be well advised to emphasize these issues in all future discussions with the Russian leadership.

CONCLUSION

Russia is playing a tremendously important role as the main test case for the transition from communism to democracy and market economy. If it fails, many other societies may turn away from the rule of law, participatory government, and a competitive, private-sector-based economy. If it becomes either unstable or authoritarian, it may emerge as a destabilizing force in Eurasia and threaten its neighbors in the former Soviet Union and in Eastern and Central Europe.

The United States should continue to be engaged in trying to turn Russia around. But it should do so while relying on solid economic and political analysis and creative solutions--not the failing policy of throwing money down Russia's economic black hole.

--Ariel Cohen, Ph.D., is Senior Policy Analyst in Russian and Eurasian Studies in The Kathryn and Shelby Cullom Davis International Studies Center at The Heritage Foundation.