Source: RF Central Bank

1.2.3. Vulnerability of the BankingSystem

As the dollar raced ahead in 1992 to 1994,foreign currency-denominated loans predominated in the structure of commercialbanks’ assets. Therapid devaluation of the ruble-denominated liabilities allowed them to be usedto finance even those projects that were inefficient in foreign exchange terms.The situation changed when the ruble had reached a flat plateau: the high realinterest rate on ruble-denominated liabilities required a more efficientcommitment of assets. Between 1995 and 1996, therefore, commercial banks werebuilding up their forex liabilities. In the first quarter of 1997, theseoutweighed the banks’forex assets (see Fig. 1.4).

Moreover, at the close of the first quarterof 1998, the forex liabilities of commercial banks had more than doubled to$19.2 billion from $9.5 billion, reaching $20.5 billion on 1 July 1998. Theirleapfrogging was in consequence of a precipitous growth of contracted loansagainst relatively sedate current forex accounts and deposits (see Fig.1.5).

Forex assets had expanded to about $12.1billion during that period, primarily as a result of expanded lending (see Fig.1.6). This structure of the banking system balance (apart from its financialfeebleness induced by the government’s protectionism toward most majorbanks) was the obvious reason for its extreme vulnerability to nationalcurrency devaluation. Furthermore, massive foreign loans were collateralized bysecurities, which plunged in price as the financial crisis was raging, callingfor extra funds to beef up the deposit accounts and kicking off a bankingcrisis.

1.3. The Economic and Political Fallout
of the FinancialCrisis

The financial crisis in Russia, whichpeaked in August 1998, had the following major economicimplications:

–аConfidence which foreign and domestic investors had placed in thegovernment, the Central Bank, and the Finance Ministry in Russia was shaken,robbing the government of credibility in the eyes of both foreign and domesticlenders and bringing about an exodus of foreign investments and, byimplication, dimming the prospects for economic growth.

–аWith bothforeign and domestic sources of financing the fiscal deficit choked off, thecountry today is faced with the prospect of inflationary budgeting and a returnto the old practice of the Russian government being fed out of the CentralBank’s hand. And more,this turnabout would spur money supply growth rates and, inevitably, consumerprices, and sap the tough muscle of the monetary policy.

–аThecrisis of the domestic banking sector due to both financial marketlosses6 and the shutdown of the GKO-OFZ market as the principal source ofrevenues and its interrelated wellsprings would worsen the crisis ofarrears.

–аThemeltdown of the Russian stock market, which reflected the real lure ofportfolio investment in the Russian corporate sector (the RTS-1 index fell offby 90 per cent between early October 19977 and early September 1998),would further undercut the Russian manufacturers’ chances of attractingfunds.

–аExpectations of a rebound in the oil and gas industry and in otherexport-oriented sectors of the economy thanks to a twist in the ratio ofruble-denominated costs to foreign currency-denominated revenue may fail tomaterialize, as the government, squeezed as it continues to be by a budgetarycrisis, may be tempted to scoop up surpluses from the sector by either slappingit with more taxes or by wringing the long-overdue budget arrears out of it. Inmuch the same way, far from all domestic producers can build up production ofimport-substituting output, availing themselves of the long fall of the realruble rate and the consequent decline in the competitiveness of imports. Theoutlook hangs on the rate of the forthcoming inflation as well.

The socio-political aftermath of the August17th devaluation is too much in evidence to warrant detailed comments here. Itsmore prominent aspects are as follows:

First, the inflation explosion intensifiedsocial discontent. The worst hit segments and groups of the population werethose who had supported the existing socioeconomic and political system– the new middle>

Second, the President’s political standing wascritically damaged. By insisting on Kiriyenko’s approval as premier, PresidentYeltsin actually took the blame for the performance of the new cabinet. Thedevaluation and default dealt a heavy blow at the President, while thedismissal of the cabinet and the merging of the political crisis with thefinancial meltdown left a further dent in public confidence in Yeltsin andreinforced the political positions of those who had been calling for a changeof the constitutional system and election of a new president. In all fairness,these developments strengthened the hand of the legislature. Finally, theappointment of Yevgeny Primakov, with unqualified Duma backing, to lead thecabinet made the new prime minister a powerful legitimate politicalplayer.

Third, there was a conspicuous jockeyingfor power and shifting of influence wielded by different interest groups. Aboveall, the political clout of the Уoligarchs,Ф particularly those with ties tothe banking and energy business, was severely curtailed by the virtualbankruptcy of many a large bank and the waning of the financial might of theenergy exporters. The military-industrial complex has regained politicalweight, but at the moment there is uncertainty about the relationships betweenits export-oriented industries and noncompetitive partners. The chances of theagrarian lobby have gone up.

1.3.1. The Crisis: Economic and PoliticalAlternatives

The cataclysmic economic and politicalchanges in August and September 1998 opened a new page in Russia’s recent history. The currentdefinitions of the developments that followed are largely similar – they spelled the end of theYeltsin Era, an era of liberal reforms, and, now and then, even forewarned ofthe restoration of communist rule. All the definitions have their reasons andcan be logically or historically motivated. All these interpretations, most ofthem rooted in political science ideas, are generally divorced from an analysisof economic processes which always and everywhere, and particularly in thecurrent Russian context, set the mold for the possible and the necessary,guide, to a large extent, the governments’ hand, and offer a yardstick togauge the decisions taken and a crystal ball to peer into the mediumterm.

