Posted July 1, 2000
The following article was submitted to the Wall Street Journal Europe in the first week of July 1998. It was published, in shortened and modified form, on July 14, 1998, in the Wall Street Journal Europe and republished in the Wall Street Journal and the Asian Wall Street Journal on July 15, 1998. The article as originally submitted correctly predicted both the default and devaluation of August 17, 1998.
How to Reverse the Upcoming Russian Bust
For the last two years, and until very recently, it has been common to speak of the coming Russia boom. We are told that Russian economic fundamentals are sound, healthy, at least improving, or at worst in need of strengthening. But how can they be sound or even strengthening if Russia has no fiscal system, no monetary system, no banking system, and has lost over 40 percent of its national income with no recovery in sight? In the West, we take a healthy financial system almost for granted. In contrast, Russia's financial system is, to all intents and purposes, bankrupt. The country is heavily leveraged relative to its meager financial assets. It is living on borrowed time, on borrowed foreign money. When it dries up or flees, the currency and banking system face collapse, as events last December and this May and June clearly demonstrate.
Russia is insolvent, not just illiquid. Bankruptcy runs from top to bottom. Foreign exchange reserves held by the Central Bank of Russia (CBR) in June were less than its short-term debt to the International Monetary Fund. The equity of Russia's commercial banks was a stunning, negative $7-13 billion, depending on the method of accounting (they are bankrupt either way). The banks' foreign liabilities exceeded their foreign assets by $7 billion, excluding off-balance sheet forward exposure (which explains the fear of devaluation). The government's short-term, ruble-denominated debt stood at $55 billion, of which the ruble equivalent of $38 billion was held by Russians, while $17 billion was held by foreigners.
The net foreign exposure (liabilities minus assets) of Russia's financial system stood at $24 billion, more than twice the $10 billion in liquid foreign exchange reserves, excluding gold, of the CBR in June. Each week the government must raise $1.3 billion just to refinance its maturing internal debt, compared with weekly federal tax revenues of $0.8 billion. The country's stock of private ruble deposits only amounted to the equivalent of $36 billion, which is less than the short-term, domestically held public debt.
The fiscal system is just plain non-existent: The $55 billion in short-term public debt is less than the $63 billion of tax arrears owed by the privatized and semi-privatized corporate debtors. They have collected consumption and payroll taxes, but did not remit them to the government. Any government effort to enforce payment of tax arrears through bankruptcy or seizure of assets would amount to renationalization and an admission that Russian privatization has turned into private access to the public purse and a fiscal trap. Russian privatization ended up privatizing public finance, not enterprises.
Moreover, the enterprise sector itself is bankrupt. Its delinquent payables (trade debt, tax arrears, payroll arrears, and sunk loans) exceed its delinquent receivables (trade credit and uncollected government payments) by $153 billion. This means that the $63 billion in tax arrears are uncollectible. Tax arrears by themselves are 33 percent higher than federal tax revenues budgeted for 1998.
Foreigners also own some $15 billion of volatile Russian equities (halved from nearly $30 billion by the stock market crash of 1998). It may be hard for foreigners to cash out much of this money in Russia's thinly-traded market. Still, foreign selling of Russian equities puts additional pressure on the ruble and deals a severe blow to market confidence.
The world's wealthiest country in natural resources, and one of its wealthiest in science and education, can hardly service its fiscal, banking, and commercial debts. The proceeds from new government debt cannot keep pace with the cost of refinancing existing maturing debt due to high interest rates and the fact that short-term government debt averages 173 days. Since the government cannot increase tax revenues (as tax arrears are uncollectible) and substantial expenditure reductions have already been made via payroll and pension arrears, its only options are external loans or to default on its debt through devaluation and inflation. Russia is trapped in a debt pyramid, which has guided Western rating agencies in their serial downgrading of Russian debt. Russian financial stabilization, the only achievement of reforms, has turned out to be a mirage.
Only the West's fear of rudderless nuclear arsenals in the hands of a bankrupt former superpower may keep Russia from technical insolvency. Inasmuch as Russia is hostage to foreign inflows, the West is hostage to Russian decay. The IMF, the U.S. Treasury, and the G-7 nations stand ready to assist Russia with a guarantee against default or devaluation. On this implied insurance, private Western banks and investors appear willing to buy Russian dollar-denominated sovereign debt (Eurobonds) at 13 percent interest. Western bailouts, whether direct or disguised as a private loan, may keep the ruble and Russia's financial system afloat, at least temporarily, but cannot fix the problem. Moreover, if Western investors see the Russian financial system as insolvent rather than illiquid, Western bailouts will just help evacuate Western capital from Russia, instead of restructuring the debt and fixing the financial system.
