Source: Focus (Zurich)
Perspectives on post-communist transition have changed repeatedly. At first, it looked pretty hopeless with extraordinary crises all over. Then, shock therapy seemed to do the trick, and one country after the other started healthy economic recovery. Yet, few countries achieved high growth rates, and some countries stayed stagnant. Then, the Russian financial crash of August 1998 seemed to draw down the curtain over economic transformation in the former Soviet Union, and the post-communist world seemed divided into the successful Central Europe and the Baltics, on the one hand, and the failed Balkans and the former Soviet Union, on the other.
To start with the good news, few now contest the success of Central Europe and the Baltics. These countries have established fully-fledged market economies. Their inflation is in the single digits, and they have privatized at least 70 percent of their economies. Their bureaucracies might be slightly messier than in the West, but their corruption is reminiscent of Greece. All of these countries have had a foreign direct investment inflow of 10 percent of GDP at least one year, which is as much as any country can absorb.
Although these countries have registered significant growth, their growth rates remain far too low. Only Poland and Slovakia have recorded over 6 percent growth for three years. These countries suffer from being, what the leading Hungarian economist Janos Kornai have called, "premature social welfare states." Their public expenditures and taxes are too high, which hamper their dynamics. Yet, with average wages around $300 a month for a highly qualified labor force, all kinds of enterprises can benefit from investment in these states, and the Central Europeans are undertaking major social reforms must faster than Western Europe. The Baltics have already undertaken radical liberal reforms, such as introducing low flat income taxes. This year, Estonia has even abolished its profit tax, as it was a tax on honesty, initiative and entrepreneurship. These countries are bound to improve and advance, as they adopt EU standards in their EU accession process.
Further to the East, the situation is not that hopeless. The critical country is of course Russia. The mood was awful after August 17, 1998, when the Russian government devalued, defaulted on its domestic debt and declared a 90-day moratorium on foreign payments. Russia and the world were devastated. Within a week, President Yeltsin sacked the Sergei Kirienko government and the leadership of the Central Bank. The exchange rate plummeted three times. Russian output seemed in a free fall and inflation approached hyperinflation. An old-time partially-communist government came to power, and the reform efforts seemed to have come to a final halt.
However, everything has turned out differently from what virtually everybody predicted after the Russian crash. For the last year, Russia has had a growth rate of slightly over 7 percent, and also other countries in the region are growing fast. The Ukrainian economy is expanding by over 5 percent this year and the Kazakhstan economy by close to 10 percent. Inflation is under control in the whole post-Soviet region, with the Soviet theme park of Belarus being the sole exception. Russia is heading towards a huge trade surplus of almost $50 billion this year, and a current account surplus close to $40 billion. The Russia budget is in surplus. During the first half of this year, investment in fixed assets soared by 14 percent.
The conventional wisdom is that these splendid new developments are merely results of high oil prices and the large devaluation, prompting import substitution, but this view is no longer tenable. A fundamental qualitative change has taken place. The explanation is as simple as apparent: The financial crash of August 1998 delivered a shock to the Russian elite that it so well needed. Russia's problem was never too much "shock therapy," but on the contrary that the reformers were unfortunately to feeble so that they fail to impose both the necessary shock and undertake sufficiently radical reforms.
Yet, the reformers? efforts were still significant and not in vain. Even before the crash, Russia had undertaken almost as much reform as Latvia and Lithuania, according to the European Bank of Reconstruction and Development (EBRD). After all, Russia and Kazakhstan have privatized as large a share of their economy as they had. The mystery is why especially relatively-reformed Russia did not obtain real growth until last year.
Comparing with other post-communist countries, it is pretty easy to say why. The problem was that Russia had a small elite that wanted to make money on economic distortions during the transition, and they managed to do so for too long. Curiously, the problem was not that Russia is particularly corrupt ? it is not according to surveys by the EBRD, but that particularly large state resources were diverted to dubious businessmen. A World Bank study assessed total direct and implicit enterprise subsidies at no less than 16 percent of GDP in 1998. In order to finance their huge subsidies, unscrupulous dealers pushed for a large government deficit of around 8 percent of GDP, and, in their competition over corrupt revenues, they pushed their country into the abyss.
The financial crash was frightful. It devastated half the Russian banks and the savings of the burgeoning middle class. Yet, it did many good things. It altered the economic thinking of both the elite and the government. The basic cause of the crash was the persistently large budget deficit, and the government realized that it had to balance the budget and not promise more expenditures than it could afford. By refusing to bail Russia out in August 1998, the IMF clarified that even Russia faced a hard budget constraint in international finance. Bankruptcies caught on, and enterprise managers understood that they had better get paid, and barter that had been used to extract government subsidies rapidly shrunk. Until August 1998, the big oil companies Lukoil and Yukos had opposed legislation designed to attract foreign investors, for whom they saw no need. After the crash, on the contrary, they lobbied for conditions that would attract foreign investors, as they realized that they could not develop some new oilfields without foreign assistance.
Russian reformers had prepared a full-fledged tax reform by early 1997, but the long-time Prime Minister Viktor Chernomyrdin stalled it, as his energy lobby was not interested in paying normal taxes. Under Prime Minister Sergei Kirienko, some liberal tax laws were adopted just before the crash, and this summer most of the rest has been adopted, although the tax cuts have become more radical over time. In particular, Russia has introduced a flat income tax of 13 percent, which undoubtedly will reduce the underground economy. Since few paid the old progressive income tax, tax revenues just cannot fall.
Most of the enterprise subsidies had been disbursed by regional governments. In July 1998, Prime Minister Sergei Kirienko tried to rein them in, but the Duma refused to transfer any regional government revenues to the federal government, leaving the regional subsidies intact and the federal deficit bloated. However, federal state revenues have increased from11 percent of GDP in 1998 to 18 percent of GDP during the first half of this year, so the federal government has seized the resources it needed, while enterprise subsidies have been sharply cut, which benefits the economy. Therefore, President Vladimir Putin managed to check the power of the previously so powerful regional governors with surprising ease this summer.
The tax reform and the reform of the regions were arguably the most important issues on the reform agenda for Russia this year, and both have been done. Such a legislative momentum is not easily stopped. Last December, the Russian Duma got a non-socialist majority for the first time, and it has persistently voted for sensible legislation. Even the Communist Party revoked its anti-market stand before the parliamentary elections.
The election of President Putin has meant that a group of young radical economists and lawyers from St. Petersburg have taken over economic policy making, and they enjoy excellent relations with legislators. By and large, Putin wants new and younger people, and this change of staff provides in itself a necessary discontinuity and a reinforcement of purpose. The new government has adopted a substantial economic reform program, including government reform, land reform, all kinds of social reforms and much more. Set-backs are inevitable, but the Russian situation has changed fundamentally. We are probably seeing a new politics of growth rather than the old politics of redistribution of state subsidies.
This means that investors need to take a new look at Russia. Nothing succeeds like a resounding failure, if people learn the lessons. This time around, foreign direct investors are likely to take the lead, while equity investors remain wary of all the money they lost in 1998. Russian growth is likely to turn several neighboring countries around as well. Ukraine is lagging behind in reforms, but it has seen many positive developments this year as well.