THE IMF and the Russian economic bailout

September 10, 1998

Testimony before the Subcommittee on General Oversight and Investigation,
The House Banking Committee

Ariel Cohen, Ph.D., Senior Policy Analyst, Russian and Eurasian Studies
The Heritage Foundation

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THE IMF and the Russian economic bailout

September 10, 1998

Testimony before the Subcommittee on General Oversight and Investigation,
The House Banking Committee

Ariel Cohen, Ph.D., Senior Policy Analyst, The Heritage Foundation

The chain of events to be addressed in this testimony began in the fall of 1997, as the Asian flu caused a bout of pneumonia on the Russian stock exchange. Moscow’s financial markets went into a tailspin and an exodus of foreign investors began after the spectacular performance of the Russian stock market in June 1996-June 1997, when it rose 150 percent. 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; crime, corruption and crony capitalism.

The process escalated in late May 1998. The economy almost collapsed on May 27^th, when foreign and domestic investors went into a panic and began selling 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 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. With the fundamentals remaining negative, it was only a matter of time until the government had to borrow funds to support the ruble. Some economists, such as Director of Institute of Economic Analysis Andrei Illarionov, predicted the ruble’s devaluation and called for measures to face this inevitable development as a managed process. Instead, however, then-Prime Minister Sergei Kirienko called upon former First Deputy Prime Minister Anatoly Chubais to negotiate yet another bailout package with the International Monetary Fund (the IMF).

Several other factors contributed to the drop in foreign investor confidence in spring and early summer of 1998. The communist-dominated State Duma (the lower house of Parliament), passed legislation prohibiting foreign ownership of more than 25 percent of the stock of Unified Energy Systems (UES), the national electrical monopoly, when the company already had over 28 percent foreign ownership. Foreign investors also became jittery when Rosneft¾ a huge government-owned oil company with oil reserves worth tens of billions of dollars¾ failed to attract any buyers at the asking price of $2.1 billion.

Oil prices dropped approximately 30 percent between 1997 and 1998, which severely decreased the earnings of Russia-based companies as well as government receipts. Investors also began to take serious notice of the fact that corruption and nepotism are endemic not only to Asia, but are in full bloom in Russia as well. For example, purchases of highly lucrative short term government bonds (the so-called GKOs) were dominated by several well-connected Russian banks, while the broad masses of Russians had no access to them whatsoever.

The Government of Russia and the Clinton administration commenced intensive lobbying of the IMF Board to approve new funds and bail Russia out. These funds were to come in addition to the $11 billion package approved by the IMF in 1996.

On July 13^th, the IMF Board announced "in principle" a new package that amounted to a $22.5 billion dollar international bailout; and which included the previously committed funding from the IMF, the World Bank and the Government of Japan. On July 20^th, 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 to defend the ruble for long enough to enable Russia to implement the reforms needed to achieve long-term stability. Indeed, the IMF plan¾ detailed in an IMF press release¾ specifically stated that the "exchange rate policy should remain broadly unchanged during the remainder of 1998." Many, including this witness, doubted it would work. In fact, the lull in the Russian market purchased with IMF credits lasted only two weeks.

On August 17^th, just three days after President Boris Yeltsin unequivocally stated that the ruble would not be devalued, then-Prime Minister Kirienko announced that the government would allow the ruble to devalue 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^rd, Kirienko was fired, and Chernomyrdin was brought back on the scene. On August 26^th, the Russian Central Bank announced that it would not be able to support the ruble any longer. In less than a month it collapsed three hundred percent, from 6.2 rubles to the dollar to over 20. Inflation shot up 15 percent in August versus .2 percent in July and has continued to climb. On September 7^th, the Chairman of the Russian Central Bank, Professor Sergei Dubinin, who together with Chernomyrdin was the architect of the recent economic policy, resigned.

An examination of statements by IMF officials indicates that they apparently had little, if any, knowledge what was coming:

• During Moscow press conference on May 29^th, the top Fund official with line responsibility for Russia, Director of the IMF’s 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.."

• When asked at a July 13^th 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 shape¾ and the devaluation wasn't going to do anything for the budget¾ you would be back in this situation."

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

• Commenting on the Russian devaluation and debt moratorium on August 17^th, 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." In other words, the operation was a success, but the patient died.

It is 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, nothing could have been further off target than a new infusion of funds. Additional IMF loans could only have prolonged the systemic disorder afflicting the Russian economy. Despite having 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 had repeatedly demanded the implementation of reforms to no avail. There was no basis to assume that providing additional loans would have proven any more effective than it had in the past.

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. There are interconnected problems that together generated the current systemic failure of the Russian economy.

