The Chastening

by Paul Blustein

  The transition strategy the two institutions favored was “shock therapy,” which involved dismantling the Communist commandand-control system and liberalizing prices and markets as rapidly as possible, much as Poland had already done. Among the reasons for swift, radical change rather than gradualism was the decrepit condition of Soviet industry, a vivid example of which was a huge factory making ZIL trucks that a team of World Bank economists visited in 1990. The ZIL assembly line was producing vehicles that looked like 1950s models, and the real eye-opener came when the visitors went to the roof, where they saw thousands of trucks parked outside—painted either light blue, for commercial sales, or brown, for the military. “One of our guys commented on how large the inventory was,” recalled John Nellis, a World Bank private-sector specialist, “and one of the Russians who was guiding us said, ‘That is not inventory, those are mistakes’—things that came off the line so wrong, they can’t even be fixed. The idea that this system could be reformed with some tinkering around the margins seemed to us nonsensical.”

  The Western advocates of shock therapy found a highly receptive audience in the top officials Yeltsin picked to run the newly independent Russian Federation shortly after his famous stand atop a tank in August 1991, which thwarted an attempted coup d’état by hard-line Communists. Known as the “young reformers”—most were in their thirties—their leaders were Yegor Gaidar, a short, moon-faced intellectual who became finance minister and deputy prime minister; and Anatoly Chubais, a tall, redheaded former chief economist of St. Petersburg with ruthless skill as a political infighter. They were itching to bulldoze the state-run apparatus and establish Western-style markets together with a property-owning class that could serve as a bulwark against a Communist revanche. Nellis had these observations:When you went to Russia in those days, you met some extraordinary people. You could meet some dinosaurs, who were saying, “This will all settle down, all this fervor will die away, and we’ll reestablish socialist orthodoxy.” And you could also meet people like Chubais who were saying, “We have a small window of opportunity.” At that time, there were a lot of people in the parliament recommending daily that Chubais should be fired, and when someone asked him whether it bothered him, he said, “I try to act as if I have only two weeks left in office, so I have to think of what I can do in fourteen days to make sure the Communists never come back.” That was a lot more pleasing to us than the people who said, “We’re going to reestablish the Brezhnev regime.”

  The first hard Jolts of shock therapy coursed through the Russian economy shortly after New Year’s Day 1992, when the government ended controls over the overwhelming majority of prices, and soon thereafter Russians were allowed to establish private retail shops and import foreign goods. The next big step was privatization, in which the government sold some 15,000 factories and enterprises, employing nearly two-thirds of the labor force, from 1992 to 1994. Millions of Russians received vouchers from the state, which they could use to buy shares in newly privatized companies or, if they preferred, sell for cash.

  The resulting transformation of the Russian economy was dramatic, yet it was only a half-finished revolution. The majority of privatized companies remained under the control of their Soviet-era managers—known as “red directors”—because the voucher system gave special rights to an enterprise’s workers and managers to buy their firm’s shares. Many of these enterprises suffered from inefficiency, bloated payrolls, and outright theft by their red directors, yet few of them underwent the drastic restructuring they needed because the red directors had little desire to change the status quo. Furthermore, the institutions necessary for the proper functioning of capitalism—in particular, a legal system capable of enforcing contracts effectively and impartially—remained rudimentary at best.

  Meanwhile, as the living standards of ordinary citizens suffered, the young reformers found themselves on the outs with Yeltsin, who over the next few years would alternately hire them and fire them as his enthusiasm for reform waxed and waned. Old-guard apparatchiks who obtained positions of power managed to keep enterprises afloat by funneling them government loans and other subsidies—the predictable result being a towering budget deficit, an explosive rise in the money supply, and an inflation rate of 842 percent in 1993 and 224 percent in 1994.

