The Roots of the August 1998 Crisis

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August 1998and

The Development of Russias

Post-Communist PoliticalEconomy



y Russias experience of financial crisis has been novel:crisis was followed by growth rather than depression,and did not lead to any increased role for foreigneconomic agencies or actors in Russias economy

y This novel experience resulted from the structure of Russias economy in the 1990s, the limited role of financial intermediation in the Russian economy andrising oil prices

y Consequently, the chief outcome of crisis has beenpolitical, the renewal of central political authority anda reining in of major economic interests



y This has helped to solve the problem of state finances, which was the source of the 1998 crisis, but neithereconomic growth nor increased central politicalauthority have managed to deal with the problem of

capital deficiency in Russia so that it remainsdependent on energy exports to continue growing

y Potentially, this leaves Russia exposed to resourcecurse problems.

y While these have been avoided so far, the absence of constraints on political leaders might lead to suchproblems in the future



y This paper explains Russias post-crisis development by arguing that crisis was both caused, and its economiceffects ameliorated, by the structure of the Russian

economy and its demonetization during the 1990sy This demonetization consisted of, first, the use of

monetary substitutes or surrogates such as bills of exchange, promissory notes, barter or payment in kind

instead of money in exchanges between producers andcustomers, memployers and labor, taxpayer and thestate, in place of rubles



y This meant that there was considerable continuity betweenSoviet and post- Soviet economy: economic activitywas notcommercialized, and subsidies and unprofitable economicproduction continued

y Second, demonetization meant that the post-SovietRussian economy did not develop an extensive system of financial intermediation

y As a result, one of the main economic legacies of centralplanning, the shortage of investment resources relative to

demand and what was needed to modernize the economy,and a consequent underdevelopment of credit andfinancial liquidity, was not tackled after 1991



y Demonetizationmeant that the Russian state struggledto avoid economic crisis throughout the 1990s

y Central political authorities fought to gather taxes and

raise revenue and were resisted by the tendency of local authorities and enterprises to use barter,payment in kind etc. to support economic continuity

y Equal to any economic impact of August 1998 was its

effect on Russias internal political balance



y The changes in Russias internal political balanceproduced by crisis enabled greater state control overthe economy

y However, neither the states new authority over theeconomy nor economic growth have resolved thefundamental structural problems of the Russian

economy, namely that it is energy dependent andcapital deficient, with a low level of monetization



y Central political control has developed under Putinrather than the capacity of the state to manage theeconomy

y The Russian state has not got the administrativecapacity to develop or manage a regulatory frameworkthat can stabilize its relations with powerful economic

groups and is unable to manage the economy in any other way other than by the coercive domination of major economic interests



THE ROOTS OFTHE AUGUST 1998

CRISIS



y Russian adapted to follow neo-liberal policy prescriptions at the and of the 1991 and reform waslaunched with the liberalization of prices in 1992

y Reform was soon heavily contested and opposition was too great



Attitudesof Yeltsin against

Argument Y eltsin maintained

credible

commitment to

reform and gurantee

his own politicalsurvival

He compromised on

both reform policy

and the composition

of the government



These compromisescreated a looming fiscalcrisis for the Russian

state throughout the1990s as the failure of economic reform meantthere was nostabilization of staterevenues or expenditure



This crisis was shaped by the structure of the theRussian Economy.

The bulk of the Russianeconomy, that is most of its manufacturingindustries, becamedemonetized and

dependent on resourcetransfers from the energy sector to subsidizeproduction



Oligarchs

Those sections of the economy not

demonetized were where Russia had a

revealed comparative advantage, the energy

and metals sectors of the economy

These sectors became linked with Russias

commercial banks from the mid-1990s to

create a group of economic actors who have

been labeled oligarchs



y Y eltsin regime could not stabilize the relationshipbetween these two parts of the Russian economy, thedemonetized and resource dependent, and the

oligarchic, and the state or get either to supportmarket reform

y They both squeezed the state financially



y Central political authorities were unable to halt thisdrain on the state budget.

y Over time the drain got bigger as those sectors that were not demonetized had an incentive to act in the

same way as the demonetized sectors and delay oravoid tax payments.



y First, it was to push the state to try to back up its poordomestic revenue collection by seeking funds fromabroad. This was to tip Russia over from imminent to

actual crisis in August 1998y Second, it laid the foundation for the political changes

that were to follow August because it meant that therelationship between central political authorities and

big business interests was already under stress on theeve of crisis.



