Russia's virtual economy.

Clifford G. Gaddy, Barry W. Ickes

The immediate causes of Russia's current financial crisis are clear--a large budget deficit and an inability to service the debt, especially short-term dollar liabilities. Equally straightforward steps to solve these problems have been widely proposed. Moscow is being asked to reduce its budget deficit by collecting more taxes and cutting spending. International financial organizations and Western countries in July pledged an emergency loan package of $17 billion to stabilize the immediate financial crisis and restructure the short-term debt. These measures, it is argued, will allow the government to get back to the business of market reform.

But such measures cannot remedy Russia's economic problems. They are premised on a fundamental, but nearly ubiquitous, misunderstanding of the Russian economy, which goes something like this: Russia showed early success in market reform, but progress has been slowed by widespread corruption, crime, and incompetence. The explosion of barter arrangements and nonpayment of wages and taxes is due to faulty management of enterprises. Poor tax collection has weakened the state. Overcoming these obstacles is a formidable challenge, but if they can be surmounted, movement toward the market can continue.

In fact, most of the Russian economy has not been making progress toward the market or even marking time. It is actively moving in the other direction. Over the past six years, Russian companies, especially in the manufacturing sector, have indeed changed the way they operate, but to protect themselves against the market rather than join it. What has emerged in Russia is a new kind of economic system with its own rules and its own criteria for success and failure.

The new system can be called Russia's virtual economy because it is based on an illusion about almost every important parameter: prices, sales, wages, taxes, and budgets. At its heart is the pretense that the economy is much larger than it really is. This pretense allows for a larger government and larger expenditures than Russia can afford. It is the real cause behind the web of wage, supply, and tax arrears from which Russia cannot seem to extricate itself.

The virtual economy is robust, deep-rooted, and broadly popular. For those reasons, it has defined a new reform agenda basically aimed at preserving current arrangements. The virtual economy presents the West with difficult choices regarding continued support of Russia's economic transition. The principal motivation for providing bailout funds is a belief not only that more money is required to preserve social and political stability but that strings can be attached to induce more reform. The opposite, however, is true: a bailout will prop up the virtual economy, which is fundamentally not market-based and whose inefficiency will ensure continued economic decline and further crises. A bailout will merely postpone the day of reckoning. When that day comes, the economic consequences and political backlash will be even worse.

REALITY AND PRETENSE

A close reading of the statistics reveals the reality of the Russian economy. After 8 years of decline, according to the State Statistics Committee, industrial output grew by 1.9 percent in 1997, and GDP increased slightly. But to stop there is misleading. Real profits in industry were down 5 percent last year. Nearly half of industrial enterprises reported losses, up from fewer than 27 percent in 1995.

Fixed capital formation also reflects the economy's true straits. Capital formation fell last year for the seventh year in a row and continues to decline this year. In 1997, overall capital investment in the economy's production sectors--industry, agriculture, transportation, and communications--fell to just 17 percent of the 1990 level. In the core manufacturing sector of metalworking and engineering products, spending on plant and equipment in 1997 was no more than 5.3 percent of what it was only 7 years earlier.

Very few negative signals are being sent about this state of affairs. Bankruptcy is still a rarity. There are more corporate bankruptcies in the United States in a typical month than there were in Russia during all of 1997. It might therefore appear that despite its lagging performance, nothing is changing in Russian industry. But on the contrary, in 1997 Russian companies had more workers on the payroll at the end of the year than at the beginning.

On top of these problems is the notorious payments arrears crisis. This is a familiar story: enterprises do not pay their suppliers, workers, or taxes. While nonpayment of taxes and wages attracts media attention, it is not the real story. Payments are being made, just not in cash. The share of barter in payments among all industrial enterprises in Russia has now reached more than 50 percent. Last year, 40 percent of all taxes paid to the Russian federal government were nonmonetary. In local and regional budgets, the degree of nonmonetary payments was even higher.

