What Yeltsin Must Do

Ugly streaks of soot mar the once-pristine white marble facade of Russia's Parliament building in central Moscow. The former icon of Russia's democrats, the ruined White House now symbolizes the two years Russia has largely wasted on infighting. And its scars are an ugly reminder of the angry confrontation that erupted into pitched battle on Oct. 4, when troops loyal to President Boris Yeltsin took back the building from right-wing legislators and their heavily armed backers.

Yeltsin's victory came at a heavy cost. The tank, machine-gun, and sniper fire killed more than 150 Muscovites. For hours, the country teetered on the brink of all-out civil war. But the outcome looks promising: Rebellion ringleaders Alexandr V. Rutskoi and Ruslan I. Khasbulatov sit in Lefortovo Prison. The Parliament that obstructed reform at every turn is dissolved for good. A new, bicameral legislature is due to be elected in December.

Yeltsin stands at a unique juncture in Russian history. Always a strong performer under pressure, he now has the opportunity to build a new Russia with a market-oriented economy and democratic institutions. Western governments and most foreign businesses are behind him. If he can move nimbly enough and head off hard-line rebellions and separatist tendencies, he can give his citizens what they most want--security and prosperity. "We must press on with the economic transformation, and we need support for all government's efforts in that direction," Yeltsin exhorted Russians in an Oct. 6 televised address.

The effort is mammoth. Russia is mired in a deep recession. The country's economy is wracked by 30% monthly inflation, and the ruble that once traded at 1.60 per dollar is now virtually worthless at 1,200 (charts). Meanwhile, the jobs of millions of Russians are tied to hugely inefficient industries and state enterprises left over from a failed era.

What must Yeltsin do now? Many of the answers seem straightforward. His first priority is to restore a semblance of stability and sanity to the economy and state finances. To do so, he must quickly rein in the inflation that threatens millions of Russians' savings and livelihoods. To combat it, Yeltsin will have to propose a new budget to replace the irresponsible one adopted by the dissolved Parliament--a plan that called for huge deficits approaching 20% of gross domestic product. To shore up the ruble's value, Yeltsin must enact tight money policies. And he must force the central bank to shut off its printing presses and boost interest rates--steps his government seems ready to embrace.

But Yeltsin's best efforts to restore economic stability won't mean much unless he finally prepares a frontal attack on what remains of the entrenched, old-style communist system. "The old elites are looking for safe footholds....Election and competition don't come easy in Russia," warns Jeffrey Sachs of Harvard University, who advises the Russian government.

DINOSAURS. That means Yeltsin has no choice but to stamp out the continued, huge subsidies for farms and factories that are major contributors to the deficit. Though a limited privatization program has been a big success, huge swathes of money-eating dinosaur industries and unproductive collective farms still exist on the dole of cheap state money. He will have to shove the millions of bureaucrats, managers, and others off state subsidies and out into the real world.

At the same time, Yeltsin must come up with a viable social safety net that can protect the countless Russian lives that revolve around propped-up state factories. While fear of a social explosion has so far kept unemployment at an absurdly low rate of 1%, a surge of layoffs is now inevitable. Yeltsin must take measures allowing those displaced workers to move to new jobs and provide for their temporary housing, food, and retraining. "Too swift a move to market forces would flatten everything like a typhoon. Fine-tuning will be awfully important and awfully difficult," says Michael St rmer, a political analyst with the Institute for International Affairs, a German think tank.

In dealing with the West, Yeltsin must force Russian bureaucrats and newly successful businessmen to take a more enlightened stance toward foreign investment. They must shed nationalist beliefs that without economic protection, Russia is doomed to become a Third World country surviving on sales of oil and cheap resources. That means quickly unraveling a ridiculously complicated maze of tariffs, duties, royalties, and taxes for imports and exports.

OLD HAND. The payoff could be huge. The U.S. Commerce Dept. says American companies have invested just $400 million in Russia since 1987 vs. $2.5 billion in Hungary. "Business won't invest more until the Russians set up some coherent laws," says James A. McClung, vice-president of Chicago-based FMC Corp., which has been doing business in Russia since the 1930s.

