9047 The Economy of the USS-J% International Monetary Fund The World Bank Organisation for Economic Co-operation and Development European Bank for Reconstruction and Development FILE COPY  The Economy of the USSR Summary and Recommendations International Monetary Fund The World Bank Organisation for Economic Co-operation and Development European Bank for Reconstruction and Development The World Bank Washington, D.C. @ 1990 International Monetary Fund; International Bank for Reconstruction and Devel- opment/The World Bank; Organisation for Economic Co-operation and Development; and European Bank for Reconstruction and Development All rights reserved Manufactured in the United States of America First printing December 1990 This study has been prepared by the staffs of the International Monetary Fund, the World Bank, and the Organisation for Economic Co-operation and Development, and by consultants to the designated president of the European Bank for Reconstruction and De- velopment. The findings, conclusions, and interpretations expressed in this paper are those of the staff concerned and should not be attributed to the International Monetary Fund, the World Bank, the Organisation for Economic Co-operation and Development, or the European Bank for Reconstruction and Development, to the executive boards or council of these organizations, or to their member governments. Library of Congress Cataloging-in-Publication Data The Economy of the USSR: a study undertaken in response to a request by the Houston Summit: summary and recommendations/International Monetary Fund ... [et al.]. p. cm. Includes bibliographical references. ISBN 0-8213-1768-7 1. Soviet Union-Economic Conditions-1985- 2. Soviet Union- Economic Policy-1986- 3. Perestroika. 4. Economic assistance- Soviet Union. I. International Monetary Fund. HC386.26.E28 1991 330.947'0854-dc2O 90-28630 CIP Table of Contents 1. Introduction 1 II. Summary 1 M. The Current State of the Economy of the USSR 2 1. The traditional system 2 2. Economic developments under perestroika 3 a. The 1985-87 "campaigns" 3 b. The 1987-88 reforms and their effects 4 c. Developments in 1990 9 3. Union and republic relationships 11 IV. The Present Course of Reform 11 1. The presidential guidelines 11 2. Macroeconomic policies and outlook for 1991 14 V. Alternative Approaches to Reform 16 1. The essential requirements for successful reform 16 2. Conservative versus radical approaches 18 VI. Main Elements of a Recommended Strategy 19 1. Macroeconomic policies 19 a. Fiscal adjustment in the short run 19 b. Structural fiscal reforms 20 c. Monetary policy 22 d. External policies 23 e. Incomes policies 24 2. Systemic policies 24 a. Price reform 24 b. Enterprise reform 26 c. External trade reform and foreign direct investment 29 d. Financial sector reform 31 e. Social safety net, labor market, education and training 32 f. Legal reform 34 g. Accounting, auditing and statistics 36 3. Sectoral issues 36 a. Environment 37 b. Distribution, transportation and telecommunications 38 c. Agriculture 39 d. Energy sector 40 e. Metal and mining 43 f. Manufacturing sector 44 g. Housing 46 VII. Criteria for, and Forms of, External Assistance 47 VIII. Endnotes 48 Text tables 1. USSR: Output and Expenditure 4 2. USSR: Fiscal Developments 10 3. USSR: Balance of Payments, 1986-90 10 4. USSR: Balance of Payments Scenarios for 1991 16 5. USSR: Domestic and World Energy Prices 42 Appendix tables I. USSR: Incomes and Prices, Money and Credit 49 II. USSR: External Trade, External Debt and Reserves 50 III. USSR: Distribution of Population, NMP and Budget Revenue by Union Republic, Social Indicators 51 Charts 1. USSR: Fiscal and External Imbalances 5 2. USSR: Money, Incomes and Prices 6 3. USSR: External Debt and Debt Service 8 4. USSR: Energy Production and Trade 41 5. USSR: Employment by Sector 45 iv The Economy of the USSR I. Introduction authorities discussed the various reform propos- als that have been tabled in recent months and At the Houston Economic Summit in July 1990, their implications; they also released much infor- the Heads of State and Government of the seven mation thathad hitherto been unavailableoutside major industrial democracies and the President of the USSR, but have not provided information on the Commission of the European Communities gold and foreign exchange reserves. requested that by the end of the year the IMF, the As requested by the Heads of State and Govern- World Bank, the OECD and the designated presi- ment, we have maintained close contact with the dent of the EBRD, in close consultation with the Commission of the European Communities Commission of the European Communities, un- throughout the course of this study. Information dertake a detailed study of the Soviet economy, has been exchanged on a regular basis; a number make recommendations for its