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THE RUSSIAN CRISIS: BY NO MEANS A UNIQUE EVENT
The third issue of the Economic Survey of Europe published by the United Nations Economic Commission for Europe (UN/ECE) provides in its chapter 1 an overview of economic developments in 1998 and discusses at length the policy implications of the Russian crisis. It also suggests some preliminary steps forward. Chapter 2 discusses the economic situation in more detail in the western market economies and in the transition economies of eastern Europe, the Baltic states, and the CIS. Particular attention is given to an analysis of the origins and unfolding of the Russian crisis and its impact on other transition economies. Chapter 3 reviews international trade developments in eastern Europe, the Baltics and the CIS; and chapter 4 looks at the development of current account balances and their financing, especially in the wake of the Asian and Russian crises. Chapter 5 examines the attempts to create a system of Production Sharing Agreements in Russia which, in their promise and relative failure, illustrate at a micro-level many of the problems which have held back the reform of the Russian economy. Finally, the Survey contains a Statistical Appendix containing long time-series for the principal macroeconomic variables in the ECE member countries. These tables, as well as those in the text, reflect revisions and updates made by national statistical offices and available to the secretariat as of mid-November 1998.
Lessons of the Russian crisis
This issue of the Economic Survey of Europe devotes particular attention to the Russian crisis (pp. 7-13 and pp. 31-41). It concludes that the policy course that has been followed so far has led precisely to the present unpromising situation, and thus a fundamental reappraisal is necessary. The standard policy prescriptions which were followed in Russia turned out, given the institutional setting and the difficult initial conditions prevailing in the country, not simply to be ineffective, but to give increasingly perverse results which moved the country further and further away from establishing effectual free markets and stable government.
There is wide agreement that a major fiscal imbalance was the proximate cause of the present Russian financial crisis. But the persistent fiscal problem is itself the consequence of the grave, and the more fundamental problems of the process of economic and political change in Russia. Essentially, the crisis reflects major failures in the actual Russian transformation model. The Russian fiscal dilemma was made progressively more, not less, acute by the policy mix adopted in 1995, and the actual dynamics of the particular stabilization recipe in fact led to an increase in the budget deficit rather than its reduction. The perverse incentives generated by macroeconomic policy, moreover, were magnified by the deeply flawed privatization process which produced a private ownership structure which neither encouraged effective corporate governance nor the efficient allocation of resources.
Given the profoundly inappropriate character of so much of the Russian institutional infrastructure for the new market environment, disinflation turned out to be a more easily achievable goal, given the operational policy levers actually available to policy makers. The increasingly excessive emphasis on price stabilization necessitated increasing monetary austerity as the commitment to what became, in effect, an exchange rate anchor, involved a further policy commitment to high interest rates. To help complete this particular vicious circle, the higher interest rates raised the cost of debt service, and thus increased the fiscal burden. This process ruled out a return to growth, and fixed investment has continued to fall throughout the entire period.
Whilst there is little doubt that there has been some concealment of corporate profits, particularly in light of the continued complex and arbitrary tax structures, aggregate corporate profits have actually fallen. Enterprises and regions increasingly resort to monetary surrogates and barter, further extending the demonetization of the economy. All this has continued to shrink the tax base. The issue of non-payment of taxes by the important energy sector further reveals the unusual character of the Russian fiscal dilemma. The popular perception that arrogant oil and gas barons were simply unwilling to pay the taxes they owed needs some correction. In the complex Russian tangle of non-payment, the government also came to demand effectively that energy be provided free of charge (that is, with no disconnection for non-payment) to a substantial proportion of users.
In sum, the path taken in an attempt to restore fiscal balance in Russia since 1995 has proved to be counterproductive and, in the end, has resulted in a disastrous financial and political crisis. In this unpromising atmosphere, it is easy to be paralysed by the sheer scale of the problems, yet positive first steps can lead to others, provided that there is an overall sense of direction. The greatest source of disorientation, however, has come from the belief that economic policies can be advocated in an institutional vacuum. A critical lesson which emerges yet again from consideration of the Russian crisis is that active assistance in the creation of appropriate institutions should never have been relegated to the rank of "second-generation" transition issues.