It's important to understand the nature of banking in Russia. It bears little resemblance to the standard concept of banking that is taught in Western university courses on "Money and Banking." In Russia, banking interlinks productive enterprises with the fiscal and monetary systems, channels public finance to enterprises, extracts subsidies for them and for itself, strangles private finance, and undermines public finance. A real banking system, a crucial leg in the triad of the financial system (fiscal, monetary, and banking), would effectively separate management of the monetary system from private finance, beget private productive incentives, mobilize private savings, and finance private investment. Any real, lasting solution for Russian can only be internal. It requires the creation of a private, market financial system from scratch, not just opening buildings and putting the name "banks" on them. Fixing Russia's banks can make a first, crucial step in this direction, as well as lay the foundation for the long sought after recovery and growth.
One fact above all highlights Russia's perverse banking: There are more U.S. dollars under mattresses in Russia today than the total value of ruble deposits in Russian banks. These private holdings of U.S. currency, the bulk of the savings of the population, fuel little economic activity. Rather, they represent a store of value, an escape from inflationary rubles (the Russian people, unlike Western governments and investors, did not buy Russian claims of financial stabilization and sound fundamentals).
Russia's financial system is composed of "ersatz" banks. They have the look and feel of normal banks as found in Western market economies, but they are not real banks. They are inferior imitation banks, which have served largely as branches of the government or the Central Bank.
How did this come about and how can real banks be established?
Russia's financial system has developed in three stages. The first stage, 1991-1995, consisted of a nonmonetary system and an ersatz banking system. The Central Bank of Russia (CBR) was a central bank in name only. It failed to perform any of the functions normally associated with real central banks. The CBR could not control the quantity of money in circulation, the price level, or effectively regulate the country's ersatz banks. The ersatz banks, in turn, were simply arms of the Central Bank, redistributing taxpayers' money or CBR credits to favored firms, or simply pocketing the cash for themselves.
The second stage, 1996-1997, is traceable to the IMF, which insisted that the CBR act like a central bank if the government was to receive financial assistance. Thus the CBR emerged, for the time being, as a real central bank. It reduced inflation to low double-digit levels, stabilized the ruble within a gradual downward-sloping band, and closed numerous small insolvent banks. But ersatz banks were not similarly transformed. They continued to function as before. Since 1992, the banking system as a whole has been insolvent, kept afloat by injections of inflationary credit, preferred sales of high-interest bonds, management of government deposits, delinquent tax payments, arbitraging foreign exchange, sales of shares in state-owned natural resource firms at bargain basement prices for final resale to foreigners at higher prices, issue of unbacked promissory notes, extensions of Lombard credit—everything imaginable under the sun but earning money from loans to enterprises for productive activity.
The balance sheets of individual Russian banks, and that of the commercial banking system as a whole, are grossly misleading. They fail to differentiate between performing and nonperforming assets, while non-performing loans constitute a quarter of all loans and worthless enterprise-issued promissory notes raise this fraction to a third. The balance sheets exclude such liabilities as internal loans to bank-owned enterprises, tax arrears of bank-owned enterprises, tradeable bank bonds, the full extent of bank-issued bills of exchange (which represent unbacked ersatz money and privatized seigniorage), and direct government loans to bank-owned enterprises. Adding these liabilities to the standard balance sheet and subtracting non-performing assets transforms the equity of banking system as a whole from positive to negative, and nonborrowed reserves also become negative.
Since late 1997, the banking system has stood on the brink of collapse with all old options to keep it afloat exhausted. But this can be made a starting point for fixing the entire Russian financial system.
As we mentioned, the Russian people have sufficient financial wherewithal to restore the solvency of the country's fiscal, monetary, and banking systems. The challenge is to mobilize the $40 billion in U.S. currency in private hands, which amounts to just under $275 for every man, woman, and child. The ultimate goal is not just salvaging Russia's fiscal system, currency, and banks, but starting the economy on a path of sustained growth. Two complementary solutions stand out.
A first solution is straightforward. The government should immediately authorize unrestricted foreign banking operations throughout the country in both rubles and dollars. At the beginning of 1998, foreign banks represented about 4 percent of all banking capital in Russia, which indicates the potential for expansion. Banks could be asked to insure foreign currency deposits up to, say, $1,000-5,000 per household, backed by their global assets, in exchange for unrestricted access to the Russian market. Foreign banks could lend to productive enterprises in rubles or dollars. The dollar would emerge as a second currency, mobilizing some of that $40 billion into insured, interest-earning accounts that would provide the credit for real investment. Over the longer-run, the normal deposit multiplier could generate several hundred billion dollars in new real credit. This new banking system will be independent of public finance and will separate production from it.
A second solution represents a series of somewhat more complicated debt-for-equity and debt-for-debt swaps. Taken together, these swaps would diminish public debt, constrain the fiscal and monetary systems from directly financing production, and establish sound private banks. Here is how it might be implemented.