In effect, Yeltsin must now define a new, distinctly Russian economic model that will reposition the vast nation in the world economy. It must provide some continuity with the past--not a system dreamed up at Harvard or by the International Monetary Fund. Indeed, some of Yeltsin's advisers are looking to Asia and Latin America for answers. In some cases, Yeltsin may allow vestiges of the old system's defense, energy, and technology industries to combine their efforts in new industrial conglomerates. That might allow the centrally planned system to wither over time rather than be abruptly scrapped. One model for the painful restructuring: Japan's keiretsu system.

The trick for Yeltsin will be to find a new balance between the Soviet system that is dying and a completely free-market system that is still out of reach. If he fails to do that, he leaves an opening for opponents in the lower reaches of the bureaucracy and particularly in the regions. "This is Yeltsin's last window of opportunity to get rid of old communist structures," says Wilfried Schmidt, senior analyst at Daiwa Europe Ltd. in London. "Either he wins now, or we'll see communist uprisings for a long, long time."

Now that the deadlock with Parliament is settled, Yeltsin's team is already turning its attention to some of these issues. In an exclusive interview with BUSINESS WEEK, First Deputy Prime Minister Yegor T. Gaidar promised to assault the underpinnings of Russia's web of subsidies and loans: "The sums are enormous," he says.

Buoyed by the return of Gaidar, whom Yeltsin was forced to drop as acting Prime Minister last December, Yeltsin's team is mapping out a series of sweeping moves aimed at accomplishing much of their agenda (table). During the next few weeks, Gaidar and other insiders say, Yeltsin will issue a blizzard of decrees in an attempt to turn the economy around. He'll free prices on products and services still set by the government, such as bread and, perhaps, apartments. Among the most sensitive will be gasoline prices, which are still set by local governments. Motorists willing to wait in line for at least three hours currently can buy gas at about 40 a gallon from a state gas station.

Perhaps the centerpiece of Yeltsin's campaign will be to accelerate privatization. He's already moving fast, with some 4,500 state enterprises having been sold--and sell-offs are continuing at the brisk rate of 700 to 800 a month. The Supreme Soviet, however, had tried repeatedly to slow down or demolish the program by restricting voucher sales or placing government properties off limits. That roadblock is now gone.

Yeltsin also will be in a better position to throw a wrench into the central bank's printing presses, now that it no longer answers to the hard-line parliamentarians. To slow inflation, the central bank is ready to increase Russia's discount rate charged to commercial banks from 180% to 200%. Many observers are surprised that Yeltsin is keeping as bank chief the controversial Viktor Geraschenko, who orchestrated a farcical partial call-back of the ruble in July.

RING OF TRUTH? But Yeltsin needs all the allies he can get to help implement his reforms. If he fails to show quick progress on raising living standards, he could face another grass-roots rebellion. While the hard-core Rutskoi supporters were mostly fringe elements, their complaint that the state economy was being destroyed without anything to replace it rang true for many Russians.

One crucial question is whether Yeltsin can achieve his agenda without lapsing into heavy-handed authoritarianism. Yeltsin has dissolved obstreperous local and regional councils in Amur, Novosibirsk, and Moscow. In a stern speech on Oct. 6, he dissolved the regional Soviets, or parliaments, because he believes they're breeding grounds for the hard-line opposition. Even liberal newspapers that have supported him find themselves under censorship--if only temporarily. Until the December elections, Yeltsin will be, in effect, a dictator, ruling by fiat.

For now, President Clinton and other world leaders are solidly behind him. Yeltsin is so confident of his strong position that on Oct. 11, he'll embark on what could be a historic three-day visit to Tokyo, where he'll try to make progress on resolving the 47-year-old Kuril Island dispute that has blocked any significant Japanese investment in his country. But that does not mean that the international community is ready to open up the aid spigots without conditions. Indeed, the International Monetary Fund has made it clear that a second $1.5 billion loan installment--originally to be delivered this fall--will not be released until the government demonstrates progress on curbing inflation and reducing subsidies.

Foreign business executives also seem to be backing Russia's President. Many believe that putting down the Supreme Soviet's revolt foreshadows a better business climate later. Even though McDonald's Corp. closed its three Moscow restaurants on Oct. 4 as gunfire broke out nearby, they were open and packed the following day. "This hasn't deterred us in any way, shape, or form," says Redmond Langan, an official with McDonald's Canadian unit, which runs its Russian operations.