  Led by Chubais, the young reformers made a bold foray in 1995 at putting the Russian economy back on the right track, and they got help in the form of a $6.8 billion loan from the IMF. The IMF program was aimed chiefly at taming inflation; the Fund’s long-standing doctrine holds that economic stabilization is an essential condition for economic growth—a sound principle, since in a climate of unstable prices, interest rates tend to be inordinately high and business firms tend to shy from expanding their operations. In accord with Fund demands, the Russians imposed strict limits over the printing of rubles and slashed subsidies by two-thirds, thereby shrinking the budget deficit from 10 percent of GDP to about 5.7 percent.

  The outcome was gratifying: Inflation quickly subsided, and in a potent symbol of the government’s commitment to stability, it pegged the ruble loosely to the dollar, ending a long and debilitating slide in the currency’s value. But once again, the success was adulterated. To help fund the government’s operations, and to win powerful allies for Yeltsin against the resurgent Communists, Chubais permitted rigged auctions to be held in late 1995 in which some of Russia’s newly rising business tycoons grabbed control of some of the state’s most valuable assets—huge mining and oil producing enterprises—at absurdly cheap prices. The winners of the auctions, known as the “oligarchs,” gained wealth and influence over government policy that would rival the caricatures of capitalist elites conJured up by Marxist propagandists during the height of the Cold War.

  The IMF essentially held its nose at this outrageous giveaway of public property and continued monthly disbursements of its loan. The auctions didn’t technically violate any of the program’s conditions, and as a Fund staff report noted at the time, the Russians were “fully complying with the quantitative targets of the program” in areas the Fund cared about most—namely, inflation and the budget deficit. “The realistic view on Russia is that outsiders’ ability to influence things is limited,” Stan Fischer said in explaining that decision years later. “You can move things in one direction or another. But you’re fighting huge domestic forces. We tried to use the leverage we had to move them in the right direction. Whether the West is better off walking away, whether the IMF is better off walking away—that’s a Judgment you have to make all the time. On balance, I think we tilted things in a better direction than they would have been otherwise.”

  The IMF’s tolerance for Russian transgressions underwent even more severe tests starting in 1996, a presidential election year in Russia. When the IMF approved a $10 billion program in March (the second largest, at the time, after Mexico’s), suspicions naturally arose that the Fund, by providing resources that Moscow could spend on government activities, was being used by the G-7 to help Yeltsin overcome a stiff challenge from his Communist opponent. IMF officials dismissed the criticism, arguing that the three-year loan, granted under the terms of the IMF’s Extended Fund Facility (EFF), was fully Justified on economic grounds. Russia’s macroeconomic results under its 1995 program had been splendid, they noted, and now the time had come to consolidate the gains it had made in stabilizing its economy. So the program contained a battery of conditions aimed at moving the economy to the next stage of reform, such as creating a modern banking system. It also contained tough targets for the budget deficit—4 percent of GDP in 1996, 3 percent in 1997, and 2 percent in 1998.

  But Russia’s performance made a mockery of the program’s ostensible purposes. Even after Yeltsin won reelection in July 1996, the government failed to deliver on promises to shore up tax collection and impose fiscal discipline. The deficit for 1996 ended up at 8.4 percent of GDP—more than double the target level—and for 1997, 7.4 percent of GDP. Although the IMF occasionally su
spended monthly disbursements of its loan, it usually granted waivers allowing Moscow to continue receiving the funds—in effect, easing the targets. To Justify these moves, Fund officials contended they were only showing realism and flexibility. Furthermore, the Clinton administration and the rest of the G-7 heartily backed the overriding strategy of nudging the Russians in a positive direction and helping the beleaguered reformers. Within the Fund’s private councils, however, officials such as Michael Mussa were voicing misgivings about the leeway afforded the Russians in late 1996 and 1997. “We kept lowering the hurdles; now we’ve dug a hole in the ground and buried the damn hurdles!” the Fund’s chief economist fulminated at one meeting.