The first problem Russia is facing 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 even worse, the tax collection system is failing, as it is mismanaged, corruption is rampant and the tax base is extremely narrow. To top it all off, the government fiscal and disbursement process is corrupt as well. According to the admission of then-Prime Minister Viktor Chernomyrdin and publications in the most reliable Russian media, $250 million in World Bank credits provided to Russia to restructure its coal industry disappeared without a trace. There are allegations that hundreds of millions of dollars allocated for restoring Chechnya after the civil war of 1994-1996 also disappeared. Finally, the government lagged behind on disbursing salaries and pensions because it tried to keep inflation down, and because local officials postpone payments while utilizing the 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 it 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 back to the 1920s, 1930s, 1940s and 1950s, while equipment from the 1970s is considered modern. The quality of Russian finished goods is so low that they are often not competitive in the domestic market, let alone on the global scene. Soviet industry was oriented towards military production, having manufactured huge amounts of every kind of military hardware – from ICBMs to tanks to rifles, often surpassing the U.S. and its allies as far as the quantities of hardware was concerned. Over 30 percent of the Soviet GDP was in the military-industrial sector. It was definitely guns instead of butter, and Russia has been experiencing a very hard time in making 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".¹

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 provided little investment into industry. Russian entrepreneurs preferred the high returns on 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. The estimates of post-communist capital flight from Russia range between $80 to $300 billion¾ more than all the Western assistance combined to date. In addition, rampant corruption on all levels of government, local, regional and federal, made Russia an inhospitable land for investment. Rampant crime also contributed to keeping domestic and foreign capital from investing in Russia. According to some estimates, 25 percent of business expenses in Russia were allocated to paying for "security" and outright bribes. Thus, Western investors as a group remained lukewarm at best (in 1996 Russia received less funds than resource poor Hungary, population 10 million).

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, while many businesspeople and managers have not background in finance, marketing, or management. If you try 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 for enforceable 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 by law offices; of judges setting the bribe amount as a percentage of the claim, of lawyers paying for judges’ office supplies as the government would not do so. The courts lack the support structures to enforce their decisions and collect fines. Organized crime has come to play a major role in commercial dispute resolution and the enforcement of court rulings, filling the vacuum left by the state. Again, this was an important cause for the low level of foreign and domestic investment, as well as being a contributing factor to capital flight.

Finally, there is the issue of business culture and ethic, or rather, the lack thereof. For example, Western businesses supplied numerous case studies of Russian partners forcing foreign investors out of joint ventures, up to and including the use of force by the Russian side. Several Western companies have abandoned and walked away from multi-million dollar investments because of the deteriorating business environment. IMF officials and financial experts agree that a competitive business culture needs to be established before Russia can increase its economic efficiency and capital accumulation.

Before Russia takes out huge IMF loans it has no hope to repay in the near future, drastic reform of the national economy and its institutional and legal frameworks is necessary, including:

• 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. 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 monopolitistic utilities (gas, electric power, district heating and railways). Similar to PEMEX, the Mexican oil monopoly, the Russian gas giant Gazprom is a state-dominated entity. Its financial statements are opaque, and its shareholders are at the whim of its top management. The same goes for the national electric utility, RAO UES, 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 to foreign investment can make these sectors efficient and competitive.

• Urban land and real estate reform; housing market liberalization; promoting agricultural privatization. A hundred years ago, Russia was an agricultural superpower, efficiently competing with the U.S. In 1897, 50 percent of Europe’s grain and 25 percent of its eggs 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 because 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.

These are just some of the most urgent policy reforms that need to be implemented. Others 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.² The governments of both Prime Ministers Chernomyrdin and Kirienko were fully aware of this priority list. In Kirienko’s case it might be argued that he didn’t 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.

Russia’s economic troubles did not start yesterday and cannot be resolved overnight. The resistance to the reform should not be underestimated. The Russian Duma has not¾ and is not likely to¾ adopt the IMF sanctioned reform agenda even today. For the Duma’s communist majority, in Vladimir Ilyich Lenin’s words, "the worse, the better." Elements in the parliament are already pressing the Russian government to back-pedal on promised budgetary cuts and increase domestic spending.

The devaluation and debt moratorium amount to an expensive policy debacle for both the IMF and the Russia leadership. Russia’s dollar exposure was increased while the national currency was devalued, making it three times more expensive to repay the debt. Devaluation and the resultant price hikes may still create devastating social and political consequences for Russia.

Since 1992 (before the most recent $22.5 billion bailout), the IMF gave Russia over $18 billion. In each case, the IMF demanded that Russia adopt the necessary economic reforms. But despite defaulting on its promises, Russia 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.

National Security and International Aid to Russia

To date, the Clinton administration has attempted to decouple national security issues involving Russia and IMF assistance to that country. It claimed that the 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 more eagerly supported lending to Russia than to other countries in similar predicaments, such as Ukraine; and the reason that the Administration put pressure on the IMF to bail Russia out 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 it collapses or becomes anti-Western, these weapons may be used to threaten or harm US interests¾ either directly, or by being sold to rogue regimes.