The problem is most widespread in the large enterprise sector. Last year the Karpov commission reported that the country's largest companies conducted 73 percent of their business in barter and other nonmonetary means. Even more remarkable was the way these large enterprises dealt with the tax authorities. They paid 80 percent of the taxes they owed to the federal government--not a bad figure--but only 8 percent in cash. The report summed up the commission's conclusions about the current Russian economy as follows:

An economy is emerging where prices are charged which no one pays in

cash; where no one pays anything on time; where huge mutual debts are

created that also can't be paid off in reasonable periods of time; where

wages are declared and not paid; and so on... [This creates] illusory, or

`virtual' earnings, which in turn lead to unpaid, or `virtual' fiscal

obligations, [with business conducted at] nonmarket, or `virtual' prices.

In short, what has emerged is a virtual economy.

THE ROOTS OF THE VIRTUAL ECONOMY

The virtual economy originated in the largely unreformed industrial sector inherited from the Soviet Union. At its heart are many enterprises that produce goods but take away rather than add value. This sector has survived six years of market reform. The reasons are complex, but the most important is that enterprises can now operate in Russia without paying their bills. This is possible because value is redistributed to them from other sectors of the economy. One way this is done is through tax arrears, which are a form of continued budget subsidies. More important, however, is direct redistribution from the value-producing sectors of the economy, primarily the natural resources sector.

This situation is more a continuity with the past than a break from it. The Soviet economy appeared to be a large industrial economy, when in fact Soviet industry was subsidized by underpriced raw materials and capital. The economy appeared to have a large manufacturing sector that added value; in truth, manufacturing destroyed part of the value of the inputs it used, but arbitrary pricing kept it a secret. The roots of the virtual economy lie in the continuation of this pretense.

One way to understand Russia's economy is to adopt a simplified model that consists of only four sectors. First is the household sector (H), which supplies labor. Second is a government sector (G), which transfers tax receipts to households. Third is a value-adding, resources-producing sector (R). Last is the value-subtracting manufacturing sector (M), which encompasses the rest of the economy. Suppose M is a single plant that takes 100 rubles of labor from H and 100 rubles of resources from R and makes a product worth 100 rubles. It subtracts 100 rubles worth of value, but it pretends it is a value-adder. To do that, it overprices its output. It claims it is worth not 100, but 300. And everyone else accepts that pretense because they can use the overpriced output in barter with one another or to pay their own taxes.

M pays R for the resources by giving it one-third of its final product, claiming it is worth 100 rubles. (It is really worth only 33 1/3.) Assuming, for simplicity's sake, that there is a 100 percent tax on value-added, that is fine with R, since it simply passes the product on to G in fulfillment of its tax obligation. M, of course, pays its own taxes--100 rubles--in kind as well.

With respect to households, problems begin to arise. H expects to be paid 100 for its labor but cannot accept in-kind payment, since it cannot consume M's product. It needs cash. But the cash value of M's remaining product is only 33 1/3. Hence wage arrears arise. Similarly, the government budget of 200, which is equal to its tax collections, is worth only 67 in cash. Assuming G transfers its budget to H as pensions, pension arrears also kick in.

This model is of course highly stylized, but it captures much of the contemporary Russian economy--not only the wage arrears, but also the unrealistic budget, the pension arrears, and the apparent increased output. Equally important, the four-sector accounting model immediately suggests the futility of various policy measures. Take, for instance, the tax collection crackdown the IMF is urging. The Russian government, under pressure to increase the amount of cash in the budget, is demanding that enterprises settle their tax debts in cash, not in kind. The model makes it clear that such an approach can only mean shifting a given amount of value--too small already to satisfy claims by both government and workers--from one recipient to the other. One's gain is the other's loss. If taxes are paid, wages will not be.

That is what has happened at regular intervals in recent years, including in the first quarter of this year. From January through March, Russia's State Tax Service increased its intake of cash by slightly over five billion rubles (after accounting for inflation). During that same period, enterprises' debts to their workers for overdue wages rose by almost exactly the same amount. In April, in connection with a nationwide day of labor union protest against wage arrears, Russia's Federation of Independent Trade Unions called for an amendment to the civil code to prohibit enterprises from paying taxes before paying their wages. The unions argued that "the government's recent efforts to squeeze more taxes out of industrial enterprises to pay public sector workers was only worsening the problem of private sector wage arrears..."