The Parliament's demise is also good news for foreign bankers. This summer, the legislature passed a law banning foreign banks from making commercial loans to Russians. That jeopardized the prospects for the more than half a dozen foreign banks that had won licenses to operate here and dashed the hopes of many others. Yeltsin's government hopes to attract foreign banks to Russia. Now, it may have a chance. Says Steven Fullenkamp, head of the Moscow office of Chase Manhattan: "Everyone has been waiting for a breakthrough. We're hoping that this is it."

Other foreign business executives express guarded optimism. PepsiCo Inc., which has been bottling soft drinks in Russia since 1974 and now has 19 franchised plants there, closed down its office during the shooting en Monday but quickly reopened the next day. "Obviously, things are pretty tense, but we're still bullish on the markets," says a Pepsi spokesman.

Also pressing ahead is United Technologies Corp. Its Otis Elevator Co. unit has a deal in Russia, while its Pratt & Whitney unit plans to develop and produce midsize commercial aircraft engines and industrial gas turbines with Russia's Perm Motors Ltd. United Technologies "remains confident that its investments in Russia are safe," says President George A. David.

But Western executives are worried about some proposed changes, particularly plans to ban doing business in dollars after Jan. 1. Executives had assumed that they could freely use more stable foreign currencies in internal Russian trade.

Many experts doubt that a dollar ban will work. "You cannot stop the flow of cash in Russia. Dollars will find their way to the black market," says Sergei Yegoruv, president of the Russian Banking Assn. Such objections may be one reason that Gaidar seemed to softpedal the plans in his BUSINESS WEEK interview.

Whatever path Yeltsin takes, the remade Russian economy is hardly likely to form in the Anglo-Saxon mold. Instead, key forces within Yeltsin's camp, such as Prime Minister Viktor Chernomyrdin, are looking around the globe. "They have not been pushing for a real market economy, but for some intermediate stage," says Konstantin Borovoi, president of the Russian Commodity & Raw Materials Exchange: "They want an administered market."

One organization that could give hints of Russia's industrial future is a company called Rosshelf. When DuPont Co. subsidiary Conoco Inc. expressed interest in developing a vast natural-gas field under the deep and frigid water of the Barents Sea not long ago, Russia's scientific elite took notice. With high-level backing from the Yeltsin insiders, Ros- shelf, a Russian consortium, was put together to compete against the Westerners for the natural gas project. The consortium includes Gazprom, the state natural gas monopoly, various geological institutes, and a nuclear submarine shipyard. It won the deal, meaning that Western companies had squandered millions in preliminary exploration expenses and other costs.

Rosshelf hopes to promote new Russian industries while converting military industries to civilian use, says Yevgeny Velikhov, the venture's nuclear physicist chairman. Rosshelf expects that by designing and building new offshore oil platforms capable of drilling for oil and gas in extremely deep and cold water, it "can save 50,000 jobs at the shipyard since there are no more orders for nuclear submarines," says Velikhov, who says the venture is modeled on a keiretsu. All in all, he expects to save 200,000 defense and industrial jobs if the Ros- shelf experiment works.

Of course, there are dangers in that kind of industrial reengineering. More radical reformers such as Gaidar and Finance Minister Boris G. Federov fear that these new combines would be only a sleight-of-hand that allows old state-backed enterprises to emerge in new form. Allied with prominent laissez-faire economists from the West, they prefer a mix of policies that encourages entrepreneurship from the ground up. Harvard's Sachs says, for example, that Yeltsin probably will issue decrees that will make it easier for entrepreneurs to start new companies and break into the heart of the industrialized economy. Other steps to open up foreign trade could benefit this entrepreneurial sector of economy.

The upshot is that it's no longer a question of whether Yeltsin will dismantle the old Soviet system--only how. Even if Yeltsin himself cannot define the precise makeup of the future Russian economy, his bold moves are raising hopes, yet again, that someday Russia may be able to transform the world's biggest military production complex into something that better serves millions of needy Russian consumers. It might still happen.

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