April 25, 2001
CAN MORE LIBERAL SUBSIDIES SPUR GROWTH AND REDUCE INFLATION?
The question sounds absurd. Except for special cases of education and science, subsidies divert resources from more productive to less productive uses. Subsidies increase public expenditures, which invariably lead to higher taxes and/or inflationary finance. In all, higher subsidies result in lower economic growth and higher inflation. So, why raise this question?
Only because a remarkable consensus has recently surfaced among Russian policy makers, from the President on down, and Western observers and investors. They are concerned about rising inflation and slowing growth. As a remedy, they advocate larger subsidies. No, they do not use the word subsidies. They would never acknowledge that they advance subsides. They most likely do not even recognize that they promote larger subsidies. Indeed, they would openly oppose subsidies. Instead, they use sophisticated arguments and esoteric language: They speak about the inflationary growth of the monetary base, real appreciation of the ruble, the exotic Dutch Disease, the loss of import substitution, and advocate liberalizing capital outflow to remedy all of the above. But behind all these lie, even if unrecognized, larger subsidies to producers of natural resources and also to inefficient and value-subtracting domestic producers of tradeable goods.
The Central Bank of Russia mandates and enforces repatriation of 75% of foreign exchange revenues by Russian exporters. We have shown how this policy, unintentionally, contributed to economic growth in 19992000. (See "The Secret of Russian Economic Growth"). The Russian government endorsed this policy in 1999 as it enabled the government to borrow $6.7 billion dollars from the Central Bank and make timely payments on external debt. (See "How Big Are Russia's Foreign Exchange Reserves?") Now the government and interested observers have turned against Central Bank policy. They argue that forced repatriation restricts capital outflow, which entails several negative consequences:
1. The Central Bank purchases dollars from exporters and adds them to its foreign exchange reserves. To purchase dollars, it print rubles (technically, expands the monetary base), which fuels inflation.
2. When the Central Bank does not purchase all repatriated dollars, the supply of dollars on the market exceeds the demand for them. This imbalance could lead to the nominal appreciation of the ruble, thereby strengthening the ruble. Recall, though, that the Central Bank purchases some of the repatriated dollars, for which it prints rubles. The resulting inflation slowly depreciates or weakens the nominal exchange rate. Since Russian domestic inflation exceeds nominal ruble depreciation, the ruble appreciates in real terms. The inflationary rise in domestic production costs exceeds the dollar's appreciation against the ruble.
3. Hence, Russian goods become more expensive in terms of dollars. They become less competitive on the world market. Imported goods become more competitive in Russia. Import substitution diminishes, which is said to suppress domestic production.
The proposed solution is to abolish the Central Bank policy of mandated repatriation of foreign exchange revenues, to liberalize capital outflow in order to increase the outflow of dollars. No extra dollars in the country means no monetary expansion, no inflation, no real appreciation of the ruble, more competitive exports, less competitive imports, and more production. In short, as this logic implies, Russia needs to transfer or leave abroad more income from its production in order to increase production, so that it could transfer or leave even more income abroad, and so on.
Alas, simple accounting arithmetic shows that liberalization of capital outflow cannot achieve the desired objectives of higher growth and lower inflation. It can achieve only the intermediate objectives of higher capital outflow, reduction of imports, and ruble depreciation, but all to no avail. It cannot cure the Dutch Disease in Russia, because there is no Dutch Disease in Russia. But greater capital outflow will have the perverse effect of supporting low and negative value-added activities in manufacturing at the expense of high value-added activities in natural resources. Proposing greater capital outflow as a policy measure amounts to an upside-down Russian version of the Dutch Disease.
Capital Outflow and Inflation
Liberalizing the capital account can initially change the composition of capital outflow, but does not increase its volume. Then it can reverse ruble appreciation and reduce imports, which automatically increases capital outflow.
The negative balance on the capital account, also termed the capital deficit, net exports, or capital outflow, consists of external and internal components.
