Russia: Is There A Solution?

By abandoning reform, Chernomyrdin is inviting hyperinflation, capital flight, and food shortages

It is a bitter August for Boris N. Yeltsin. Nearly seven years to the day after he defeated a coup plotted by hard-liners and helped bring down the Soviet empire, the Russian President experienced his own embarrassing defeat. The triumph of his presidency--a stable ruble--collapsed on Aug. 17 as his government defaulted on $40 billion in short-term debts and devalued the currency. Six days later, Yeltsin humbled himself by reappointing Viktor S. Chernomyrdin, the stodgy bureaucrat he had fired only five months earlier, as his Prime Minister. It was, opined Izvestia, "like swapping parachutes in free fall."

It's far more than that. Russia's economy is melting down amid signs that Chernomyrdin's return to power is the end of the era of reform. The ruble is collapsing. The financial markets have stopped functioning. Banks are short of cash, stirring panic among ordinary citizens. Within months, Russians could once again be coping with hyperinflation and food shortages. And Yeltsin, already a lame duck, could be forced to resign, prompting elections. Now, in what some are describing as "a quiet coup," Chernomyrdin is preparing to team up with Communist and nationalist factions in the Russian parliament and with powerful business tycoons to return Russia to a far more statist style of economic management.

TIMELY MORATORIUM. Behind the scenes, Chernomyrdin is believed to be pushing Yeltsin to give him powers to rule Russia's battered economy by decree. Among other things, insiders say, Chernomyrdin may introduce limits on outflows of capital as well as price controls. The bailouts of some banks may amount to their nationalization. The government's default and its debt moratorium are an open acknowledgment that Russia's top priority is its own internal stability rather than in meeting its financial commitments to the outside world.

After years of stagnation, Chernomyrdin wants to reflate the Russian economy, revive industry, and spur economic growth. "Our first priority will be defending the social welfare of the population, paying salaries and pensions," he declared after his appointment. "By purely monetarist measures, we will not pull Russia out of the crisis."

Although the details are sketchy, the power shift in Russia was sparked by banks worried about meeting payments due on syndicated loans from Western financial institutions. Among others, Chernomyrdin ally Mikhail Khodorkovsky's Menatep Bank was under pressure. Indeed, the government caved in and announced its moratorium on the day that he was due to make a payment on an $80 million loan. But the moratorium and devaluation touched off a wave of panic among ordinary Russians and foreign investors. To preserve stability and their own empires, influential tycoons such as oil and media baron Boris Berezovsky began urging Yeltsin to bring back Chernomyrdin as Prime Minister. Yeltsin also anointed him as his preferred successor.

Chernomyrdin's return is a watershed event. Russia may become the first major emerging-market economy in the post-cold-war era to insulate itself from the forces of globalization. By vowing to pour money into Rus-sian industry, Chernomyrdin seems ready to reject the International Monetary Fund's canon of tight money and belt-tightening. Russia's new stance may tempt countries from Indonesia to South Korea to fend off the market forces that have similarly disrupted their own hard-hit economies.

CLINTON'S CHALLENGE. Russia's free-market failure is a big blow to the West. Led by the U.S., Western industrial nations have gone to great lengths to hasten Russia's transition to capitalism--from sending economic advisers to lending tens of billions of dollars. With 11,000 nuclear weapons, Russia would become a major threat to global security if it plunged into chaos. President Clinton is now faced with a devilishly complicated task as he heads to Russia for a summit with Yeltsin scheduled for Sept. 1. With the IMF strapped for cash, he can't offer any financial help. As Russia closes ranks against Western market solutions, Clinton will find it much less willing to bow to U.S. interests.

Meanwhile, global financial markets are also jittery. Investors around the globe had assumed that Russia was too big and politically important to fail. But Russia's debt moratorium and the $32 billion debt restructuring program it announced on Aug. 25 changed that psychology overnight. Investors reacted angrily to the plan, which forces them to swap high-interest, short-term Treasury bills for longer-term ruble bonds paying 25% to 30%. Analysts estimate that investors will receive just 15 cents to 30 cents for every dollar invested. Says E. Gerald Corrigan, managing director of Goldman, Sachs & Co. and a former president of the Federal Reserve Bank of New York: "There was no alternative. But it is a very bad precedent that runs into a head-on collision with the whole global credit system." Adds Robert Devane, a Moscow-based investment adviser: "The restructuring deal will hurt Russia's ability to finance itself in global markets in the West for some years to come."