The Primakov government formed in September1998 made no bones about its intention to veer decisively off the economiccourse the country had been steering. No executive had been making similarstatements, at least since late 1992. And now, in September 1998, a Уchange oftackФ was discussed in public. What else could be expected under thecircumstances

First, the Primakov government was formedwith an active support and close involvement of the left political forces andtheir respective political factions – the Communists and Agrarians, inthe first place. True enough, Communists and Agrarians were a frequent sight inthe previous governments, in secondary roles, though. Now, it was their day.The familiar leftist heavyweights plonked into key cabinet chairs from wherethey could pull the strings. Most of them wore two hats – membership in or affinity withthe Communist Party and affiliation with the traditional Soviet economicestablishment, which has been a strong lobbying force in the last few decades.This two-hatter type is exemplified in the new government by Yury Maslyukov,Vadim Gustov, Victor Gerashchenko, and Gennady Kulik. Unlike the left andright, which are actually converging on common grounds in most West Europeancountries, the leftist views on the economics and politics in present-dayRussia differ cardinally from the conceptions and backgrounds of non-communistpoliticians.

Second, the need for a resolute change oftack was dictated by the scale and depth of the economic crisis. The meltdownin August 1998 was not just a financial collapse, without a disastrous dominoeffect on the country’s social and political fabric. The price spike and loss of savingsby the population, the multiplying unemployment figures, especially among thepopulation groups with the greatest stakes in the market economy, the consumermarket crisis, contraction of demand, and deterioration of the businessenvironment pounced upon the country without warning, it seemed. Everybody wasdemanding change, even though different socio-political forces put totallydifferent meanings into the term.

For all the turmoil, no one bothers toanswer the question: how is the change to occur and what will the currentpolicy be abandoned for It is not difficult to work out that the real optionsopen to the government are scarce and obvious enough. They logically flow fromthe hand-on experience in economic politicking in the post-communist period,particularly in 1995 through 1998.

Back to our subject, the Primakovgovernment was, from day one, confronted with a tough political choice, whichit could not skirt or reduce to a compromise between the alternatives. Onealternative was a return to the practices of 1992-1994, which combined a softmonetary and an equally soft budgetary policy. Another was to hang on toa rigid monetary policy and work toward exchange rate stabilization, withradical budgetary reforms added for good measure, so the treasury revenues andexpenditures could be put in balance, that is, seek compatibility andcoordination between the Finance Ministry and the Central Bank. The choicebetween these two alternatives had an unmistakably political color.

The first alternative clearly leans towardinflation. The money supply in the economy is built up, sparking price hikesand devaluation of the national currency. The trick is expected to dispose ofthe heaping social problems, wipe out stagnant arrears, flush businesses withworking capital, and jack up demand for domestically produced consumables,giving a boost to domestic consumer industries. This scenario was acted out inRussia in 1992-1994, when a spell of short-lived stabilization of production(that held for two or three months) was followed by a spurt of inflation andruble tumbling. Given the stronger communist pull on the government, the mostlikely response to the price scramble would be attempts to freeze prices andintroduce a mandatory dollar exchange rate. These attempts could have fullypredictable consequences: a blooming black market and snowballing commodityshortages. Given our current circumstances, however, prices would wriggle outof effective control so we would end up with both an inflation and consumershortages.

The second alternative aims atstabilization (keeping a lid on inflation). It seeks to achieve a rigid budgetequilibrium and macroeconomic stabilization, which lie at the base of economicrecovery. These aims are to be attained by determined measures to push thegovernment budget into surplus, pursue a restrictive monetary policy (evenintroducing the currency board regime, if necessary), and continue measuredeconomic liberalization. The structural and budgetary reform next in thepipeline are to brace up businesses for competition and readiness to find amarket niche.

Both alternatives were made publicliterally within days and weeks following the outbreak of the full-scalefinancial crisis in mid-August. Most of the Economics Division staff of theRussian Academy of Sciences (RAS), led by D.аLvov, was consistently pushing forinflationary and dirigiste government policies, giving full voice to itspreferences in a published open letter to the government, which spelled outtheir views and proposals. On the other extreme, a policy of rigidstabilization was formulated in a program put forward by liberal economistsrallied around Yegor Gaidar.8

Making the choice between inflationism anda rigid stabilization policy is largely a political one. At the time, thechoice of policy, of course, depended not on the choice of government, or thegovernment’sideological, political, and social preferences alone; it also was influenced bythe logic of events and obtaining circumstances. In particular, as domestic andoutside finance sources were gone with the resignation of the Kiriyenkogovernment, the country was being nudged toward the inflationary option. Thisoption had not, however, been made inevitable by the previous developments; ithad to be written by the government on a clean slate.

The chief political problem of choosingbetween the inflationary and stabilization alternatives was picking the socialsegments and groups who were to pay most of the bill for either economic policythe government opted for. These two models differed essentially in socialcontext and payoffs.