reform, and es- of joint meetings were held in Moscow; and tablish the criteria under which Western economic meetings were also held in Brussels, Paris and assistance could effectively support such reforms. Washington. Our main findings and recommendations are summarized in this study; a series of background H. Summary papers, pulling together the substantial amount of material that has been collected and which un- The deceleration of economic growth, evident derpins our views, will be issued shortly. from at least the early 1970s, has recently turned Members of the four organizations met with a into a fall inoutput and employment, accompanied wide variety of civilian interlocutors at both the by evident and growing imbalances. The old union and republican levels, and were received planning system has broken down but has not with much courtesy and helpfulness. The staffs of been dismantled; meanwhile, the structures vital the Ministry of Foreign Affairs and the State For- to the functioning,of a market have yet to be put in eign Economic Commission of the Council of place. This will require an early and effective Ministers organized most of the discussions. The clarification of the division of responsibilities be- Gosbank, Goskomobrazovaniye, Goskomstat, tween the union and the republics. Goskomtrud, Goskomtsen, Gossnab, Gosplan, Three points are worth stressing. First, there is Ministry of Finance, Ministry of Foreign Economic no example of a successful modern centrally Relations, the State Commission for Economic planned economy. Second, attempts to enhance Reform of the Council of Ministers, performanceundertheoldsystemhaveproved to Vneshekonombankandmany other organizations be counterproductive: central control was reduced and individuals provided, at an already excep- but market signals and discipline were not estab- tionally busy time, unstinting assistance. ahe lished. And, third, the revolutionary opening up 1 of public debate has cast doubts on earlier enterprises would generally begin with their achievements while exposing the extent of the commercialization;' all of this in the context of the economic deterioration and creating uncertainty. imposition of a hard budget constraint on enter- Ideally, a path of gradual reform could be laid prises remaining under state ownership and ac- out which would minimize economic disturbance companied by an opening up to foreign trade. and lead to an early harvesting of the fruits of The authorities face an enormous task, involv- increased economic efficiency. But we know of no ing reforms of the legal, financial and trade sys- such path, the more particularly given the difficult tems and also of vital sectors of the economy, starting conditions. Indeed we doubt that a return especially agriculture, distribution, energy and to central control is a viable option, and would manufacturing. These changes cannot be made in urge the authorities to move rapidly to give sub- a matter of weeks. But the imperative is to make stance to their commitment to a market economy. sufficient progress at the beginning so that reform This involves addressing simultaneously issues is seen as an irreversible break with the past and of stabilization and structural reform. the process gains an unstoppable momentum. In our view, the restoration of financial stability The necessary economic reform program cannot will require a very sharp reduction in the deficit of beimplemented withoutan initial declinein output the general government-the equivalent of the and employment, but delays in implementation state budget-from its 1990 level of some 8 percent would lead to an even larger and longer decline. It of GDP; the absorption of excess money holdings; is therefore essential that a safety net be in place at a strong hold on credit creation; and movement the start of the program. towards positive real interest rates. In the short The rest of the world can help the reform pro- runthis should be supported by anincomes policy cess. Technical assistance, in which the private whichwould setbothafloorfor social reasons and sector could play a substantial role, could be a ceiling on the growth of incomes. Given the provided over a wide area and would be of great weaknesses in other control instruments, incomes value in preparing for the introduction of markets. policy seems indispensable at least for the transi- There is also a case for humanitarian assistance, tion. provided that the distributional problems can be Financial stabilization by itself does nothing to solved, as well as for well defined programs in the establish a market. It must be accompanied by environment and energy areas. General balance rapid and comprehensive price liberalization, of payments assistance or project assistance may which is clearly the appropriate response to be useful when a comprehensive