Clifford Gaddy and Barry Ickes coined the term "virtual economy" to describe the complex relation between the barter and cash sectors of the Russian economy. This relation exists, they argue, because unprofitable enterprises seek to protect their value-destroying activity. In an article published in Transition Newsletter (Vol. 9, No.4, August 1998) and in more detail in Foreign Affairs (Vol. 77, No. 5, September/October 1998), they explain Russia's economic crisis in terms of the virtual economy. Now that Russia is showing signs of recovery, is the virtual economy shrinking? Is this model still a useful one for analyzing the Russian economic situation?
Russia is in the midst of an economic recovery. GDP is growing for the first time since transition began. Signs of improvement appear widespread. Immediately after the financial collapse of August 1998, the future of the economy was spoken of in apocalyptic terms. More recently, optimism has returned. One recent evaluation asserts that the "current performance of Russia's macroeconomy could not be more impressive." Since the crisis, it is argued, there has been "a positive reversal in all the indicators of the so-called 'virtual' economy." The question then arises whether the virtual economy model remains applicable to Russia.
We argue that the answer is "yes." The virtual economy hypothesis remains the best way to understand current economic developments. The recent performance of the Russian economy does not pose a puzzle for the virtual economy hypothesis but is fully consistent with it. The real puzzle is why the recovery is so weak relative to the massive change in Russia's external competitiveness. As we show, the recovery occurred because of the windfall brought about by the exchange rate shock and the rise in world market prices for oil and other resources that Russia exports, not because of any essential change in the behavior of enterprises in Russia. This suggests that although postcrisis developments have given Russia a window of opportunity, this window is likely to close before any serious structural reforms take root.
Depreciation of the Ruble Improves Exporters' Balance Sheets
Understanding the current state of Russia's economy has to begin with an examination of the real devaluation of the ruble that occurred in the wake of the crisis. Thanks to a nominal depreciation that exceeded the ensuing inflation rate, the real value of the ruble at the end of 1998 was only about 36 percent of its immediate precrisis value.
In view of this dramatic real depreciation, it should hardly be surprising that Russia has shown signs of recovery. This exchange rate shock has hugely increased the ruble value of exports. Hence even without any behavioral changes, the balance sheets of exporters improve significantly.
One important mitigating factor slowing recovery is that the increase in competitiveness has coincided with a dramatic fall in household incomes. This was especially true in 1999, when incomes were roughly 75 percent of the 1995 level. This decrease in real incomes depressed domestic consumption. The increased competitiveness of domestic manufacturing has caused expenditure switching in favor of domestically produced goods, but the extent of this import substitution has been constrained by the decline in real incomes.
Perhaps the more important reason for the limited response to the real depreciation is that the incentives to undertake costly restructuring activities remain weak. Hence enterprises continue to operate as before. Poor quality means that producers are unable to reap the benefits from the huge improvement in their external competitiveness: despite the improvement in the terms of trade, Russian producers are exporting less than they did before the financial crisis.
How can we account for the fact that while Russian unit labor costs (measured in dollars) are still much lower than before the crisis (figure 1), machinery exports (measured in dollars) are below the levels achieved in 1998? One reason is that the real depreciation increased the cost of imported inputs, and the possibilities for import substitution in components for machinery manufactures may be slim—much smaller than in, say, food processing. Machinery producers may thus see their cost advantage dissipate.
There is an ironic paradox here. Consider the plight of enterprises that had invested to improve their competitiveness before the crisis. They may have purchased foreign-made machinery or retooled to be able to use high-quality imported components and materials, incurring dollar-denominated debt to purchase them. Although their efficiency improved, they now face an increased burden to import components and service debt. Were it possible to switch to domestic producers, they would be in a better position. The data on machinery exports suggest differently.
Level of Barter Declines
There has been a significant decline in barter as a share of industrial sales in Russia since the August 1998 crisis. There has also been an increase in tax payments paid in cash. These trends are widely interpreted as a sign of a healthy behavioral change on the part of manufacturers, even as an indication of the demise of the virtual economy.
To understand why these signs may have been misinterpreted, it is important to dispel a common misunderstanding. Barter is not the essence of the virtual economy. The essence of the virtual economy is the transfer of value from value-producing sectors—primarily, but not exclusively, energy and raw materials—to value-destroying sectors. Before the August meltdown, barter was a means of implementing this transfer.
One needs only to think about the effect of the real ruble depreciation on barter to understand what has been happening. The extent to which enterprises use money or barter is an economic decision. Because barter is costly, enterprises used cash for some transactions even when use of barter was at its peak. Enterprises traded off the transactions cost of barter against the cost of using money. (In the current Russian environment, that cost is primarily increased visibility, which implies greater tax liability.) When cash is more plentiful, the margin between using barter and using money shifts. Real depreciation thus shifts behavior toward greater use of money. This is a behavioral change, but it does not represent restructuring.
