Shocking therapy in Russia and interenterprise arrears in post-communist economies

Transition to market economy in Russia, unlike its Eastern European Comecon partners, proved to be lengthy and arduous. Hyperinflation initiated in 1992 lasted for at least 4 year, while recession even longer. Most evident reasons for recession were falling of both investment and military expenses, those reasons accounted for 50% of industrial decline from 1991 to 1995. Nonetheless, recession took place in the most unexpected sectors, like, a production of food. Steady economic growth resumed only in 2000 after unheralded shocking therapy of 1998. The main designer of the reforms Yegor Gaidar was hoping for relatively fast economic transformation, but it took long 7 years and when everybody started to believe that market economy is impossible in Russia the growth took place. Reforms took so long due two reasons: absence of national payment system and mental inertia of soviet enterprises.

A priori, a central idea of reforms of overcoming the shortage in the consumable commodities by liberalizing prices and theirs consecutive stabilizing looked impeccable. Late USSR had a huge deficit of products, while people had enormous saving, buying a car required being on the waiting list for many years. Initial jump in prices was supposed to not only take away excessive amount of money from population, but also always plug the holes from which new money poured into economy.

During the first period of price liberation, January-May 1992, the problem of restraining of money in circulation was central for both the government and Central Bank. Tight control of the money supply was considered as the most important, and, essentially, the only way, to prevent sliding of the economy into hyperinflation. In retrospect, that was the most proper policy, which was implemented quite successfully due to both apt planning and fortunate spontaneously factors. Initial growth rate of the quantity of money in circulation around 9 – 13% per month. It still gives about 200% per annum, however in those macroeconomic conditions it was a victory. Huge initial jump in prices allowed to balance the budget. The government budget could become the main source of pumping money into economy, due to social obligation, yet they were incremented only 3 times. By January 1992 average pension were $3 per month, by the end of the year Ruble strengthen, but average pension made up to $7 per month. Meanwhile, average salary for the same period jumped from $7 to 39$ per month. Meaning the government did not increase pension, a budget outlays, to keep pension to salary ration constant. Credit emission (money base) of Central bank was only 8%.

Nonetheless, tight monetary policy was not that important. Inflation was not monetary in nature, it was cost driven. Taxation novelties changed the relation of wholesale to retail prices (in USSR companies were adding costs along the production line, no taxes or profits existed) and most enterprises tried to keep the same pre-reform level of real wages shifting costs to final product. Expectations of liberalization of energy prices also precipitated the inflation, while an actual increase took place on May 18, 1992. The contraction of the monetary supply did not effect the real economy, deepening recession were almost entirely determined by supply side factors. Falling demand and difficulties with sales in several industries forced companies to manufacture for stock, which fully met companies’ interests during hyperinflation. As the result, curbing of the money supply has not led to the stabilization of prices on the equilibrium level, but to rapid accumulation of trade credits which have led to interlocking webs of arrears among enterprises. This phenomenon called soft budget constraints, or virtually limitless source of credit for enterprises.

The first reason for arrears was a settlement principle of Soviet economy that companies kept following. Almost most settlements were based on payment requests. Simultaneously with shipment of products (rendering of service) provider send a payment request in bank. In many cases (electricity, transportation) provided did not even needed the acceptance from account owner. Chances of not having a required money on account were almost nil. In case of liquidity problem State Bank almost automatically lend money to enterprise. However, paying incapacity would put the enterprise on so-called “card-index number 2” and the director’s professional suitability would be questioned. This system without any change migrated to the market economy, which formally became so on January 1, 1992. With this system, the amount of money in the economy does not limit the demand, and as the result, the price inflation. In Soviet economy, there were no need for it, since all prices were dictated. However, in new environment price growth of purchased products did not worry enterprises, since they automatically shifted the price growth to its own good. The same thing happened with the rates of loans. As the result, higher interest rate led to even higher inflation. Non-payment from the costumers was compensated by non-payment to supplier, which essentially, was a credit from one enterprise to another. Signals of overpricing and lack of demand could come only from retailer sector, to which this “commercial loans” did not apply, at some point retailers would stop buying too expansive products. Meanwhile, produces would also stop supplying chromic non-payers. Demand restrictions that could stop eventual overpricing did not works since inflationary expectations made reasonable to accumulate unsold inventory, which could have been used as the collateral. When demand restrictions finally reached the producers, the only reaction available was to reduce output, not prices.