  Behind the huge deficits lay a deeper problem—the warped manner in which Russian capitalism was functioning. Even though the government had cut off many direct loans and subsidies to enterprises in its effort to quell inflation, uncompetitive enterprises were still managing to stay in operation by using a vast web of dealings involving barter, finagling, and bribes. This system was aptly dubbed the “virtual economy” by American scholars Clifford Gaddy and Barry Ickes, because instead of buying and selling for cash at prices that reflected genuine supply and demand, Russian businesses and government agencies were conniving in all sorts of noncash transactions that enabled them to stave off factory shutdowns and unemployment.

  In this never-never land, factories “paid” their suppliers by swapping goods they made for the raw materials and inputs they needed—tractors for steel, for example, or plastic for electricity. Workers were often “compensated” with goods in lieu of paychecks; an underwear factory gave its workers brassieres, and a crystal factory handed out cartons of shot glasses on payday. The government “levied taxes” by obtaining goods it needed from companies—buses, say, or military uniforms—in exchange for documents that reduced the recipient’s tax liability.

  Theoretically, an economy can function reasonably well under a barter system, but not so if the prices of the goods being bartered diverge significantly from their true value. In Russia’s virtual economy, the “official prices” charged by enterprises in barter deals were invariably much higher than the prices at which they sold for cash (twice as high or even more in many cases), which meant the enterprises were only pretending to make products that were competitively produced and priced. Instead of adapting to the brave new world of the free market, Russian firms were insulating themselves from the market. Instead of restructuring and providing goods that people would willingly pay decent amounts of cash for, they were using other methods to obtain the resources they needed to continue operating—for example, persuading friendly officials at the state gas monopoly to provide gas in exchange for bartered goods. The gas monopoly, in turn, was willing to provide gas to keep the factories running because it could count on powerful politicians protecting it from having to pay taxes. This system was rife with opportunities for managers, middlemen, and government officials to enrich themselves in all sorts of improper ways, and it is small wonder that Russia became a hotbed of rent-seeking, organized crime, and capital flight.

  The IMF and World Bank tried to dismantle the virtual economy, or at least some of the more egregious parts of it. The Fund demanded as a condition of its 1996 loan that Moscow stop issuing “KNOs,” or treasury tax offsets, by which government officials obtained goods and services their agencies needed by canceling vendors’ tax bills. But no sooner had KNOs been discontinued than officials began issuing a new type of tax dodge called a “monetary offset” (MO) that involved the use of banks as middlemen. And after the Fund shut down MOs as a condition of continuing monthly disbursements, the Russians came up with “reverse monetary offsets,” or RMOs, which technically complied with the conditions of the program but violated its spirit. The virtual economy, in sum, was more ingrained and systemic than the Fund realized, because the Russian body politic had become so wedded to it. The system flourished thanks to the failure to develop a healthy rule of law in Russia that might have protected the rights of creditors to collect their debts and forced unviable businesses to restructure or die.

  Amazingly, none of this seemed to matter much at the time, for emerging-market fever was catching on in Russia. In 1997, with inflation at a relatively low 11 percent, the ruble stable, the Communists vanquished, and the $10 billion IMF program in place, Russia became one of the world’s prime destinations for international portfolio managers looking for high-yielding paper to fatten their returns. Portfolio investment in Russia surged to $45.6 billion, or roughly 10 percent of the country’s $450 billion GDP. Russia-dedicated mutual funds sprang up and found themselves deluged with foreign cash as the stock market, which began 1997 with its main index below 200, peaked at 571 in October. Western investment bankers traveled to regional capitals such as Omsk and Yekaterinburg, where, having braved Russia’s notoriously rickety air transport system, they demonstrated even greater appetite for risk by making syndicated loans and snapping up the bonds of local governments. The flood of incoming money reduced the IMF’s leverage over Russia, and it also reduced the Russians’ incentives to take bold reform steps, but it continued nonetheless.