A second effect of the depreciation on barter—one that involves no behavioral change at all—is probably much more important. The depreciation of the ruble increases the size of the export-oriented part of Russia's economy (which is predominantly value adding and cash based) in ruble terms relative to the dinosaur part of the economy (which is largely value subtracting and noncash based). Hence the nonmonetary transactions that are needed to subsidize production at value-destroying enterprises shrink in ruble terms. This does not reduce the cost to the economy of this value transfer, however: the opportunity cost of the transfer rises with the increased profitability of exports.
Real depreciation will necessarily reduce the dollar value of the value-destroying sector. Think of it this way: a large enough ruble depreciation would shrink the dollar value of the virtual economy to zero. But that would still not end value-destruction as long as the industries responsible continue to operate. If there is no behavioral change, resources are still being destroyed...
Consumption and Investment Recover
The most important positive sign during 2000 has been the recovery in consumption and investment. We have seen that increased monetization is not necessarily indicative of real change, but a rebound in consumption and investment may signal that recovery is sustainable. Of course, as we have shown with our simple accounting example, real depreciation causes an increase in real income. This increase ought to manifest itself in higher consumption and investment. The real question is whether this recovery is more than just that.
The recovery in consumption is an important positive sign. During 1999 recovery was fueled almost exclusively by the depreciation of the ruble. The high cost of imports led to increased consumption of domestic goods, but this effect was seriously limited by the decline in household income in the wake of the August crisis. The fact that consumption is increasing means that there are some domestic sources of demand. Though still not at the 1995 level, consumption does appear to be on a steady increase.
The recovery in consumption is a welcome sign for Russia. But it is important to recognize that consumption has yet to achieve the levels reached in 1997 and early 1998. At this point there is no evidence to suggest that this is more than a cyclical recovery from the depths of the crisis—a "catching up" from the earlier decline. There is no evidence that Russian consumers are more optimistic about the future and have altered their consumption behavior, generating a new source of aggregate demand. Whether or not consumption growth is sustainable will depend on what happens to income, which in turn depends on whether the recovery itself is more sustainable. The recovery in consumption is not an independent variable in this recovery.
The steady growth in investment appears to be an even more positive sign. Investment grew robustly in the past year, rising 17 percent over the same period the previous year between January and August 2000. But the increase is from an extremely low level. Real expenditures on new construction and equipment are about 12 percent higher than in the summer of 1999, but they are still below the level of 1995 and 1996, and the average age of the capital stock rose from 8.4 years in 1970 to 16 years in 1998. It is hard to believe that the recent upsurge in investment can make a serious dent in this trend. Moreover, direct foreign investment was actually 22 percent lower in the first half of 2000 than in the same period in 1999.
The real question, however, is not the volume of investment but what this investment is used for. It could be that enterprises are using their export windfall to make necessary changes that will increase competitiveness. But it is also possible that enterprises are using this windfall as breathing room to avoid having to make such changes. Enterprises may be continuing to invest in good relations with officials and workers rather than in better productive processes. The critical question is whether this investment is an indicator of restructuring. An illuminating discussion of how the export windfall has translated into investment comes from a recent discussion of reform in the region.
Some view [the devaluation] as the latest removal of a hard budget constraint and an opportunity to recreate the firm [sic] which existed before the collapse in production. They are reinvesting in social assets to create a better environment for their workforce, and see their major task as increasing production to pretransition levels with little thought to efficiency or profitability. The General Director of Uralsyazinform, one of Russia's most successful and potentially promising regional telecoms, in the same breath mentioned that he was planning to sell 8 percent of his company in the form of ADRs to increase liquidity (perfectly laudable) and that his number one aim for investment was to improve the quality of his firm's social assets, which included hospitals and kindergartens.
The General Director of Uralsyazinform is investing—but not necessarily in reducing the competitive disadvantages of his enterprise. Investing in relationships may be advantageous to the director—and even to the enterprise in its negotiations with officials—but it does nothing to improve the economy as a whole. Investment may thus rise in response to the improvement in the financial condition of enterprises; whether that investment will be directed toward restructuring will depend on how durable agents expect the recovery to be.
Is the Windfall Disappearing?
The real depreciation of the ruble ended in January 1999. Since then the ruble has appreciated gradually in real terms, as a result of inflation, which averaged more than 19 percent during 2000 while the ruble held fairly steady. The rise in inflation has been due to rapid money growth, a consequence of unsterilized capital inflows, the counterpart to Russia's large current account balance.