Chernomyrdin's strategy is straight out of the old Soviet book. The former chairman of gas monopoly Gazprom believes that the backbone of the Russian economy is its industrial enterprises. Since Yeltsin launched his economic reforms in 1992, industrial enterprises have been starved for investment as governments slashed subsidies. At the same time, though, the government kept enterprises afloat by allowing them to pay for electricity, fuel, and other necessities through long chains of wasteful barter deals. This system has become known as Russia's "virtual economy" because it managed to keep millions of workers employed in unproductive factories.

PRESIDENTIAL AMBITIONS. Now, to please his nationalist and Communist supporters in the Duma, Chernomyrdin wants to turn these companies around by flooding them with cash. With no money coming in from foreign investors or international institutions, the only way the Prime Minister can do that is by printing rubles. Chernomyrdin is expected to allow favored private banks run by his powerful business supporters to channel credits to industry. That could further strengthen the grip of powerful financial industrial groups on the economy.

Above all, Chernomyrdin's goal is to become Russia's President. Elections are scheduled for 2000 but could be held much sooner if Yeltsin resigns. Until recently, Chernomyrdin was in the political wilderness. But if he can somehow pull off his rescue plan for Russia, he will stand a chance to upstage more charismatic politicians who have already signaled their intention to run for President: former General Alexander Lebed and the popular Moscow Mayor Yuri Luzhkov.

But Chernomyrdin's hopes could soon fade. The risk is that cranking up the printing presses will lead to hyperinflation and a totally worthless ruble. Increasingly desperate Russians could begin to hoard goods rather than hold on to money. At the same time, the country's financial squeeze and shortage of hard currency may make it difficult to keep up the imports of food and other goods that have flooded shelves over the last seven years. That could pose political and social problems, especially in cities such as Moscow, which imports close to 80% of its food.

If inflation takes off, one safety valve for the economy may be the American dollar. Already, millions of Russians hold their savings in dollars stashed under their mattresses, while many companies have bank accounts in the West. As Russia's ruble crashes, more and more business will likely be done in dollars, either openly or on the black market. That was true in the early 1990s when the dollar circulated parallel to the ruble and kept part of the economy ticking along. In recent weeks, business in dollars has already been picking up as the inevitability of devaluation became clear.

Now, the Russian economy is reeling from an overall collapse in confidence. From St. Petersburg to Vladivostok, the outlook for many Russian businesses--as well as ordinary people--is growing bleaker by the day. Virtually all of the country's 1,600 banks are in trouble. Hundreds of smaller banks are likely to fail over the next few weeks. Even the country's leading banks are feeling the pinch. In the week following the ruble devaluation, seven of Russia's top banks were involved in mergers. The spate of deals was sparked by an offer by the Central Bank chairman of a "velvet nationalization"--bailout loans in exchange for equity stakes in the various banks. Default would convert ownership to the government.

NIPPED IN THE BUD? In Russia's return to statist capitalism, the vibrant part of its economy could be damaged. Alongside cash-strapped industry has grown a dynamic private sector encompassing everything from retail stores to computer software companies to small consumer-goods manufacturers. Now, they are caught in the financial squeeze, unable to withdraw their funds from banks or to pay for imported goods. In Moscow and other big cities, middle-class workers in new private companies are facing a tough autumn. Already, some brokerages and banks are cutting their staffs sharply. If layoffs soar, some observers think the young new middle class could take to the streets to protest Chernomyrdin's regime.

Will Chernomyrdin's counterrevolution succeed? By restructuring Russia's debt, the Russian government has bought some time. Even if Chernomyrdin can delay payments coming due in the future, he will still have to cope with the staggering flaws in Russia's economic system. He needs to attempt to make Russia's enterprises more productive, a task that will undoubtedly involve political pain. And the oligarchic rule of Russia's economy, while providing short-term stability, will continue the corruption and misuse of assets that has plagued the transition so far. Until the oligarchy is broken, Russia's economy won't be able to grow.

Perhaps it was wishful thinking to believe that a country so badly damaged by communism for 70 years could make the transition to capitalism in just a decade. Despite the fervent hopes of Westerners and Russian reformers, Russia moved only partly down the path to a democratic market economy. In the name of guaranteeing prosperity and well-being for ordinary people, Chernomyrdin has returned to power with the strong backing of a small political and economic elite. Now it's up to the Russian people to react--either through the ballot box or in the streets.

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