Step 1. The government stops subsidizing a few preferred banks through its no-interest deposits worth $3.5 billion, which banks presently use to purchase high-interest government bonds. It instructs the banks to transfer these deposits to the Treasury, which would improve the government's cash flow and reduce the issue of new debt. Since the banks, which are functionally insolvent and illiquid, will be unable to produce these funds for transfer to the Treasury, then the government would reclaim the market equivalent of its bonds stored in the vaults of these banks. In so doing, the government would save about $5 billion in redemption and debt service costs.
Step 2. The Central Bank further instructs banks to repay some $2 billion in long-term delinquent debt (the multi-year rollover of CBR credit) and some $1 billion or so in recently accumulated delinquent debt on Lombard loans. As before, the government would reclaim another $3 billion in bonds, further reducing debt and debt service charges without any issue of new money.
Step 3. The Central Bank instructs the banks to submit comprehensive balance sheets based on international accounting standards that expose all non-performing assets and all inclusive liabilities, including the liabilities of bank subsidiaries (e.g., tax arrears, internal loans to bank-owned enterprises, etc.). Then the government instructs the banks to remit the tax arrears of their subsidiaries, which amount to at least $10 billion. Since the banks will be unable to remit these arrears, the government will reclaim another $10 billion of its bonds. Savings in interest and refinancing costs are worth another $15 billion.
Step 4. The Central Bank conducts the same operation for $6.5 billion of unbacked bills of exchange, which were issued by banks as high-interest loans to enterprises and local governments. These bills of exchange represent implied seigniorage delegated by the CBR to banks, as well as off-the-books' CBR credit to banks. Since the true balance sheets of the banks reveal negative capital, which makes issuance of these instruments illegal, the government would reclaim another $6.5 billion in bonds from this swap of government bonds from the portfolio of bank assets in exchange for the banks' implied debt to the CBR.
Step 5. True balance sheets will reveal the insolvency of most banks. The swap of government bonds for repayment of overdue debts would make this insolvency operational, that is, banks would default on various payments and go bankrupt. At that point, the CBR would take over the banks and transfer them to new private institutional domestic and foreign owners. This would be part of a broader and a longer-term overhaul.
Space precludes a detailed description of this overhaul. In a nutshell, the reform would create the equivalent of mutual funds of owners of banks, in which the shares would belong to foreign institutions as well as to a broad cross-section of the Russian people, who would choose to surrender their explicit and implicit fiscal claims on the government (e.g., pensions, public housing, etc.) in exchange for these bank-holding funds. The banks would be capitalized with the real natural resources remaining in government hands and the shares of enterprises belonging to the former banks, as well as equities which the government can take over in a swap for enterprise tax arrears. This recapitalization bears no fiscal costs because it swaps real assets for long-term, unsecuritized public debt. Moreover, a swap of longer maturities for short-term bonds would be part of this deal.
Step 6. As new, independent, private banks are established, they can open dollar-denominated accounts, convertible on demand into equities in natural resource enterprises which were taken over for tax arrears and mobilized from current government holdings. These real assets can be loaned to the CBR, exchanged for CBR holding of bonds, and stand ready to back the convertible accounts. Such accounts will be the principle vehicle for mobilizing household dollar holdings from mattresses to the newly-established, real private banks. The CBR can purchase and have as its nonborrowed foreign exchange reserves a large part of that $40 billion in exchange for mineral rights (real assets) sold to the banks. The value of these mineral rights will serve as assets, matching the new banks' initial deposit liabilities of the same portion of that $40 billion. In this sequence of swaps, the stock of rubles in circulation will become backed by foreign exchange reserves, and the stock of deposits will become backed by natural resource equities. This creates a flexible, quasi-currency board system for the entire money supply. Unlike the standard currency board, the CBR will not issue additional rubles by purchasing dollars. It will sell mineral rights for dollars, and individuals could own those rights in lieu of deposits, or deposits denominated simultaneously in both currencies, in any way they wish. As the CBR sells mineral rights, kept on loan from the government, it repays the government in bonds, thus retiring the debt without reducing the supply of base rubles. As deposits multiply, what grows is the real money stock and the deposit-credit portion of the money stock, not the inflationary monetary base. This is a recipe for growth.
Step 7. The reconstituted banks can swap non-performing loans of indebted enterprises for their equity and either participate as new owners in restructuring enterprises or sell these equities to various funds, which will establish efficient ownership and management. This will complete reprivatization of the banking and corporate sectors, establish a genuine market economy, save the fiscal system, and launch economic growth.
Failure to fix the banks means a never-ending series of financial crises. Moreover, unless they are fixed, the next generation of elected leaders may opt to nationalize the banks, take direct control of natural resources exports, and restore central planning, in the fashion of Belarus and the city of Moscow. Worse still, the Russian people will face a future of further contraction, not growth, and the West will face an unstable Russia.