This raises the question of whether the windfall is disappearing—an especially troublesome question given the lack of restructuring that seems to have taken place during this window of opportunity. Some evidence can be inferred from recent profit data. In the first four months of 2000, real profits in large and medium-size enterprises in Russia were up about 50 percent over January-April 1999. However, most of this growth came from the resource industries. Excluding oil and oil products, real profit growth was only about 10 percent. Excluding metals (ferrous and nonferrous), profits were 13 percent lower in January-April 2000 than in the same period in 1999.
Infrastructure Remains Weak and Capital Flight Continues
One barrier to a robust recovery in Russia is the still frail nature of its infrastructure. The sorry state of Russian infrastructure was highlighted, to some extent, by the events of last summer: the Kursk tragedy and the fire at the Ostankino TV tower. Generally, though, Moscow is somewhat of an outlier with regard to infrastructure. The situation elsewhere is much worse.
Perhaps the most important sign of the state of the Russian economy is capital flight, an important indicator of how agents view the stability of the economy. Capital flight from Russia remains high. The net outflow as of mid-2000 was about $18.4 billion—double the 1999 rate and about 18 percent of GDP. This increase coincides with a massive improvement in the current account balance. To some extent this is a blessing for Russia. If capital flight were not so high, inflation would be worse, because the Central Bank of Russia cannot effectively sterilize inflows. Given the lack of behavioral change, it is likely that a substantial share of domestic investment is going into production capacity typical of the virtual economy (that is, soft goods production). Given that likely alternative, capital flight at least preserves some of Russia's wealth until it can be used more productively.
One thing that is clear is that banks do not seem to have identified profitable investment opportunities. They are still flush with cash: bank credit (loans and interbank credit) accounted for less than 38 percent of total banking assets during the first half of 2000 (in the West the figure is 80-90 percent). The banks hold about 45 percent of their assets in foreign exchange and another 14-15 percent in noninterest-bearing accounts at the Central Bank of Russia.
The August 1998 devaluation represented a pure windfall for Russia's raw materials exporters, whose earnings rose by a factor of four as a result. The devaluation represented a massive, positive cash shock for these enterprises and for local economies based on them. As a result of the devaluation, tax revenue also increased, and wage, pension, and tax arrears fell. The devaluation also had modest benefits for a small sector of the economy that gained a price advantage relative to foreign imports. But these benefits carried a heavy cost. Incomes fell drastically, and they remain down. The poverty rate rose by nearly 50 percent.
The squeeze on households has been important. If there has been pressure to change anywhere in the economy, it has been not on enterprises but on households. The rise in profits has come largely at the expense of a decrease in real wages. The consequent pressure on households has not led to a push toward the market. The virtual economy is a protective mechanism. When it prevails, further pressure merely tightens the cocoon of protection against the market. The greater the hardship, the less likely people are to leave the cocoon.
The real depreciation of the ruble, followed by the rise in commodity prices on the world market, gave Russia a window of opportunity to alter the course of its transition. The depreciation could have provided the cushion needed to begin extricating Russia from the grips of the virtual economy. To date, however, there are few signs that such an effort is underway. This window opened at great cost to the Russian population, and it is now starting to close.
Even if this opportunity is not seized, there will no doubt be another in the future. But lessons from this current experience must be drawn. The key question is why behavior has not responded to the real depreciation, why the opportunity provided by the devaluation is being dissipated. The most basic answer is that structural factors that generate the incentives facing enterprise directors have not appreciably changed. The underlying structure of the virtual economy remains intact—value producers are still subsidizing value destroyers. Costly restructuring that could make an enterprise more competitive is still inhibited by fear of tax consequences and an end to subsidies. The economy is still stuck in the virtual economy trap.
The power of that trap is clearly huge. One would think that a 70 percent real depreciation would be a large enough shock to change the expectations of all players in the virtual economy. And yet if such a shock is viewed as temporary and if departing from the behavioral strategies of the virtual economy has long-term consequences, it should not be a surprise that agents are wary. To induce behavioral change it is necessary to convince them that the policy regime has changed.
What, then, can we say about policy, both in the postcrisis period and in the future? Since the financial crisis, the primary imperative of Russian leaders, including Yegeniy Primakov and Vladimir Putin, has been national security and domestic stability, not radical economic reform. This is not surprising. Radical reform would require wrenching economic change at a time when real income is already declining due to the real depreciation. As a result, the windfall in tax revenue that these governments enjoyed was used to pay arrears rather than to close plants that need to be shut down. Given the absence of government leadership, enterprise directors most likely concluded that the window of opportunity was not likely to remain open. For the overwhelming majority, the response has been to pocket the windfall rather than make painful adjustments.