program of shortages (though a few prices for key industrial systemic reforms has begun to be implemented, inputs might be adjusted progressively to world leading to a closer integration of the economy of levels, perhaps over three years after an initial the USSR into the world economy. sharp adjustment). At the same time there should be rapid progress towards trade liberalization. III. The Current State of the Economy of the Rents and prices of a few essential consumer USSR2 goods may also need to continue to be subsidized to a limited extent in the near term. This would 1. The traditional system provide an effective safety net to the population, a significant part of which is estimated to be below The system of central planning established in the the poverty line. A rationalization of the price USSR in the late 1920s and early 1930s remained structure would be facilitated by a broadening of fundamentally unchanged for the next 50 years. It the parallel market for foreign exchange, and had been developed to facilitate accelerated in- within, say, a year, the unification of the exchange dustrialization based mainly on the rapid mobi- market for current account transactions. lization of capital, labor and material inputs, with But stabilization and price reform together will lesser emphasis on their efficient use. This ap- only set the scene for a meaningful supply response proach implied the need to raise substantially the if they also are accompanied by the establishment share of investment, to increase labor force partici- of private ownership rights and the elimination of pation rates and to redirect factors of production the panoply of controls which currently prevent from agriculture to industry. Meanwhile the de- competition and discourage the efficient use of velopment of consumer goods production was resources. Smaller firms should be privatized neglected. Virtually the entire capital stock was quickly and directly; ownership reform in larger nationalized and agriculture collectivized; pri- 2 vate ownership of the means of production was by the late 1960s and 1970s, the limits of continued outlawed; and activities not in accordance with rapid mobilization of capital and labor had been the plan could be considered economic crimes reached. At the same time, rigidities in the system carrying stiff penalties. hindered the increases in productivity needed to Through the Five-Year Plans, and in particular sustain rising output. As a result, the rate of the annual plans, the State Planning Committee economic growth began a secular decline. This (Gosplan), along with other agencies and branch slowdown is reflected even in official statistics- ministries, directed the physical allocation of re- widely acknowledged to have exaggerated sources, structural change, and the pace of eco- growth-which show the annual average growth nomic growth. Prices played little role in the rate of net material product (NMP) falling from allocation of resources. Producer prices tended to almost 8 percent in the second half of the 1960s to be fixed by the authorities for long periods, while a little over 3 percent in the first half of the 1980s. retail prices generally were kept stable, with low However, as the world's second largest exporter prices for staples being a matter of social policy. of oil, the USSR was a major beneficiary of the oil As a result, there were sporadic, and in some cases price shocks of 1973-74 and 1979-80. The resulting chronic, shortages of specific goods. enormous terms of trade gains cushioned and to Insulation of the domestic price structure from some degree masked the growing limitations of world prices was achieved through a system of the extensive growth strategy and the shortcom- variable taxes and subsidies on foreign trade-so- ings of the existing economic system. called price equalization-which relegated the Periodic piecemeal reforms-intended largely official exchange rate to an accounting role. For- to improve the functioning of the existing system eign trade was carried outby non-competing state- rather than to change it fundamentally-were owned foreign trade organizations. The aggregate unsuccessful in halting the underlying decline. In foreign trade plan was an integral part of the the early 1980s, the leadership began to adopt a overall national economic plan, with export levels more critical view of the existing system, and to determined on the basis of the imports required to consider the implications of major economic re- meet output targets in priority sectors. The insu- form. lation of the economy meant not only that gains from trade were forgone, but also that the transfer 2. Economic developments under perestroika of technology from abroad was impeded. Financial policies were passive, in the sense of A. THE 1985-87 "CAMPIGNS." Beginning in 1985 being