The implementation of any set of economic policies must perforce be done through institutions, the state and its public administration. Arguably the most serious consequence of the "policy overshooting" on transformation issues was the widespread and deliberate downgrading of the role of the state. Even for the establishment of an effective fiscal administration, there will be little progress without the creation of a professional civil service, a functioning public administration, and the development of broader societal attitudes regarding the legitimacy of the state and of its right to levy taxes. It is evident that the gap which must be bridged in this respect is substantially greater for Russia and other countries of the CIS than for most of the states of central and eastern Europe.
The Survey argues (pp. 10-11) that the policy impasse, however desperate it may appear at present, can be broken by articulating a coherent and long-term strategy to tackle these myriad problems. A carefully sequenced programme is needed in which high priority must be given to creating the key institutional foundations of the market economy and for changing the structure of incentives so as to encourage entrepreneurship and fixed investment. The precise content should be decided by the Russians themselves, but it must be designed to convince the G-7 and the Russian public of the credibility of the strategy and therefore attract the necessary financial and popular support for the programme. This will be costly B but there are no qUick solutions, and further delay will be even more costly.
The Russian crisis is by no means a unique event. Recent cases of economic distress in other transition economies (for example Bulgaria, Romania and some of the CIS countries, especially Ukraine and the Republic of Moldova) in fact have much in common. The 1997 exchange rate crisis in the Czech Republic although not so acute and devastating was also symptomatic of important, transformation-specific economic weaknesses and was followed by a painful economic downturn. A common feature is that the causes of these crises are deep-rooted in the microeconomics of transition. The principal microeconomic factors that have led to macroeconomic distress during the transition are often related to market distortions and/or the malfunctioning of markets; perverse incentives and the perverse behaviour of economic agents; weak or poorly functioning regulatory, judicial and other state institutions; weakness and poor regulation of the banking system; and inherent inefficiencies in the corporate sector of the economy. The lesson here is that without microeconomic reforms macroeconomic stabilization is likely to be short-lived and may even produce perverse effects; but without a reasonable degree of macroeconomic stability, the micro-reforms may not be undertaken.
Russia's experience has once again highlighted the daunting policy task of restructuring and rehabilitating the corporate sector in many transition countries. The lack of satisfactory progress in structural reforms in some transition economies, especially in dealing with unviable enterprises, has often been due not so much to a lack of understanding of the problems and an absence of "political will" to address them, but to the very severe political and resource constraints stemming from the sheer magnitude of the required restructuring effort. The existence of a large, critical mass of unviable firms is a major stumbling block to the successful implementation of the whole transformation policy agenda. Its restructuring will continue to require special efforts not only by national policy makers but also by the international community at large.
The global context
Recent developments in the global economy have prompted a more pessimistic assessment of short-term economic prospects in the ECE region. This reflects in the main the recession in Japan and the Asian emerging markets, which has turned out to be much deeper and longer-lasting than expected earlier this year. The crisis in Asia was transmitted to the rest of the world via the steep fall in domestic absorption in the region and the adverse change in financial conditions facing emerging markets.
The sharp fall in international commodity prices in 1998 is also largely due to the crisis in east Asia. Falling commodity prices have improved the terms-of-trade of the developed market economies, thus supporting growth in real incomes, but increasingly their exports have been negatively affected by the reduced import capacity of the commodity exporters.
In contrast to Asia, Russia's role in world trade is very small, and the deep crisis there has affected other regions mainly through the financial channel, with significant adverse trade effects limited in the main to some of the transition economies. Essentially, the Russian crisis has amplified the recessionary forces originating in Asia.
The international financial situation looked quite precarious for some time in late summer and early autumn, but fears of a global liquidity crisis appear to have receded in late October 1998 although further setbacks cannot be excluded.