y Demonetization was a complex process but at its heart was a structural deficit of credit and capital inheritedfrom the USSR

y This was caused by the high demand for investmentinherited from the Soviet system, where soft-budgetconstraints and inefficiency in resource allocation andusage created high rates of investment

y Russia thus inherited an economic system from the

USSR that was accustomed to significant inputs of capital and used to operating without accounting forthe use of capital or improving the efficiency with

which capital was used



y The collapse of the Soviet economic system meant thatthe supply of cheap capital and credit economy dried

up

y Russias reformers also took money out of the economy through subsidy cuts and the nascent banking sector

favored financing arbitrage and currency speculationrather than extending loans to industry



y The combination of Soviet collapse, reformist subsidy cuts and the preferences of the financial sector to fundtrade rather than production meant that enterpriseshad to use another Soviet legacy, relational capital, the

good will inherited from relationships developedunder planning, to support economic activity

y It enabled resistance to reform by subvertingcommercialization (seeking profit through cost

management, reaction to prices etc.), and was centralto demonetization as the use of monetary substitutesdepended on negotiating the acceptance of monetary substitutes



y Trust built-up in the Soviet era greased the wheels of this negotiation so that production could bemaintained in spite of costs and recreated subsidies

and soft-budget constraintsy Soft-budget constraints persisted as state and labor

were deprived of income through simple non- ordelayed payment of wages and taxes, or as payments

were made in kind, through tax offsets or by promissory notes



y The value of these payments in kind/offsets/notes was set at a rate higher than the value of the goodsproduced and traded

y

In thisway, loss-making activitywas hidden, the lossbeing born by labor or the state through fallingconsumption and decreasing tax revenues

y By 1997, some 40% of all tax revenues paid to the

central state was in kindy Subsidies persisted through transfer of value from the

energy sector to industry



y The transfer of value from the energy sector to the rest of the economy was centered on Gazprom

y Gazprom and other energy firms received tax concessions which further denied the state revenue

y

Regional governments colluded with enterprises by allowing the payment of taxes in kind and pressuringenergy companies to take payment in kind

y Firms that were making goods that could be sold at a cashprofit had an incentive to join in behaviors developed indemonetized sectors because paying taxes and bills in kind

at inflated pricesmeant that they could divert any money they made to other profitable uses such as buyinggovernment debt



y Demonetization was thus self-reinforcing; it sucked inmore and more sectors and enterprises as firms eithertook the decision to join in, or were forced to do so by

trading partners

y This meant that while there was a form of capital flowto enterprises in the shape of value transfers from

energy firms there was very little actual investmentin the economy or restructuring of economic activity



y Indeed, demonetization and the opacity in economicactivity that it created inhibited restructuring by blocking foreign investment investors could not

distinguish where profits could be made in ademonetized economy and hid areas other thanenergy and metals where Russia might have had acomparative advantage

y As a result, foreign direct investment in Russia duringthe 1990s was small and heavily skewed towards theenergy and metals sectors



y Pressure on the budget helped create the oligarchicstrand of the Russian economy

y Russias oligarchs were formed by two policies

developed to deal with the fiscal effects of demonetization

y The government first passed over control of thoseindustrial sectors where Russia had a revealed

comparative advantage, and second, accessed theresources that the banks accumulated in the early 1990s through the short-term government debt market



FROM DEMONETIZATION

TO

A RESOURCE CURSE?



y The actions of the government after Y eltsins 1996 re-election in trying to improve tax collection and thefocus on the FIGs(financial-industrial groups) had

already presaged a time when the state would changeits relationship to the economy

y The crisis added stress by throwing in to doubt Y

eltsins ability to provide concessions and controlaccess to power



The government of

Sergei Kiriyenko

resigned and a more

independent government

under Y

evgeny Primakov was appointed



Primakovs appointment

as Prime Minister, and

his better relations with

the Duma, gave the

impression that he would

be best placed to succeed

Y

eltsin at his scheduledretirement in 2000



y Regional political leaders saw Y eltsins weakness as anopportunity to organize independently and maximizetheir bargaining power over the choice of his successor



y Y eltsin, however, was able to reassert himself politically andcontrol the succession process so that the effect of the August 1998 crisis was to separate the politics of Y eltsinssuccession from elite interests

y The divide between government and parts of the businesselite (although this was not yet as strong as it was tobecome later under Putin), and the weakening of thecenters control over the regions that the crisis exacerbatedor created either neutralized or made these forcescompetitors in the succession struggle, rather than parties