geared to provide the state-owned enter- several major initiatives were introduced to revive prises with the financial means to fulfill physical economic growth and to deal with the main plan targets. Monetary and fiscal policies had no weaknesses of the economy. While these came to active, independent role to play. The monolithic be encompassed under the broad heading of banking system-consisting of the state bank perestroika, or "restructuring," the initiatives un- (Gosbank) and several state-owned specialized dertaken in the 1985-87 period were more in the banks-granted credit to enterprises to support nature of traditional "campaigns" than reforms of the plan, accepted deposits from enterprises and the economic system. These campaign themes households, and issued currency. The deposits of focused on the retooling and modernization of enterprises were not freely usable, as control was industry (largely through a step-up in the rate of exercised through branch ministries and different investment); heightened emphasis on quality funds were earmarked for specific purposes. In- control; the policy of glasnost and other measures terest rates were kept low, and played virtually no designed to unleash human initiative and make role in allocating financial resources. Similarly, the bureaucracy more accountable; and the anti- fiscal policy was subordinate to the plan and state alcohol campaign. enterprises effectively faced soft budget con- While some met with initial success, they did straints. Nevertheless, until the 1980s,conservative not in the aggregate address the underlying sys- fiscal management and administrative controls temic problems. Indeed, over this three-year pe- over enterprise spending prevented serious riod, economic conditions actually deteriorated. macroeconomic imbalances. Officially measured growthof net material product In the 1930s and again in the early post-World (NMP) averaged some 2 percent in 1986-87, below War II period, this system and the so-called exten- the average rate reported for the first half of the sive growth strategy produced rapid growth. But 1980s (Table 1). Allowing for hidden inflation 3 Table 1 USSR: Output and Expenditure (annual average growth in percent; comparable prices 1) 1990 (official 1976-80 1981-85 1986-89 1986 1987 1988 1989 estimate) NMP 43 3.2 2.7 2.3 1.6 4.4 2.5 -4.0 of which: Industry2 5.1 3.9 4.2 5.5 4.6 6.3 0.4 - Agriculture -0.2 1.0 2.4 7.1 -1.4 2.5 1.7 - Construction 3.1 3.2 6.6 12.1 5.5 7.6 1.6 - Transport and communications 3.8 2.9 0.8 4.2 0.3 5.8 -6.5 - Private consumption 4.2 2.9 3.4 1.9 2.7 3.9 5.3 3.0 Net fixed investment 2.6 -1.7 -1.1 4.9 5.7 -7.4 -6.7 -20.0 1. This is similar, though not identical, to the Western concept of constant prices. As noted in the report, it is widely believed that official Soviet statistics underrecord inflation, and hence overe timate real growth in both output and expenditures. 2. Excluding turnover taxes. Source Data provided by the Soviet authorities. (price increases not included in the official price Another major reform step undertaken in this index because they are supposedly offset by qual- period involved the decentralization of foreign ity improvements), output may well have stag- trade, with the share carried out by entities other nated. Economic difficulties were aggravated by than the traditional state-trading organizations the sharp decline in world oil prices in 1986, which reportedly rising substantially by 1989. Other adversely affected both export earnings and the reforms in the external sector included the intro- budget. The authorities reacted to these adverse duction of a foreign exchange retention scheme, a events by boosting export volumes to the con- systemof differentiated exchangecoefficients, and vertible currency area and by slashing imports. foreign currency auctions with limited transac- Fiscal performance, already weakened by the tions. As these measures were introduced in a declining value of foreign trade, further deterio- piecemeal fashion, they had the opposite of their rated asa result of a stagnation in receipts from the intended effect. Imports from the convertible turnover tax and increases in subsidies. Hence, currency area grew strongly following the decen- the fiscal deficit rose from around 2.5 percent of tralization of foreign trade and financing and GDP in 1985 to more than 8.5 percent of GDP by manufactured exports scarcely changed (Appen- 1987(Chartl). Correspondingly,monetarygrowth dix Table 11). accelerated; but since much of this was held in Increased enterprise autonomy was severely enterprise deposits, which were not freely usable, circumscribed by the system of state orders, which the immediate impact on demand was largely covered most of industrial output in 1988 and suppressed (Appendix Table I and Chart 2). 