Liberalizing the capital account can increase one type of external capital outflow, namely export revenues left or transferred abroad, only at the expense of all other types of capital outflow, external (government repayment of foreign debt) and internal (Central Bank reserves and household dollar savings). More dollars left abroad mean fewer dollars purchased in Russia for debt repayment, Central Bank reserves, and household balances. Thus liberalization substitutes one type of external capital outflow for other types of capital outflow, which serve fiscal (debt repayment), monetary (Central Bank reserves), and saving functions. The substitution itself leaves the total outflow unchanged.
However, liberalization of the capital account can make far-reaching changes. An increase of export revenues left abroad brings fewer dollars into Russia and strengthens the dollar against the ruble (weakens the ruble exchange rate). A weaker ruble should reduce imports, which is what the policy advocates want. A reduction of imports automatically increases net exports, that is, total capital outflow. This is also what the policy advocates want. But more capital outflow, a weaker ruble, and fewer imports increase, not reduce, inflation. Here's why.
1. The cost of external debt service for the government increases. The government has to pay a higher ruble price for purchasing dollars on the market. This will increase government expenditures and the budget deficit. Raising taxes other than natural resource royalties does not solve the problem and is self-defeating. This is because the already rampant tax non-remittance will increase, while government tax revenues will not (see Chapter 1 of From Predation to Prosperity for a detailed discussion). Strapped by rising costs of external debt service, the government will have to borrow dollars or rubles (to buy dollars) from the Central Bank. In either case, the Central Bank will have to print rubles (expand the monetary base), either to purchase dollars or to purchase government bonds, which will increase inflation. Only increasing natural resource royalties (capturing economic rents) will increase tax revenues. Indeed, the government does mention raising royalties. But higher natural resource royalties would automatically repatriate export revenue dollars to Russia, which contravenes the advocated policy of ousting dollars. So, if the dollar is out, inflation is in.
2. If the Central Bank continues to purchase dollars to build up its reserves in order to insure that the government can meet future payments on its external debt, it has to print more rubles than before if the ruble weakens (say, it falls to 35 rubles to the dollar instead of the current 29). Again, this would be inflationary. If the Central Bank stops purchasing dollars for reserves but prints rubles to lend to the government, expectations of currency collapse will fuel even more inflation. When people race to stay ahead of inflation, they stampede the price level and trash the currency.
3. Fewer imports mean fewer goods and higher prices. Higher imports reduce inflation because more goods absorb money expansion and mitigate price increases. Higher imports also increase the demand for dollars and reduce the nominal appreciation of the ruble. By reducing inflation, more imports also prevent the real appreciation of the ruble. Encouraging more imports by lowering trade barriers helps achieve the stated objectives of reducing inflation and ruble appreciation.
But the policy advocates do not want to prevent inflation and ruble appreciation at the cost of losing import substitution. However, when they achieve their intermediate objectives of increasing capital outflow and, subsequently, ruble depreciation and import reduction, they defeat their principal objective of reducing inflation.
Capital Outflow, Import Substitution, and Value-added Output
An increase in capital outflow and the subsequent reduction of imports cannot increase value-added domestic production. Import substitution helps only some industrial sectors at the expense of other sectors and consumers. It only substitutes production between sectors. It does not increase GDP and may, under Russian conditions, reduce it. (1)
There is an immediate adverse effect of lower imports on value-added output. In Russia, reduction of imports actually reduces GDP. Under specific Russian conditions of value subtraction in manufacturing and agriculture (see Chapter 1, pages 23-25), imports add to GDP while import substitution subtracts from GDP. This is because domestic manufacturing and agriculture, which substitute for imports, produce negative value-added. They subtract value-added output. When imports crowd out negative value-added economic activity, they automatically subtract value subtraction, that is, they automatically add value and increase GDP! Curbing imports stimulates more value subtraction and reduces GDP. The goal of import substitution has the perverse effect of reducing GDP.