that negotiated the result of that struggle as they hadnegotiated to ensure Y eltsins 1996 re-electiony Y eltsin dictated who was to succeed him rather than

brokering a succession deal



y In the absence of negotiation he was forced to find asuccessor from within his administration eventually choosing V ladimir Putin and use the extensiveformal powers of the presidency to reclaim somedegree of control over the political process

y Y eltsins ceding of authority to him, developed abandwagon effect that swamped the efforts of hisrivals



y Putins hard line towards Chechnya helped as war

restarted there at the end of September 1999, as didthe shallow impact of the 1998 crisis on Russianindustry



Putin WonthePresidency

The net effect of these

changes was that Putin won

the presidency in 2000

The only real question was

whether Putin would securea first-round victory, which

he did in which Putin made

no promises to any group,

voter or vested interest, to

win, but did talk about

liquidating the oligarchs as aclass, echoing the Stalinist

threat to rich peasants from

the late 1920s



y Free of campaign debts because the political fallout of the August 1998 crisis had divided the Kremlin fromRussian elites, Putin was able to begin the reassertionof central state control very quickly after his election

y He reined in regional leaders and began to attackoligarchs with media interests, particularly VladimirGusinsky and his Media-Most group, and BorisBerezovsky, who had a 49% stake inObshchestvyennoye Rossiskoye Televidyeniye (ORT),the main Russian TV channel



y Action against oligarch media interests wasaccompanied by the opening of investigations in to theprivatization and tax payments of other FIGs

y Together, the investigations and the takeovers of business media interests were a strong signal tobusiness leaders that the political situation had

changed, and not in their favor



y Putin made this signal even more explicit in a meetingheld with business leaders in July 2000

y Putin, whilst appearing conciliatory, warned them thatfurther interference in politics would no longer be

tolerated



y The growth of the central executive authority has not,however, created a state that has the ability to

transform Russia and has had only a minimal impacton economic growth

y Political changes lagged behind economic recovery



y Growth started before the first moves against oligarchsor regional leaders and thus helped complete thepolitical realignment that followed the August 1998crisis rather than the other way around



y Political realignment in favor of central political

authorities continued unabated across Putins twoterms as president but despite the numerous changesPutin made to the balance of political power, thecapacity of the state has remained low



y Corruption is still a major, and in some accountsgrowing, problem, and the overall effectiveness andcompetence of many state agencies is still low

y Changes in central executive power have thus notquickly translated into changes in publicadministration so that change has been more

rhetorical than actual as far as the state generally isconcerned



y They would be next, privately owned oil companies

reacted to the moves against Media-Most andBerezovsky by expanding production massively



y The export value of oil, gas and metals nearly doubledin dollar terms between 1998 and 2002

y

This was partly due to increased prices and partly dueto increased export volumes. Volume growth wasparticularly marked in 2000, the year in which Putinexpanded his power, when oil exports were 171.5% of

what they had been in 1999; this level of output wasmore or less maintained in 2001 and then expandedagain in 2002



y A large proportion of post-1998 growth was thus notplanned or balanced, but the result of a scramble by oligarch oil firms to cash in before property rights werelost

y State administration may not have improved but theability of political authorities to control elements of

the economy without opposition has grown.



y The states economic role has partly developed in orderto prevent opposition from consolidating

y Initial attacks on oligarch media interests helped tobuild-up presidential authority after Putins election



y There was an element of pure politicsabout the extension of the states

economic role the effect was, as in otherlate developing states, to substitutebureaucratic management of theeconomy for the development of state

capacity to manage market economicactivity by creating regulatory frameworks of law and bureaucracy

y This has led some analysts to describe

the development of Russia under Putinas heading toward a form of statecapitalism



y From 2005, state interference in the economy extendedbeyond the political logic of controlling the economy tostymie opposition

y

There were moves to curtail foreign investment throughlegislation; the blocking of the sale of companies likeSiloviye Mashiny (Power Machines, which producesequipment for the energy sector and nuclear power) toforeign firms; more state representatives were placed oncompany boards, such as the board of Avtovaz; Sibneft(Roman Abramovichs oil firm)was sold to Gazprom andthe state increased its holding and control of Gazpromitself



y Overall, state ownership of Russias equity market

capitalization rose from20% to 30% between 2003 andmid- 2006

The Roots of the August 1998 Crisis

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