  By early 1998, downtown Moscow was brimming with new offices and planned expansions for the financial titans of Wall Street, London, Frankfurt, and Zurich. Credit Suisse First Boston, which employed 300 people in its Moscow operation, was getting ready to move into a new nine-story building near the Kremlin. Dresdner Bank unveiled an elegant Moscow mansion as the new headquarters for a Russia staff of 180. Deutsche Bank held a soiree at the sumptuous Metropole Hotel to celebrate its plans for turning its representative office into a full subsidiary, with a staff of about 150 offering a wide range of financial services for domestic and international clients. Merrill Lynch, which employed 25 people based in the glittery Marriott Hotel, announced plans to move into new digs to accommodate a doubling of its Moscow-based personnel.

  Reckless though they were, financial market participants may be forgiven for reaching the conclusion that the IMF would always bail out a friendly Russian regime so long as it demonstrated a minimal commitment to reform. Moral hazard may have been a poor explanation for why foreign investors thronged to emerging markets like Thailand and South Korea, but there was no gainsaying its importance in luring the Electronic Herd to Russia.

  Policymakers in Washington could only wince at the “too big, too nuclear to fail” syndrome that had taken hold among investors. In spring 1998, David Lipton attended the annual meeting of the European Bank for Reconstruction and Development, where, he recalled, he became “particularly alarmed” over a term he heard commercial bankers using. The bankers were referring to Ukraine, because of its close resemblance and proximity to Russia, as “the latest moral-hazard play.”

  Boris Berezovsky, the oligarch whose empire included oil refineries, airlines, and a television network, had injured himself in a snowmobiling accident, so he couldn’t meet Michel Camdessus when the IMF managing director visited Moscow in mid-February 1998. But most of his fellow oligarchs showed up at the central bank of Russia to hear what Camdessus had to say. Shocked over the speed with which financial crises had decimated Asia, the IMF chief wanted to spread the word among Russia’s elite that Moscow must show the markets its readiness to slash the budget deficit and rid the economy of pernicious practices. Russia was vulnerable, he warned the oligarchs, and since they were the country’s biggest property owners, it was in their interest to support economic reform and pay taxes on time and in cash. With Yeltsin, too, he was blunt. “Mr. President, I’ve Just come from Indonesia,” Camdessus said. “And I want to tell you, what I’ve seen there can happen here.”

  Russia’s weak point was different from Asia’s. Whereas the Thai, Indonesian, and Korean crises stemmed from the debt incurred by private banks and companies, Moscow’s problem was its government budget deficit, which had totaled $33 billion in 1997. But like the Asian-crisis countries, Russia had become hooked on short-term foreign capital. Specif
ically, Moscow depended on foreigners to buy large quantities of its GKOs.

  On behalf of the GKO, this much must be said: It was preferable to the alternative. Russia needed a way to cover its deficit without printing large quantities of rubles, which would rekindle hyperinflation. So the government, as part of its anti-inflation drive, began selling GKOs in substantial volumes to investors in 1995, and with IMF encouragement, it loosened the rules in 1996 and 1997 to allow foreigners to buy and sell GKOs freely.

  Big-time financial crapshooters at foreign hedge funds, brokerage firms, and commercial banks were heavily invested in GKOs, to the tune of about $20 billion in early 1998. The chief attraction was the yield, which offered returns in the 20-30 percent range (on an annualized basis) during this period, and the short maturity—often three months—which made the risk seem low. The downside for investors was that interest and principal were payable in rubles. But Moscow had succeeded brilliantly in holding the ruble stable against the dollar since 1995, and the government attached top priority to keeping the currency fluctuating within a band around 6.2 rubles per dollar. In many respects, GKOs were similar to the high-yielding, fixed-currency deals offered by, say, Thai bank certificates of deposit that international investors found so irresistible during Thailand’s heyday of foreign capital inflows. They would pay off beautifully—as long as the country wasn’t forced to devalue. And they had an added, uniquely Russian enticement—namely that the IMF appeared to view Moscow’s financial soundness as a matter of the utmost importance.