1989. Some dismantling of the traditional plan- ning system began, but the inflexible and dis- B. THE 1987-88 RFoRms AND THEI EFFECmS. Cam- torted official price system was left essentially paigns to modernize the economy and instill a intact, as was the role of the state distribution new sense of discipline gave way in 1987-88 to a agency (Gossnab) in allocating most material in- more pronounced emphasis on reform of the puts. From 1988, enterprises were allowed to system itself. The centerpiece of this new effort negotiate "contract" prices for so-called new was the Law on State Enterprises which replaced products, but these were still subject to official traditional mandatory output targets for enter- surveillance and, in any event, covered only a prises with so-called state orders (namely centrally fraction of enterpriseproduction. Encouragement directed orders to firms to deliver specified of private economic activity was limited to small quantities of goods). The law also permitted firms numbers of joint ventures with foreign participa- some latitude to negotiate with each other, and tion and a grudging acceptance, beginning in granted them greater autonomy in the allocation 1988, of so-called cooperatives, which were, how- of their internally generated funds, in particular, ever, subject to various restrictions and sporadic in the payment of wages and bonuses. campaigns of harassment. Although a two-tier 4 Chart I USSR FISCAL AND EXTERNAL IMBALANCES a. State Budget Baare I/ 0 0 (as percent of GOP) -2 -2 -4 . -4 -6 -8 -8 --8 -10 . -10 1985 1986 1987 1988 1989 1990 b. Trade Balance 0.6 JO. (as percent of GDP) 0.4 - curre**. - 0.4 -0A with nonconvertible currency area -0.41 -o4with convertible *,--0.4 currency area 2/ . 1985 1986 1987 1988 1959 19 Source: Ministry of Finance. Goskomstat and staff calculations. 1/ Including extrabudgetary agricultural price support. 2/ Excluding gold. 5 Chart 2 USSR MONEY, INCOMES AND PRICES 18 18 (annual percentage change) 16 - - 16 14 - M2 . 14 12 12 10 Household ~ 10 Money Incomes 8 8 6 -6 Retail price index , 2 --, '2 0 0 1986 1987 1988 1989 1990 Source: Goskomstat. 6 banking system was created in 1988, the central debt and debt service ratios continued to be below bank (Gosbank) was given neither the indepen- those of most other Eastern European countries dence nor the instruments to combat inflation. (Chart 3). Administrative controls over financial flows were The uneven degree of liberalization involved in relaxed but not replaced by market mechanisms the reforms and their bias towards financial laxity for credit allocation or new instruments of mac- was accompanied, as the decade ended, by a host roeconomic management. Interest rates on both of special factors that aggravated shortages. Oil deposits and credits remained low and fixed; al- and coal production, which had been maintained though bank credit to enterprises declined during byhighratesof generally low-yielding investment this period, enterprise liquidity rose, boosted by in the 1980s, began to fall in 1989, and the decline higher retained profits. Lack of discipline in wage continued into 1990. Bottlenecks became a serious settlements grew, and successive attempts to rein problem in the railroad network. Agriculture in the growth of wages through the taxation of continued to be a drag on growth, and suffered $1excess" wage increases were unsuccessful, as from serious storage and distributional problems. these schemes were undercut by exemptions and An important side effect of glasnost was an in- lax enforcement. To the extent that firms had creasing display of ethnic consciousness. By the wider scope for making production and invest- end of the decade, instances of open conflict be- ment decisions, they did so in an environment of tween nationalities were leading to disruptions in distorted and rigid prices. Arguably, a serious output and transport. Under glasnost, public mistake was made by loosening trade, wage and concern with severe environmental problems in- financial controls on enterprises whilst failing to creased. Well-publicized cases such as Chernobyl harden their budget constraints or to liberalize led to the formation of environmental pressure prices. groups sometimes associated with nationalist There was a second sharp terms of trade loss in movements. These groups forced plants to close 1988. As in 1986, it resulted in a further deterio- and blocked new developments, thereby adding ration of the fiscal balance, which was aggravated to the economic dislocation. by a decline inprofit remittances from enterprises, Throughout this period, the measured growth as well as by a rapid increase of consumer subsi- rate of the capital stock continued to decline; net dies both inside and outside the budget. The fixed investment (excluding unfinished con- deficit widened, reaching 11 percent of