But this is not the only problem the U.S. is facing in Russia. Moscow is involved in strategic cooperation with the Islamic Republic of Iran and is supplying it with ballistic missile and nuclear technology. It supports Saddam Hussein and Slobodan Milosevic. It has refused to sign the START II treaty yet insists on U.S. compliance with the obsolete ABM treaty, which denies America the ability to deploy anti-ballistic missile defenses. This anti-Western policy package, termed "the Primakov Doctrine" in my December 1997 Heritage Foundation article, 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 are 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 considering the dire economic straits Russia is in.

The following are issues that Russia needs to address if it is to continue to receive support and co-operation from the West.

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

• Abandoning nuclear modernization. The Kremlin is implementing an expensive nuclear modernization program, including research and construction of the next generation of intercontinental ballistic missiles TOPOL-M2 (SS-27), building new, fifth generation 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 involved in building the largest bunker facility in the world, believed to be necessary for the prosecution of nuclear war.

• Stopping ballistic missile and nuclear technology transfer to Iran. Despite numerous promises by President Yeltsin and Prime Minister Chernomyrdin to the contrary, Russian companies have supplied vital components for the Iranian ballistic missile programs in violation of the H.R. 2709 Iran Missile Proliferation Sanctions Act vetoed by President Clinton on June 23, 1997. It has also supplied two civilian nuclear reactors which have potential military uses. Thousands of Russian engineers are working in Iran.

• Abandoning support of Saddam Hussein. Russian help and support in the United Nations Security Council is vital to Saddam Hussein’s continued arrogance and bullying. This support stems from the personal friendship between Saddam and the Russian Foreign Minister Primakov that goes back decades¾ to the 1960s.

Other important foreign policy issues include 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 include these issues in future discussions with the Russian leadership.

To conclude, the Russian financial crisis demonstrates the failure of the IMF toward Russia on three levels. First of all, an inadequate risk assessment was clearly conducted concerning the loan beneficiary. Risk assessment is something every banker undertakes even when disbursing a much smaller loan. The IMF has overestimated the growth rate of the Russian GDP every year since 1994. Secondly, the IMF committed to the lending package, betting that the Russian government would put policies in place that it either could not or would not implement. This is equivalent to misreading the business viability of a loan applicant by a banker. Finally, the IMF made deals with individuals, such as the former Prime Minister Sergei Kirienko and debt negotiator Anatoly Chubais, who then proceeded to disappear from the political scene¾ without the IMF being able to secure their stay. This was as if a large company lost its top management immediately after a bank loan had been made. Thus the IMF failed in its due diligence procedures and violated its fiduciary duty to the shareholders¾ its member governments, and to taxpayers who finance these governments, which fund and support IMF lending policies.

Russia is left now in an economic morass. The only achievements of the Yeltsin administration¾ stable currency and a low inflation rate¾ have gone down the drain. The political price for the future of democracy and open markets in Russia will be tremendous, as millions of workers and pensioners have not been paid for months. Prior to the August 17^th devaluation, Russia had asked if the international community was prepared to provide some additional financial support beyond the $22.5 billion promised on July 13^th. The G7 has thus far has refused to provide additional assistance¾ but now there is increasing talk about new bailouts.

There is certainly enough blame available in the Russian fiasco to go around. However, the reasoning¾ or lack thereof¾ behind certain key decisions at critical periods in the development of the current crisis needs serious reconsideration. When asked at a July 13^th press conference if the relatively low liquidity of the IMF would prevent the organization from engaging in new lending, IMF Treasurer David Williams responded, "[A]s Mr. Fischer said, we never say no." This policy lies precisely at the heart of the problem.

It is up to the Russian leadership and the Russian people to resolve the multiple crises it finds itself in. Only facing reality and administering the necessary, albeit bitter, medicine¾ not the IMF’s anaesthetics¾ holds out any hope for Russia’s economic revival. As Dick Armey, the Majority Whip in House noted in the June 2 "Dear Colleague" letter, by not approving the IMF supplemental, the U.S. Congress may help break the bailout psychology. In addition, the West can and should help with advice and support. This includes academic and professional training, the support of institutional development of markets and civil society, pro-market and pro-democracy policy work by business associations, think tanks and universities, exchanges and conference activities. Russia’s integration into the international economic community should remain an important goal for the West, with the hope that Russia will become more stable, more supportive of the international status quo and more prosperous if it succeeds.

Russia is playing a tremendously important role as the main test case for 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 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 U.S. should continue to be engaged in trying to turn Russia around. But we should do it while relying on incisive economic and political analysis and creative solutions¾ not the failing policy of throwing money at Russia’s economic black hole.

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¹Stanley Fischer, "The Russian Economy at the Start of 1998." http://www.imf.org/external/np/speeches/1998.010998.htm

²Ibid.