World output is now forecast to grow by only 2 per cent in 1998, the smallest annual increase since 1991. This stands in sharp contrast to the optimism prevailing a year ago, when a growth rate of about 43 per cent was forecast. But at that time the impact of the Asian crisis on trade, profits and other economic variables was still difficult to gauge.
The western market economies
In the western market economies of the ECE region, the pace of economic expansion has lost momentum in the course of 1998. The pronounced strengthening of industrial and consumer confidence in the course of 1997 was partly reversed over the first ten months of 1998. Exports were increasingly affected by the weakening demand in Japan and developing countries, although this was offset by relatively robust domestic demand.
Real GDP in western Europe is now forecast to increase by 2.8 per cent in 1998, broadly the same rate as in 1997. In the United States, the annual growth rate is likely to be some 3.5 per cent this year, down from 3.9 per cent in 1997. The relatively favourable economic performance in western Europe and North America in 1998 contrasts with the deep recession in Japan, where real GDP is expected to decline by 2.5 per cent this year. Altogether, the rate of economic expansion in the dEveloped market economies will be only 2.2 per cent in 1998, down from 3 per cent in 1997.
The outlook for 1999 is currently very uncertain. Against the background of the recent turmoil in financial markets, the deep crisis in Asia and the lingering uncertainty as to whether financial stability can be maintained in Latin America, growth forecasts have been steadily reduced since the summer.
For western Europe, total output is now expected to increase by about only 23 per cent next year, about half a percentage point lower than the average of forecasts made in the spring of 1998. In the EMU area, aggregate economic growth will be only slightly higher than the European average. There are, however, considerable differences among individual countries. Of the four major economies, a pronounced slowdown in the growth rate is forecast for the United Kingdom, but a clear weakening of cyclical growth forces is also expected in France and Germany. In contrast, the expectation is still for relatively robust growth in the smaller economies.
In the United States, the broad consensus of forecasters is for a slowdown to an average growth rate of 2 per cent in 1999. A slightly higher output growth is expected for Canada.
In Japan, there are hopes that the recession will bottom out, but no significant growth, if any, is expected in 1999. Much will depend on the restoration of business and consumer confidence. A coherent policy designed to stimulate economic activity and to resolve the crisis in the banking sector is therefore primordial.
All told, economic growth in the developed market economies will be only some 1: per cent in 1999 compared with the previous year. This is the lowest growth rate since 1993.
These rather benign prospects for the industrialized countries, however, are surrounded by serious downside risks. A key assumption of all the forecasts is that there will be no further round of turmoil in the financial markets. It is assumed that economic performance in the emerging markets of Asia and Latin America will stabilize or even improve, if only slightly, in 1999. But above this scenario, the financial and economic crisis in Japan is still hanging like the sword of Damocles.
In western Europe, there are widespread concerns that the average growth forecast paints too optimistic a picture of likely economic developments in 1999. It should be recalled that these forecasts are mainly based on statistical information covering at best the first seven or eight months of 1998, i.e. the Russian crisis and its likely ramifications on economic activity can only be appraised, for the moment, in broad qualitative terms. In fact, recent short-term economic indicators appear to confirm the downside risks to the forecasts for 1999 noted in the Survey. If the cyclical slowdown turns out to be more pronounced than currently expected, this will be bad news for the labour markets of western Europe where even with the current optimistic forecasts, the average unemployment rate will still be around 10 per cent in 1999, only half a percentage point less than in 1998. A more severe slowdown would also mean that the expected gains in employment and incomes would be smaller than forecast, with negative feed-back effects to private consumption, business profits and fixed investment.
