Who Needs Rubles?

Russia's virtual economy hides a lot of business--and tax revenue

Russia's Yamal-Nenets Autonomous Region, north of the Arctic Circle, is rich in natural gas, vast in size, and small in population. The local government in the capital of Salekhard gets most of its income from energy royalties. Airplanes are the preferred method of travel. But the tale of how Yamal-Nenets Governor Yuri V. Neyolov acquired a Tupolev 154 airplane shows just how far Russia still has to go before it can accurately be called a free-market economy.

To get his plane, Neyolov had to turn to what is fast becoming known as Russia's "virtual economy." Representing as much as two-thirds of all transactions in Russia, the virtual economy is a vast web of barter, promissory notes, tax offsets, and other nonmonetary forms of payment. The key players are not banks but thousands of intermediaries called barter specialists. Their job: to put buyers and sellers of goods together, often via complicated chains of transactions. Through such a middleman, Neyolov "bought" his plane by trading gas paid to his government in lieu of energy royalties (chart). The deal involved not only monopoly Gazprom, which owed the royalties, but manufacturers of aircraft and components in three other cities. The middleman earned a commission--in goods--equal to 10% of the $17 million plane.

Russia's economy revolves around such deals. They are, in effect, the tape and wire that keep the $425 billion economy together despite severe liquidity shortages and a scarcity of bank credit for companies that can't afford to borrow at Russia's 30% interest rates. Because of barter, scores of enterprises that would have been bankrupt long ago in the West are still producing--and employing workers. That has provided a safety valve, especially for one-factory towns in remote regions. And because so much business is done with hard-to-measure substitute money rather than cash, official statistics underestimated the plunge in the economy from 1992 to 1996--and the speed of economic growth today. Government numbers say that Russia's gross national product rose 0.4% last year, but the economy may actually be chugging along at 3% or 4%, says Andrei Volgin, president of Moscow-based Adamant Financial Corp., which acquires and restructures Russian companies.

That doesn't mean barter is a good thing for Russia. With so little business done in cash, the government can collect hardly any taxes. Meanwhile, barter substantially raises the cost of doing business, most economists point out. Since most sellers prefer cash, they charge a premium to accept bartered goods or promissory notes. Then, barter specialists take commissions. Together, these markups can add 10% to 70% to the cost of a transaction.

Barter may also be massively distorting the value of Russia Inc. Most companies accept more than half of their revenue in bartered goods. These sales are recorded as inventories, works-in-progress, or accounts receivable. Profits are almost impossible to measure, since the value of a truckload of widgets in lieu of payment in rubles may be arbitrary. Says Volgin: "Corporate books have almost nothing to do with reality."

NO CHOICE. Why do companies use such a cumbersome system? For many heavy industries, it's a matter of survival. Machine-tool builders, steel mills, and chemical makers have a harder time selling their goods than producers of raw materials and consumer goods, so they rely on barter. For more prosperous companies, barter is the most common way to skirt Russia's onerous taxes. "Companies report virtual profits and have no cash to pay wages or taxes," says Pyotr Karpov, deputy head of Russia's bankruptcy commission and author of a landmark government study on barter.

Needless to say, proliferating promissory notes also wreak havoc with the Central Bank's monetary policy. They are a form of private money not measured in statistics. Indeed, some experts say that just as much of this substitute money floats around in Russia as there are rubles in circulation--some $61.6 billion. So while the official inflation rate in Russia has fallen from an annual 840% in 1992 to 11.4% in 1997, hidden inflation is probably higher.

The barter boom took Boris Yeltsin's government by surprise. His reformers thought that freeing prices in 1992 and later tightening monetary policy would force inefficient enterprises out of business. But companies continued to ship to one another. Those that couldn't pay in cash simply swapped products. In 1994, after the government cut off subsidies, companies began issuing promissory notes. These circulate through a large but unregulated market dominated by local banks.

Most notes end up in the hands of customers, who return them to the issuing company in exchange for goods or services. A small percentage are redeemed for cash. Says Elizabeth Sullivan, an ex-adviser to the Central Bank: "No one anticipated that companies would rely so heavily on these cash substitutes for so long. This didn't happen in Central Europe." Although enterprises in postcommunist Central Europe also relied on barter in the early 1990s, they returned to cash as their governments tightened money and stabilized their currencies. Central European companies also do more business with European counterparts, which pay in cash.

Ironically, the Russian government has contributed to the growth of the virtual economy. Under pressure from the International Monetary Fund to cut state spending, Yeltsin's policymakers sometimes substituted tax credits for government outlays. Says Andrei Tolmachev, a barter specialist: "The government tried to pretend that offsets were real money."

Once Moscow jumped into the game, it spread. By 1997, only 10% of tax payments were made in cash, says Karpov. The rest came in the form of electrical energy, natural gas, or rail shipments that the government accepted from companies in lieu of cash. But with tax revenues collapsing, Moscow simply borrowed money to pay bills that must be paid in cash, such as state-sector wages. As state borrowings have increased and interest rates have soared, companies have been starved for credit. So they issue more promissory notes--spinning a vicious circle.

Now, Moscow wants to break the barter chain. After months of resisting, the parliament recently passed a tight 1998 budget that aims for a deficit below 4.7% of gdp. And tax offsets were outlawed as of Jan. 1, 1998. That means all taxes must be paid in cash. In a break with the past, energy giants such as Gazprom and Unified Energy System no longer will be forced to supply government and corporate customers who can't pay. That will minimize the energy trades that are at the root of the barter economy. As Gazprom and ues demand payment in cash, the government hopes, their customers will begin demanding cash payments from their own clients.

Smart managers already are reaping benefits by cutting down on barter. For example, Severstal, one of Russia's leading steel producers, has cut costs by 10% to 12% since late 1996 by paying cash for iron ore, gas, power, and transportation. The company has reduced barter operations from 30% of sales in 1996 to 17% in 1997. But Severstal is one of the major issuers of promissory notes. Some 30% of its sales are settled through these notes. Until banks begin lending money to companies, many will need to issue promissory notes to keep operating.

WHO NEEDS RUBLES? (int'l edition)
WHO NEEDS RUBLES? (int'l edition)

CRUNCH. Many more enterprises will have to follow Severstal's lead before the Russian economy can begin to function like a true market. If the government sticks with its plans to force more companies to buy, sell, and keep their books based on cash, it may sharply accelerate the much-delayed restructuring of Russian industry. Such steps may prove painful, but they could speed growth and bolster government coffers as companies generate the cash they need to pay taxes.

A big question is whether the government has the guts to push through such a strategy just two years before key presidential elections. Moscow faces a difficult task: convincing both voters and the Communist-dominated Duma that keeping the virtual economy alive will, in the end, sabotage workers' security. Barter was an innovative way for companies to survive the initial stresses of Russia's shift to capitalism. But now, the country must trade in its virtual economy for the real thing--one based on cold, hard cash.

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