WHY RUSSIANS PREFER IT

The system described above could not survive for long in a market economy, but in Russia it seems to be getting stronger every day. The virtual economy can be compared to what is really happening beneath the pretense. All that is necessary is to assume that no one pretends that the final product of manufacturers is worth more than the 100 rubles it actually is.

The first result is that M would have to report a loss of 100 instead of a profit of 100. It therefore would have no tax obligation. But with sales of only 100, M could not pay both R, whom it owes 100 for resources, and H, whom it owes 100 for wages. It would have to apportion the 100 it does have between them. Suppose it pays 50 to H and 50 to R. M thus has wage arrears of 50 and inter-enterprise arrears of 50.

R in turn pays its only earnings, the 50 it receives from M, to G. This leaves R with tax arrears of 50. G's only revenues are what it receives from R, since M has no value added. G then transfers to H the 50 it received from R. This still leaves budget arrears of 50.

The picture is starting to become clear. The table compares the performance of the virtual economy with that of the real economy. On all counts, the virtual economy's aggregate performance indicators--sales, profits, oily, output--look better than they really are. Once the pretense of the virtual economy is removed, the planned budget (total spending based on expected tax revenues) is only half as large as it appeared to be. But this would mean, for instance, that nominal pensions would be cut in half.

The arrears picture differs as well. Total arrears are the same in both the real and virtual economies. But note that two new types of arrears arise when the virtual economy's pretense is eliminated. Now R has a tax debt and M has inter-enterprise arrears to R. The web of mutual indebtedness is even more entangled than in the virtual case.

Perhaps more important than any aggregate indicator, however, is how elimination of the virtual economy would affect manufacturing. The virtual economy masks the nonviability of the value-subtracting manufacturer. In the virtual economy, M appears to add value of 100. In fact, M is clearly in the red.

In sum, none of the participants in the virtual economy would appear to gain by its elimination. Any attempt to expose the truth about the virtual economy would be widely unpopular. It would mean slashing pensions, branding the value-adding sector as tax delinquent, and threatening the bankruptcy of manufacturing enterprises and the loss of the jobs and wages they provide.

This in turn emphasizes the key point brought out by the model. The virtual economy has arisen for two fundamental reasons: most of the Russian economy, especially its manufacturing sector, takes away value, and most participants in the economy pretend that it does not. Barter, tax arrears, and other nonmonetary methods of payment turn out to be the main mechanism used to sustain the pretense. The pretense is what causes all the nonpayment difficulties. There is less value produced than there are claims on it.

DESPERATE FOR CASH

The relationship between the noncash virtual economy and the cash-based market economy is a curious one. To some extent, the system is driven by an active effort to avoid cash because cash transactions expose the pretense. But there are other reasons to avoid cash. Cash is costly to earn and costly to keep. The tax authorities might be less likely to accept noncash payments from an enterprise holding a lot of cash. Cash is also vulnerable to extortion by organized crime. At the same time, the system dictates a certain minimum requirement for cash, called the cash constraint.

Most urgently many enterprises must sell their products for cash in order to pay wages. This explains the ironic feature of the virtual economy that while it is itself a nonmarket system, it depends upon the market. It is only the market that allows some of the economy's product to be realized for the cash needed to pay workers. (In the Soviet Union, both labor and wages were centrally allocated.) Some of the product can be sold inside Russia. But the main source of cash is outside, on the world market.

Since 1992, growth in exports has been regarded as a successful part of Russia's transition. It has generally been assumed that export growth meant that a large part of Russia's economy was meeting the ultimate market test. In fact, many Russian exports lose money. But for participants in the virtual economy, the goal of exporting is not profit, but cash. The losses they incur are considered a necessary cost of staying in business.

Households in the virtual economy operate with a similar logic. They allocate effort between working in manufactures and earning cash on their own or otherwise sustaining themselves through activity not directly connected to the system, such as street vending and gardening. These sorts of activities are good for the virtual economy in that they reduce the minimum amount of cash that has to be supplied to households from within the system.