It is indeed remarkable that Russian policy makers and Western observers are even talking about import substitution. The doctrine of import substitution is just another version of the old protectionism. Import substitution is a time-worn idea that was popular in Africa, Latin America, and Western development circles in the 1950s, 1960s, and 1970s. It has been since discredited by world-wide experience and research, but has been miraculously revived in Russia in 2001. While people are talking about an imaginary Dutch Disease, import substitution is a real African disease, now being promoted in Russia. (2)
To be consistent, the advocates of ruble depreciation, import substitution, and the Dutch Disease treatment can achieve their objectives by much less esoteric and much more traditional means. Protectionism is almost as old as the world. Tariffs and administrative regulations are many and well-known. The simplest is the monopoly of foreign trade, as in the former Soviet Union. In one fell swoop, monopolizing foreign trade solves all problems of current concern to the advocates of relaxing exchange controls. There will be no undesirable imports, no ruble appreciation, nominal or real (and no currency convertibility, to safeguard this even better), and certainly no Dutch Disease. True, this will scare off foreign investors. But the inescapable logic of the new consensus argument, as recently advanced by the most consistent policy makers, should reject foreign investment. Foreign investment brings dollars in and is thus as bad as oil exports. Actually, foreign investment is worse than oil. Oil revenues can be liberalized and left abroad. But foreign investment, if liberalized, marches in. Logically, it should be de-liberalized. Only external capital outflow should be liberalized but capital controls must be imposed on inflows. But again, abolition of free trade altogether is much simpler and more comprehensive.
Two counter-examples may be of interest. Both Japan and Germany underwent long-term currency appreciation during the 1960s, 1970s, 1980s, and 1990s, with occasional reversals. The yen appreciated from 360 to the dollar to its current level of about 120 to the dollar, though it previously reached past 90 to the dollar. Similarly, the Deutschmark appreciated from 4 to the dollar in the 1960s to its current level of 2.19 to the dollar, having previously broached the 2 level before the launch of the euro. Throughout the decades of steadily strengthening currencies, Japan and Germany ran strong current-account surpluses and recorded stronger economic growth than the U.S., their main trading partner. Appreciating currencies went hand-in-hand with low inflation and strong growth, not with slow growth as Russian policy makers now contend.
Capital Outflow, Export, and Production
Joseph Stalin was a big fan of biology. In 1951, he awarded the Stalin prize to a certain Dr. Boshian for inventing a vaccine against anemia in horses. After Stalin's death, the award was rescinded because horses do not suffer from anemia. This story comes to mind when one hears about the Dutch Disease in Russia and increasing capital outflow as its cure. A few facts explain what really happens:
1. Value subtraction in Russian output may be as high as 33% of resource use (see Chapter 1, pp. 23-25). This means that if more natural resources are exported and less used at home, and manufacturing is suppressed, total value added goes up and GDP increases. Under current conditions and incentives, less manufacturing in Russia implies higher GDP. If world demand for natural resources declines, and the ruble weakens, and Russian manufacturing becomes more competitive, and Russia uses more resources at home as inputs in manufacturing, then value subtraction increases and GDP contracts. The situation is diametrically opposite to what in some countries is called the Dutch Disease, when exports of natural resources and their windfall revenues lead to strengthening the currency and thus crowd out manufacturing. The Dutch Disease causes a country to go from an initial boom to a bust. Lower value-added activities in mining substitute for higher value-added activities in manufacturing. But in Russia, high value-added activities in producing natural resources substitute for low and negative value-added activities in manufacturing. Instead of the Dutch Disease, this is the Russian cure (rather, the Russian Plague). If capital outflow increases and is left abroad, resulting in a weaker ruble, the disease of value subtraction spreads over even more domestic production.
2. Machine-tool and equipment manufacturing constitute 5% of total Russian exports (and these are primarily weapons). Fuels and energy make up 60% of Russian exports. In 2000, machine-tool and equipment manufacturing in Russia expanded by 15%, consumer goods by 22%, oil production by 5.9%, and natural gas declined by 1.3%. This means that the worries of the policy advocates that natural resources and ruble appreciation displace manufacturing are out of touch with reality. And this is unfortunate for Russia. Russia would have benefitted more if these concerns were real, because this would have meant a stronger recovery.
3. Oil production in Russia increased from 295 million metric tons in 1999 to 313 million metric tons in 2000, by 5.9%. Natural gas declined from 592 billion cubic meters in 1999 to 584 billion cubic meters in 2000. This meager supply response to more than a doubling of world energy prices and export revenues reveals a poor and perverse incentive structure. This, and not currency appreciation, is the real issue for Russian economic growth.
