Russia: And Now, The Pain

Can Yeltsin meet IMF terms--and contain a backlash?

Boris Yeltsin didn't have much choice. With Russia on the brink of default on $41.3 billion in short-term government debt and the ruble perilously close to devaluation, he ordered his special envoy, Anatoly B. Chubais, to negotiate round the clock if necessary to carve out a $10 billion to $15 billion bailout deal with the International Monetary Fund. As the talks dragged on and Yeltsin called world leaders to plead for help, U.S. officials working behind the scenes calculated that Russia was in such bad shape even $15 billion wouldn't stave off disaster. By July 13, Chubais and the IMF had cooked up a bittersweet deal: $22.6 billion in exchange for painful austerity.

Yeltsin was relieved to get his money, but now he has to pay the price. His government has no choice but to start tackling the serious structural problems facing Russia--from its leaky tax system to the thousands of enterprises barely surviving on barter (table). At the same time, Russia will have to slash its budget gap and restructure its debt, forcing companies to pay their bills or go bankrupt. Russia has lived beyond its means far too long, and now the IMF is calling a halt. "The package is a clear sign that the West will support Russia. But they won't come in again and again," warns Pyotr Aven, president of Alfa Bank, one of Russia's largest.

TIRED OF WAITING. Yeltsin must start Russia's belt-tightening just as the country is heading into a new election season. The Duma, the lower house of parliament, is up for reelection in December, 1999, while presidential elections will take place in June, 2000. Yeltsin's gamble is that his government, led since April by 35-year-old Prime Minister Sergei Kiriyenko, can administer painful reforms quickly so that the bounceback will start by election time. That's the only way a pro-reform candidate such as Grigory Yavlinsky might have a chance against a populist such as Krasnoyarsk Governor Alexander Lebed, who is likely to milk Russia's economic chaos for all it's worth. Yeltsin has said he won't run for a third term.

There's little doubt that the next year will be bleak. Coal miners and defense workers are already protesting over unpaid wages. Outside booming Moscow, people are tired of waiting for the benefits of reform to trickle down to them. Meanwhile, consumer demand, which drove last year's 0.8% growth in gross domestic product after a five-year decline, is likely to shrink this year as the government pushes through a 5% sales tax. Planned cuts in Russia's 35% corporate-profits tax won't take effect until next year, but the government is cracking down on tax collection now. Interest rates--now at 80%--are unlikely to decline to levels sufficient to reignite investment until sometime next year.

Russia must now pay the piper for failing to restructure its industry earlier. Although Yeltsin's reformers tamed inflation by tightening monetary policy, they never enforced bankruptcy laws or forced companies to pay taxes because they feared mass unemployment would trigger a social explosion. When investors fell in love with Russia after Yeltsin's reelection in 1996, Moscow financed its high spending through short-term loans in domestic and international bond markets. Now, the Asian crisis has cut off the stream of low-cost financing, as investors flee risky emerging markets for safer havens. At the same time, declining oil prices have hurt Russia's biggest source of export revenues.

NONPAYMENTS CHAIN. So Kiriyenko is putting the squeeze on Russian companies and citizens alike. One target is gas monopoly Gazprom. The government says Gazprom owes $2 billion in back taxes. In early July, tax authorities seized some of the company's summer homes and luxury cars. Gazprom now plans to sell these assets to raise money to pay some of its taxes. And it has begun to crack down on its own debtors. It recently cut off gas supplies to electrical utilities in St. Petersburg and in the Urals that weren't paying.

Indeed, the pressure to pay utility bills and taxes could shake up Russia's giant barter economy. Strapped for cash, Russian enterprises have survived over the past few years by bartering everything from components to electricity or exchanging promissory notes. Gazprom and Unified Energy System, Russia's largest power company, are at the top of this nonpayments chain. Virtually every enterprise in Russia owes money to Gazprom or UES. If these giants now require customers to pay cash, they in turn will begin demanding payment from their own clients. While some may be able to come up with cash by dipping into secret offshore accounts, many others could be forced to shut down.

The liquidity crunch is already hurting banks. Of course a devaluation would have been disastrous, probably wiping out all but the largest institutions. But Russia's 1,600 banks still face months of economic turmoil. In recent weeks, the banks' portfolios have been demolished by a decline in GKO, or Treasury bill, prices. Many banks were forced to sell at a loss to raise liquidity. Now, the government is planning to cancel its weekly GKO auctions and issue longer-term, dollar-denominated bonds instead. That change in policy will wipe out what had been a key source of banks' profits over the past three years.

Banks that can't shift to traditional lending are likely to fail. The liquidity squeeze recently forced the Central Bank to take over management of Tokobank, Russia's 19th largest. Hundreds more are at risk. While the biggest 20 to 30 will survive, says Alfa Bank's Aven, half of the banks could fold or be merged in the next few years.

Perhaps most important politically, Yeltsin's new austerity is sure to put a hole in the pocketbooks of both the poor and the new rich. In Moscow's shopping malls, hypermarkets, and restaurants, businesspeople are complaining about a slump in sales. Sales at some high-end restaurants are running 20% below July last year. Brokers and bankers are losing their jobs as commercial banks fail and investment banks are merged. MFK Renaissance, for instance, has fired almost 100 people since it was created from the merger of two banks last December.

As the government overhauls its tax system, consumers are bound to gripe. On top of the sales tax, Yeltsin wants to raise income-tax rates for the majority of the population from 12% to 20%. And for the first time, earnings from second jobs and interest income will be subject to a 20% tax, if the government's proposals are backed by the Communist-dominated Duma. It has previously refused to approve these measures, preferring higher taxes on the rich. Yeltsin says he is willing to compromise but has promised the IMF to implement by decree key measures he can't push through the parliament.

By securing the IMF bailout, Yeltsin has won some breathing room. Over the next days and weeks, the Russian President will have to rally support for Kiriyenko as the young Prime Minister puts into action measures far more drastic than Yeltsin ever dreamed would be necessary so far into his presidency. If Kiriyenko succeeds, Yeltsin may have the chance to hand over the reins to a new, like-minded President who also believes in building a democratic, capitalist Russia. But much will depend on how the Russians react to the painful medicine they are about to swallow.