Finally, the minimal amount of cash in this system does not mean cash is irrelevant in Russia. On the contrary, in the land of the cashless, the man with pocket change is king, or at least an oligarch, as Russian capitalists and financiers are called. Some Russian capitalists certainly have more than pocket change, but in international terms they are not particularly wealthy. Oneximbank, headed by Vladimir Potanin, perhaps the most famous of the financial barons, would not rank among the top 100 banks by size in the United States. The combined size of Oneximbank and one of its chief rivals, Menatep, is smaller than that of the medium-sized Centura Banks in Rocky Mount, North Carolina. It is the Russian tycoons' relatively cash-rich status in a cashless economy that gives them so much power.

THE REAL COSTS

This system has a number of significant negative consequences. But three main areas have been affected: enterprise restructuring, measuring economic performance, and the public sector. The effect on enterprise restructuring is the most obvious. Even those admittedly few enterprises that probably could restructure and become viable in the marketplace have not done so because it would be costly and because they can muddle along as they are.

The effect on apparent aggregate economic performance, such as GDP and output, has already been suggested. Depending on the form of payment used, output in the virtual economy is overpriced by a factor of two or three (for barter transactions) and up to five (for sales made against promissory notes). Since the reported value of the nation's economic product is based on these inflated prices, Russia's GDP may be even smaller than official figures suggest, even after taking into account the underreporting of the hidden economy. At market exchange rates, Russian GDP in 1997 was about $466 billion, or no more than 6 percent of U.S. GDP. Its year-to-year growth is also exaggerated. When value-subtracters increase their output it is bad news, even though in the virtual economy it shows up as increased GDP. Russia's statistics agency has reported that GDP grew by 0.8 percent in 1997. The extra value-added it reports is almost surely virtual.

The effect on the public sector may be the most important of all. The virtual economy changes the very nature of the budget. A budget should be a plan of priorities for public spending. In a democracy, the reason for a budget to be debated and adopted by the legislature is to decide democratically what society's priorities are. Because cash allows full freedom and flexibility in meeting the needs defined in the budget, it ensures maximum efficiency and equity. Payment of taxes in kind upsets this function.

The Chelyabinsk subway story is a good illustration of how fortuitous tax obligations by certain companies have distorted public policy priorities. On March 23, the governor of Chelyabinsk province, Pyotr Sumin, declared the construction of a subway system in the city of Chelyabinsk to be one of the most important construction projects in the region. The project is being financed by the tax debt of construction companies to the federal, provincial, and local governments. Construction companies in Chelyabinsk were deeply in arrears on their taxes to the local and federal government. At the same time, the federal government owed Chelyabinsk funds but was late with disbursement. The local government was more or less forced to accept the construction companies' offer of a big project in lieu of payment, while the federal government canceled the companies' tax arrears in lieu or a federal contribution to Chelyabinsk. The end result is a subway. It does not matter that in Chelyabinsk, as throughout Russia, hospitals and schools are in disrepair and that teachers, nurses, and doctors are not being paid. When goods are delivered in kind as tax offsets, it is a seller's market.

THE GOVERNMENT'S ROLE

The Virtual economy is not entirely detrimental. In the most general sense, it is Russia's social safety net. The most important contribution it makes is jobs, albeit at minimum wages. Because of this function, Russia has enjoyed social stability. Wage arrears rose to an all-time high in the first quarter of this year, but during the month of March only 70 officially declared strikes--those lasting longer than one day--took place in the entire country. Of those, 22 were in industry, involving 7,700 workers out of a total of more than 15 million. By April 1, only 7 of those strikes were still under way.

But there are limits to this stability. In May coal miners staged a nationwide protest over wage arrears. They blocked passenger and freight trains and desisted only when the government again promised to pay back wages. The coal miners' strike underscored the government's role as arbiter in the virtual economy. To pay the miners' wage arrears required shifting value away from some other purpose, as Boris Yeltsin recognized when he noted at the height of the May crisis that miners were no more deserving than teachers or others whose wages were also in arrears. Since the virtual economy constantly produces expectations that cannot be met for everyone, government must step in as referee.