Although fears of a credit crunch appear to have receded in the United States, the lending behaviour of the commercial banks has become more cautious, as is reflected in a tightening of the credit terms on business loans. A major uncertainty concerns the spending behaviour of private households. Savings fell to a negligible proportion of disposable income in the third quarter against a background of continuing strong demand for loans. The strong rise in the spending propensity of US households reflects to a large degree the surge in financial wealth over the past few years, which, on paper, has offset the rise in debt stemming from rapid credit expansion. Equity prices in the United States still appear to be overvalued in view of the expected deterioration in corporate earnings in the latter half of 1998 and in 1999. There is a risk that any sharp and sustained fall in US equity prices could trigger a major downward shift in households' spending. This would also affect the cost of investment finance in the corporate sector. The combined effect would be a much stronger slowdown in the growth of domestic demand than is currently expected.
In the United States, the Federal Reserve has reacted to the recent financial turmoil and the deterioration in the economic outlook by relaxing, albeit moderately, the stance of monetary policy. In addition, the recent dollar depreciation, if sustained, should provide support to exports. A much stronger than expected cyclical downturn would also justify a change in the stance of fiscal policy.
In western Europe, the focus of monetary policy in most countries has been on the preparations for the forthcoming introduction of the euro and the shift to a single monetary policy which will be conducted by the new European Central Bank. In the spring of 1998, expectations were that the cyclical upswing in the EMU area would strengthen in the second half of the year and that therefore the ECB might have to raise interest rates to stem inflationary pressures. But the balance of risks has changed decisively in the course of 1998. Inflation has fallen to historic lows and there appears now to be an increasing probability that the cyclical upswing in western Europe could once again be negatively affected at an early stage by a deterioration in the international economic environment. The timing and extent of changes in the stance of monetary policy is often a matter of controversy, not least because of the "long and variable lags" involved before the measures are felt in the real economy. Outside the future Euro-area, concerns about the increasing risks of recession in the United Kingdom in 1999 led to a cut in the central bank's base rate in early October and early November.
The Survey argues that in view of the increasing risk that the growth of domestic demand will be less robust than expected and insufficient to offset a deterioration in export performance, a pre-emptive lowering of interest rates in the "core countries" of EMU before the end of 1998 or by the new ECB early in 1999 was warranted. (After the Survey was completed the central banks of France, Germany and other countries in the euro-zone lowered their interest rates on 3 December 1998, a move which appears to confirm these concerns about deteriorating economic prospects.)
Given the diverging cyclical positions of the EMU members, the easing of monetary policy, however, may require an offsetting tightening of fiscal policy in a number of the smaller economies. The dilemma, however, is that there is no room for manoeuvre for an expansionary countercyclical fiscal policy in the three large member countries of EMU because of the rules of the Stability and Growth Pact. This puts the full burden of adjustment to the deteriorating economic environment on monetary policy.
Actual budget deficits in some of the smaller economies are still not down to levels at which policy makers would be free from the constraints of the Stability Pact. There is agreement among European policy makers that budget deficits have to be reduced to near balance in order to create a sufficient cushion for the working of automatic stabilizers (or countercyclical policy measures) in the event of a serious cyclical setback. This requires either additional discretionary measures or a sustained period of rapid growth to boost government net revenues. A sustained period of robust economic growth is also what is required to lower cyclical unemployment and to create an environment more conducive to labour market reforms and for starting the urgently needed reforms of the national pension systems.
The cyclical slowdown now being forecast for 1999 could therefore be a source of conflict between European governments, which are committed to growth and lower unemployment, and the new ECB, which is focused on keeping the inflation rate below 2 per cent.
The ECE transition economies
In the first half of 1998 output performance in many ECE transition economies remained relatively strong and aggregate GDP in the region grew by 2.1 per cent which was more than in 1997 as a whole. However, taking into account the negative changes in the second half of the year, the aggregate outcome for the ECE transition economies for the whole of 1998 is likely to be zero growth of GDP or even a small decline. The main reason for this is the economic downturn in Russia which, taking into account the size of its economy, will also result in a negative rate of growth of the aggregate GDP of the CIS taken as a whole. In eastern Europe, despite some deceleration in the second half of the year, aggregate GDP for 1998 as a whole is still expected to grow by more than 3 per cent, while the Baltic states remain the fastest growing region in Europe with aggregate GDP expected to grow by almost 6 per cent.