The second reason for arrears was transition of national payment system from interbranch turnover to correspondent accounts. Since 1933 all banks (all bank were, in fact, departments of the State bank) used interbranch turnover accounting for interbank settlements. Money always reached the recipients regardless of the interbank balance at the moment of transaction, moreover, the balance of a bank with respect to other bank played no role. Essentially, it means automatic interest-free and unlimited interbank credit, resources of individual banks did not require any demarcation. In 1988, five special-purpose banks were added over the existing banking system. Those banks used the same interbranch turnover accounting to get loans from the State bank, which means that in addition to existing emission center five more were added. In planned economy that system was stable, but since the beginning of reforms in 1990, system became uncontrollable and economy started to sink in the sea of money. To gain control over emission the newly founded Central Bank of Russia had correspondent accounts, the accounts of banks in the central bank. The main difference of the new system was requirement for bank to have positive balance that, in turn, gave Central Bank control over the emissions. The new system had a huge drawback: an extremely low speed for settlement operations. Within one region, say Moscow, situation was bearable, but it could take a week for transactions between different regions. New two-tier bank system failed test in the real time, rather unfortunate coincidence, as is always the case, with a critical period of reforms in other areas.

The last reason for interlocking webs of arrears was deep structural disbalance of prices, the heritage of Soviet economy. Deliberate disbalance was a social policy of USSR, for example, price for fuel and raw materials, energy, transportation and for many other categories were kelp relatively low. Low prices worked as hidden subsidizing for many industries. For example, one-bedroom apartment in Moscow was cheaper than a car. Low prices also facilitated access to fuel and energy in regions, which did not have fossils of their own. Low prices and direct subsidizing were leveling out living standards across different regions of USSR. Obviously, with such prices many industries did not break even. Basic mass of investment, including investment in circulating capital, was carried by centralized budget, which, in turn, collected all undistributed balance residual (“profit” in market economy). Even depreciation charges – income, in essence, – were transferred to the budget of the ministry, which is in charge of the given industry. Many industrial enterprises, especially in extraction, were planned money-losers and all losses were covered by centralized budget. For example, coal was gratuitous in comparison with today’s prices, but raising prices to at least industry average break-even production level would immediately affect food prices, which was impossible, especially after Novocherkassk uprising in 1962. Another example is agricultural (which were unprofitable, for the most part, because of low selling prices), where seasonal crediting had form of recursive “debt forgiveness”. Ironically, but after market equilibrating prices for farms the need for subsidizing villages did not seize, even became more grave. Hyperinflation during planting-harvesting cycle burnt all profits of villagers and they were simply giving harvest free, rather than for reduced prices as before.

In 6 month since the beginning of the reforms money started to matter, but they became less controllable. First reason was that demand for and circulation of real money (as distinct from above-mentioned webs of arrears) more or less stabilized. Reduction of enterprises’ real money balance levels out and for quite some time keeps at rather low level, around 12-15% of before price liberalization quantity. Further increase in money circulation is technically impossible, only if by paying salaries every day or even several times a day, what actually happened during the peak of hyperinflation. By the summer 1992, population normalized the cash leftovers, bringing it close to the purchasing level as for January 1. Normalizing of real money leftovers indicated that process of filling “cash-money niche” that opened during hyperinflation finalized ended. That had a dire consequence, if approximately from April until June 2012 most of cash emission fall into this niche, being amassed by population, then later emission had direct effect on the commodity prices. Second reason was that money supply in period April-June was increased by factors not controlled by Central Bank. Accretion of assets of trade balance among ruble trade zone (Russian Central Bank had a corresponding account with central bank of each trade partner), on one hand, increased demand for Russian products, on another hand, that ruble income not spent for import from those trade partners splashed out to commodity market, increasing inflation. In mid-1993 corresponding accounts for former soviet republics were closed (strictly speaking Ukraine and Baltic countries switched to new currency long before that).

Growth of the monetary base beginning from May approached 50% per month (that could be determined as hyperinflation). While growth of M2 (money supply) first 5 months ranged from 9% to 14% per month and accelerated to 28% per month. Largely lagging of money supply from potentially possible was due to the lack of banknote that did not match the new price level. By the second half of 1992 all money supply limits were completely removed. Ignoring of budget social obligations were not possible because of pressing social problems, so government and Central Bank started to amplify inflation. Since July budget deficit reached 25% of GDP and was financed by Central Bank, while credits to commercial bank started to snowball. Most money supply goes into economy as subsidies to faltering industries, eventually, that propelled the crediting activity of commercial banks and rained down to currency market. From then on the main problem became the budget balancing.


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