The second task that falls to the government is making the system more efficient by reducing leakage of value, which raises the cost of operating the virtual economy. Leakage takes several forms. It can be legal or illegal, sanctioned or unsanctioned. The value that leaks out may stay inside the country or may be transferred abroad through capital flight. The most important distinction, however, is whether the leakage is good or bad for the system. Good leakage is a cost necessary for keeping some participants in the game. In the four-sector model of the Russian economy, the resource sector contributes all of the value it produces to the system. Supposing this value-adding sector consists of a privatized gas company, say Gazprom, the owners would prefer to export all the gas for hard currency. But this is politically impossible. In practice, Gazprom is legally permitted to export a certain share of its gas to keep it performing its role in the system.

While some leakage is thus good for the virtual economy; other leakage is not, such as the theft of wage funds, which makes it more difficult to meet minimum cash requirements. Viewed in the context of leakage, the relationship between fighting corruption and economic reform can be turned on its head. Reducing corruption is typically considered a key element in accelerating economic reform. But if reducing corruption in Russia's virtual economy results in less leakage, more value remains to support the continued operation of loss-making enterprises.

MOSCOW'S IDEA OF REFORM

Recognizing Government's role in the virtual economy is critical for understanding recent political events. Improving the administration of this system is what is now being defined as reform in Moscow and throughout the country, in rather sharp contrast to what those in the West may believe. The government sworn in in April is thoroughly conversant with the virtual economy, much more than it is with the market. The heralded group of young reformers in Moscow--Prime Minister Sergei Kiriyenko, the former banker and oil executive, and his three deputies, Boris Nemtsov, former governor of Nizhny Novgorod, Oleg Sysuyev, former mayor of Samara, and Viktor Khristenko, a regional administrator in Chelyabinsk--are to a man sons of the Russian rust belt, the large industrial cities of the Ural Mountains and the Volga River valley that are home to the virtual economy. The local governments, banks, and oil companies in which the reformers served before coming to Moscow were all active and willing players in their regional virtual economies.

The new government is shaping what the West regards as instruments of market reform to serve the purposes of the virtual economy. Take, for instance, the institution of bankruptcy. The new cabinet announced in May that it will initiate bankruptcy proceedings against directors of state-owned enterprises who fail to "pay wages, keep jobs, and pay taxes," in Khristenko's words. They will, he said, be replaced with "more efficient" managers. In other words, contrary to practice in a market economy, bankruptcy in the new, reforming Russian economy does not mean selling off an unviable enterprise to new owners who restructure, cut costs, and turn a profit. Rather, it means plugging leaks of value from the system.

A perceptive Russian journalist, Yuliya Latynina, wrote last year that "Russian directors are not divided into those who steal and those who do not steal. They are divided into those who steal from the plant and those who steal for the plant. The reform program of the Russian government means replacing the manager who steals from the enterprise with one who steals for the enterprise--that is, one who does not abuse his position for his own personal benefit at the expense of his labor force and the good of the entire system.

Tax reform should be viewed in the same light. When tax reform means trying to collect more cash from insolvent enterprises, it is doomed to fail and will be detrimental to social peace. However, when tax reform means collecting taxes from those who actually have the means to pay, it may mean reducing leakage from the virtual economy. It will thus help to sustain it rather than reform it.

THE WEST'S RESPONSE

How should the West react, as it is once again called upon to provide emergency funds for Russia? The first step is to acknowledge the existence of the virtual economy and the fact that the West has been complicit in its emergence. It could not have developed to the extent it has, and arguably might not have become as corrupt and inefficient as it has, unless over $70 billion had been infused from the outside since 1992. It is futile to think that today, six years later, the West can force the Russians, as a condition for aid, to put themselves through the wrenching process of dismantling this system. They would not accede to such a demand and the attempt to foist it upon them would damage the West severely in the eyes of ordinary Russians.

Two choices remain. The first, which the West appears to have chosen for now, is to concentrate on keeping Russia stable in the short term by bailing out the virtual economy. The West should be aware of the price for itself and for Russia: further consolidation of a backward, noncompetitive economy, guaranteeing the need for a succession of emergency bailouts in the future.