The strong recovery which was underway in a number of central European and Baltic countries in 1997 and in the first half of 1998 was predominantly export driven. Exports from the east European and Baltic countries continued to grow in the first half of 1998 at some 11-14 per cent in dollar value - a rate which was comparable to that in the second half of 1997 - supported by buoyant west European demand. However, the value of total exports from the ECE transition economies declined slightly in the first half of 1998, following 4 per cent growth in 1997. This solely reflects the poor export performance in Russia and the rest of the CIS whose exports were badly affected by declining prices on world markets, an unfavourable trend which continued in the third quarter of 1998. One of the direct effects of the Russian crisis was a sharp decline in Russian imports which has had a negative impact on a number of transition economies (and which may also have longer-run negative effects if Russian demand remains depressed for a long time).
Rates of inflation continued to fall in most transition economies in the first three quarters of 1998. Compared with 1997, disinflation in 1998 was not only more widespread but also more rapid. Both domestic and external inflationary pressures weakened considerably. In the majority of countries restrictive monetary policies, and in some also a tight fiscal stance, dampened domestic demand. Wage inflation, except in a few of the smaller economies, also slowed down, albeit to rates still out-pacing price inflation. However, given the continued improvement in labour productivity, the growth in unit labour costs decelerated markedly in most transition economies. Furthermore, the weakening in import price pressures, which was already underway in 1997, became more accentuated.
In the first half of 1998, the slow employment growth of the previous two years decelerated further in eastern Europe and the Baltic region. In the CIS countries employment continued to fall, but at a slower rate. Registered unemployment rates, therefore, remained high in eastern Europe (11 per cent); in the CIS they increased further, but still remain very low compared with eastern Europe and given the cumulative decline in their output.
The impact of the global financial crisis on the current account balances in the ECE transition countries has been generally negative, largely because of its indirect effects. Current account deficits in relation to GDP on average remain high, in some cases at, or close to, double digit levels. The fall in commodity prices contributed to the transformation of Russia's long-standing current account surplus into a deficit in early 1998. The overall volume of capital flows into eastern Europe and the Baltic states in the first half of 1998 remained high; flows of foreign direct investment (FDI), which are more determined by long-term considerations, continued to rise, and for several months capital market activity partially recovered. As for the second half of 1998, there was a general deterioration in the conditions on international financial markets. The global "flight to quality" also substantially raised the cost of funds, essentially excluding most eastern countries from further borrowing. The activity of emerging market economies in the international capital markets came to a standstill again and there were sizeable outflows of short-term capital from several transition economies.
Two major external factors appear to be dominant for the short-term outlook for the ECE transition economies: the state of west European demand and conditions on the international capital markets. The high exposure of the ECE transition economies to foreign markets, while a mark of their integration in the world economy, is at the same time a source of vulnerability for the transition economies, even for the more advanced ones, in the short run. Preliminary and partial data already indicate a slowdown in the growth of exports from the transition economies in the third quarter of 1998 and this was also associated with a deceleration of industrial output growth in these countries. If this process continues or deepens, it would lead to a general and significant weakening of economic growth in the transition economies in 1999. While at this stage this can only be regarded as a "worst case" scenario with a relatively low if increasing degree of probability, it is important that policy makers be alert to the potential downside risks to the outlook so that contingency plans can be prepared to cope better and more efficiently with the consequences of a possibly sharp deterioration in the external environment.
The successful reconstruction of the transition economies depends crucially on maintaining growth and fixed investment, and a continuing inflow of foreign capital, especially foreign direct investment. A deceleration of these flows may slow the process of restructuring and recovery as well as lowering future growth potential. As a result of the deterioration of the situation on global financial markets some transition countries B especially those with structural problems and stalled reforms B may start to face difficulties in raising the funds necessary to cover their financial needs.
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