Higher external capital outflow and lower Central Bank dollar purchases can reduce one source of the expansion of the monetary base, thereby reducing one source of inflation. As we pointed out above, other sources substitute for this result. These include more expensive dollar purchases for government service of external debt, a higher budget deficit due to this factor, and higher prices due to fewer imports. But these are relatively minor sources of higher inflation. The major one is the reduction of tax remittance (increase of tax non-remittance), subsequently larger budget deficits, and Central Bank credit (money) expansion to fuel payment of taxes.
Mandated repatriation of export revenues helps the government to tax the profits of natural resource producers and induces overall higher remittance of taxes. Russia collects very low royalty taxes, for example, $3 per barrel of oil, which, on the average, costs $7 to produce and fetches $24 on the world market. Thus oil producers reap $14 per barrel of exports. Natural gas royalty taxes are even lower, about 10% of sales (with production costs representing a minor fraction of the price). Mandated repatriation at least reveals these enormous profits to the tax authority and subjects them to regular profit taxes. Even more importantly, as we described in "The Secret of Russian Economic Growth," mandated repatriation of export revenues has a major spillover effect. Export enterprises pay off their trade arrears to domestic input producers in order to reduce their money balances in the bank, which are subject to paying off tax arrears to the government. Improved and accelerated payments throughout the economy increase tax remittance across industries. This greatly contributes to fiscal revenues and minimizes the budget deficit. The Central Bank does not have to issue credit to the government for financing its budget deficit and to enterprises, through the banking system, to enable enterprises to remit part of their tax revenues.
Purchasing dollars for foreign exchange reserves has become the principal source of expansion of the monetary base. This source merely substituted, and only in small part, for the past major sources of monetary expansion and inflation: the government budget deficit and credit to enterprises for remitting tax revenues. These mechanics are described in detail in Chapter 1.
Liberalizing and increasing external capital outflow can only create a reverse substitution of inflation. Less money expansion for purchasing dollars from exporters means much more monetary expansion for financing the government's budget deficit and enterprise partial tax remittance. This can only restore high inflation, and, in addition, precipitate default on the country's external debt.
High inflation can resume faster than one thinks. While the policy advocates are calling for sterilization of the monetary base issued by the Central Bank, actual sterilization has long since been in place: The government holds about R300 billion and banks hold about R200 billion in deposits with the Central Bank. Together, this is roughly the size of the entire monetary base. With the first onset of fiscal difficulties, the government will draw on its savings. With the first fiscal difficulties in paying taxes, when input payments from exporters decline, enterprises will have to draw on their savings, and the banks will have to withdraw their deposits from the Central Bank. In turn, the Central Bank can pay its depositors only in one medium: currency, the high-powered money. This will quickly un-sterilize the accumulated claims on the Central Bank and unleash a great monetary expansion and extreme inflation.
Nothing But a Larger Subsidy
As we pointed out, ruble appreciation, import substitution, the Dutch Disease, sterilization, and whatnot are non-issues or issues that have been turned on their head. The proposed policy of liberalizing and increasing external capital outflow cannot reduce inflation and spur economic growth. On the contrary, under Russian conditions, this policy is bound to increase inflation and thwart growth, probably resuming contraction. On the latter point, we refer the reader again to "The Secret of Russian Economic Growth."
There is only one real issue behind all these old and new fallacies: higher subsidies for exporters of natural resources and protectionist subsidies for domestic producers of value subtracting goods. These subsidies are already exceptionally high. Just take, for example, $10 per barrel of exported oil if revenues are repatriated and profit taxes paid. This will increase to $14 per barrel if revenues are not expatriated and profit taxes not paid. Of $53 billion in revenues from exporting oil and natural gas, about half is a pure subsidy to owners and managers, a fraction of which may trickle down to workers in these industries. These subsidies constitute the royalty taxes on natural resources which the government does not collect and transfers to owners and managers of resource enterprises. Capital outflow in Russia is in essence the outflow of unpaid royalties on natural resources.
Under the mandated repatriation of 75% of export revenues, the bulk of these subsidies is now received in rubles. Billions of dollars worth of rubles are a cumbersome proposition. Liberalization of external capital outflow converts these subsidies into dollar subsidies and increases them by the amount of unpaid profit taxes. Most likely, the policy advocates do not see the real issue of more liberal and higher subsidies behind their proposals. It is conspicuously absent in the policy debate, it is conspicuously present in the real economic relations.