The second option is to stop financing such a costly dead end and refuse a bailout. Here, too, the consequences must be weighed. Without a bailout, the ruble's value could probably not be maintained against the dollar. Foreign capital would flee the equity markets and, most important, the domestic government debt market. Russia would have more difficulty borrowing from abroad. All of these events would have some immediate negative effects on the Russian economy. But none of them would be calamitous. More important is that in the longer run the effects would be salutary.

The most direct impact of a ruble depreciation would hit those with large dollar-denominated liabilities. The largest commercial banks would be in the most difficult straits, and some would fail. But nearly 80 percent of Russian households' bank deposits--and disproportionately more for lower-income households--are in the state savings bank, Sberbank, which would be relatively immune. The demise of some commercial banks would certainly have an adverse impact on the economy, but it would not cause a collapse in the monetary system, primarily because about half of transactions already take place outside it. One major result of a banking collapse would be a decline in the power of the banking oligarchs. But it is not clear that is all bad.

What about inflation? The past three years' battle against inflation seems to have been a success. As late as May 1995, inflation was raging at over 200 percent a year; by May of this year it was down to an annual rate of 7.5 percent. A return to the continuous price rises of 1992-95 would be unfortunate, but a revival of inflation would depend on more than a depreciation of the ruble. The crucial factor in avoiding a resurgence of inflation is maintaining the Central Bank's policy of not printing money to cover budget deficits.

Here, too, the key is to abandon pretense. Until now, the government's success in reducing inflation has involved something of a subterfuge. Beginning in mid-1995, it replaced its previous habit of monetizing the deficit with a less visible evil: massive borrowing, at home and abroad, to make up the budget shortfalls. Its debt instrument of choice has been treasury bills. The result has been a rapid buildup of around $70 billion in short-term domestic debt, an amount nearly as great as the total taxes collected in cash during that same period. This three-year borrowing spree is a big part of the problem that led to the current crisis. It is now apparent that the only way Russia can avoid monetizing its deficit (and thus producing inflation) is by borrowing at interest rates that are increasingly infeasible. Currently, more than half of the federal government's cash tax revenues go to pay interest on the national debt. By fall, that level could rise to 70 percent. Russia faces the dilemma of inflating now or later. The longer Russia waits, the more debt it piles on and the greater the inflation that inevitably comes. On that count alone, a depreciation can help rather than hurt because it will make it more difficult for Russia to borrow to finance current deficits. Currency risks that have been underappreciated will now raise the cost of external borrowing. Domestic debt will also become more expensive, given that much of the increase in treasury debt during 1997 was purchased by foreign investors. By raising the cost of finance, depreciation will make more apparent the true state of Russia's public finances. If Russian economic policy is currently addicted to borrowing, then cutting off the supply of credit maybe the best way to kick the habit.

This proposal is not a magic bullet. It is merely the better of two bad alternatives. Refusing a further bailout will not in itself guarantee any good results, and it will have some bad ones. It will of course save the money that would otherwise go toward refinancing Russian debt. But more important, it would finally place responsibility for Russia's economic future on Russians themselves. By abandoning the pretense that aid is contingent upon adoption of market reform, since it has not been and cannot be, the West would send Russians the message that the choices they make on economic policy are theirs alone: You appear to have chosen the virtual economy. Fine, stick with it if you like. But do not expect the West to remain complicit in a pretense that makes your economy progressively poorer. Denying Russia a bailout is not without risks. But bailing out the virtual economy is sure to increase those risks for the future.

TABLE THE VIRTUAL ECONOMY VS. THE REAL ECONOMY.
 
 VIRTUAL REAL
TOTAL SALES 400 200
TOTAL PROFITS 200 0
PROFIT RATE (PERCENT)  50 0
TOTAL VALUE-ADDED (GDP) 300 100
INDUSTRIAL OUTPUT 400 200
BUDGET SIZE
 PLANNED 200 100
 AS IMPLEMENTED 67  50
HOUSEHOLD INCOME
 ACCRUED 300 200
 ACTUAL 100 100
ARREARS
 WAGE 67 50
 INTER-ENTERPRISE NONE  50
 TAX NONE 50
 BUDGET 133 50

Clifford G. Gaddy is a Fellow in Foreign Policy Studies at the Brookings Institution. Barry W. Ickes is Associate Professor of Economics at Pennsylvania State University.