"I believe the oligarchs will find a less arduous and less wasteful way to govern."
(Aldous Huxley to George Orwell, in a letter of October 21, 1949, commenting on 1984).
Less arduous, they did. Less wasteful is impossible. More liberal subsidies cannot be less wasteful.
1. Herewith a simple accounting demonstration. Russian GDP in 2000 was R6,950 billion. In round numbers, at the current nominal exchange rate, Russia produces $250 billion worth of value-added output. The GDP is really worth $500 billion at purchasing power parity because the ruble is undervalued by about 50% (contrary to the policy advocates' worries that the ruble is too strong, it is one of the most undervalued currencies in the world, about as much as the Thai Baht, Indonesian Rupiah, and Philippine Peso). But we have to stick to the nominal exchange rate to discuss import substitution. So, GDP is $250 billion.
Of this total, to take crude round numbers, Russia makes $150 billion from domestic sales and $100 billion from exports. It can purchase up to $100 billion worth of imports. (This is abstracting from additional imports made available by foreign investment and other foreign capital inflows). Russia spends $150 billion on domestic purchases because it sells $150 billion worth of goods and services internally. One man's sale is another man's purchase; one man's spending is another man's income and market-valued output. So if exports remain $100 billion but imports, instead of $100 billion, add up to only $50 billion, the country still spends $150 billion at home and, equivalently, produces for domestic sales $150 billion worth of output. If imports decline to zero, still the same $150 billion is spent and produced at home. If imports increase from $100 billion to $120 billion, thanks to $20 billion in foreign investment (say, foreigners purchased Russian municipal bonds, equities, or brought in equipment), still the same $150 billion is spent on domestic goods and services. And the material equivalent worth $150 billion is produced for domestic market. Imports are bought for exports and foreign inflows, domestic production is bought for earnings from the domestic market. Domestic supply, $150 billion, domestic demand, $150 billion; foreign demand, $100 billion, domestic supply (export), $100 billion; foreign supply, $50 billion, domestic demand (import), $50 billion. No substitution in the aggregate. No reduction in domestic production due to imports. An increase in domestic production stems from exports. An increase in domestic consumption and investment stems from imports.
This is why free trade is so beneficial: it increases the size of the market, it adds to production and consumption. Ibn Khaldun knew it in 1376, Adam Smith knew it in 1776, even Soviet central planners knew it in 1976, and used it to the hilt (exported oil, gas, and other resources, imported grain, capital equipment, and consumer goods, no capital outflow). But Russian liberal market reformers and their Western counterparts would rather not know it in 2001. They want import substitution.
But this substitution takes places between domestic industrial sectors. When imports enter the country, they substitute for identical or similar (substitutable) goods. They crowd out some sectoral output. Some domestically produced goods are purchased in lower quantity and their production reduced. But then other domestic goods are purchased in higher quantity, and their production increases, because the unchanged total of $150 billion applies at home. The same $150 billion is spent internally and produced for the domestic market; the rest, $100 billion, is earned abroad and either brought back to Russia in the form of imports and dollar bills or left abroad. The composition of domestic purchases changes due to imports and the composition of domestic production changes, but not the volume. Import substitution is only domestic sectoral production substitution. If imports decline, and import substitution declines, people will spend the same $150 billion on domestic goods, only with less production substitution. But they cannot spend more and produce more in the aggregate due to this factor alone. No production increase is arithmetically possible due to lower imports.
In fact, reduction of imports prevents an increase in domestic production. By the law of comparative advantage, imports substitute for less competitive, less efficient domestic production. This means that resources are released for more efficient uses. More output can be produced from the same inputs. This means that cutting sectoral import substitution reduces potential production and thwarts economic growth. David Ricardo knew it, even Soviet central planners knew it (exported natural resources, imported industrial equipment, which could be produced domestically but of lower quality and higher cost).
2. In the midst of promoting discredited doctrines, in April 2001, the Russian government was discussing the possibility of receiving $600 million in investment loans from the World Bank in both 2001 and 2002, which would nullify its stated goal of reducing inflation.