GDP in struction) fell from 14 percent of NMP in 1988 tol1 1988. The fiscal deficits were almost exclusively percent of NMP in 1990. The growth of the labor financed by credit extended by Gosbank. As a force also continued to decelerate, reflecting a result, and despite the contraction of credit to the persistent slowing in the rate of growth of the enterprise sector, broad money growth averaged population of working age in most republics, and 14-15 percent annually in 1987-90. Enterprises, in a particularly large fall in labor participation rates their efforts to dispose of surplus liquidity, accu- in the republics of Central Asia where population mulated excess inventories and launched new growth remained strong and from which migra- investment projects that merely added to the large tion to other areas of the USSR was limited. stock of unfinished construction. The military burden on the economy remained The mounting domestic imbalances, combined significant; the actual level of military spending with the deterioration in the terms of trade and has long been a matter of debate, and it is widely lack of control over import growth, led from 1988 believed that its share in national income rose in onward to a sharp deterioration in the external the 1980s. Since 1987, however, the authorities accounts. The balance of trade with CMEA have announced that they aim to freeze and then countries worsened, as the effect of past declines reduce defense outlays. The budget for 1990 in oil prices continued to bring down the five-year shows a level of defense spending equivalent to moving average oil price used in CMEA trade. around 7 percent of GDP, although this figure is The trade surplus in convertible currencies also calculated on a narrower basis than the U.N. dropped sharply in 1988, and disappeared alto- definition of defense exenditures. If expenditures gether in 1989. Consequently, the gross external for internal security and for all budgeted research debtinconvertiblecurrenciesoftheUSSRbuiltup and development (in particular the space pro- rapidly to US$54 billion by the end of 1989, with gram) are added to defense expenditures, the most of the increase concentrated in short-term figure would rise to over 9 percent. Some have debt (Appendix Table IIVd However, the external argued that, allowing for the fact that prices of 7 Chart 3 USSR EXTERNAL DEBT AND DEBT SERVICE a. External Debt (as percent of exports of goods and services) 600 600 0o 1985 Poland e2 1989 50 - - 500 400 - 400 Hungary 300- 30 Bulgaria 200 - USSR 2o Czechoslovakia Romania 100 100 0 EII 0 b. External Debt Service 100 100 C3 1985 Hungary Poland 90 e 1989 9 so- Bulgaria so 70 - 70 60 - 60 50- 50 Romania USSR 30- 30 Czechoslovakia 20 198.L-.20 10 M , 10 Source: Ministry of Finance. Vneshekonombank and national sources. 8 many defense goods may be substantially deficit through money creation. For 1990 as a underpriced, the total defense burden might be whole, the deficit was officially projected to be twice as high. Although no official figures are broadly in line with the budget plan, implying a available for arms exports, Western estimates decline in the adjusted deficit to below 8 1/2 suggest that they might have been US$16-18 bil- percent of GDP (Table 2). The plan to finance a lion in recent years or about 15 percent of exports. larger share of the deficit by issuing government The concentration of the highest quality labor and obligations to the nonbank public, however, was material inputs in the defense sector could well largely unsuccessful. Liquidity creation remained have seriously retarded the growth of the pro- strong, as progress in cutting the budget deficit ductivity in civilian production. Since 1987, was offset to some extent by expanding credit to however, the government has pursued an active enterprises. policy of converting defense-related manufactur- Both open and estimated repressed inflation' ing to the production of civilian goods. Between continued to accelerate in 1990. Retail prices are 1988 and 1990 the production of civilian goods by officially estimated to have risen 5 percent for the thedefenseindustryroseby 9percentperannum, year as a whole and the underlying rate of infla- accounting for roughly 50 percent of the output of tion (that is, including an estimate of therepressed the defense industry at the end of that period. component) is officially projected at about 12 per- These results were, however, considerably below cent. Asa resultof rapid moneygrowth, combined announced targets; and the quality of the output with largely unchanged administered prices in was reportedly low. No detailed assessment of recent years, sizable amounts of excess liquidity these matters was made during the course of this have built up. Excess liquidity is now estimated study. at approximately rub 250 billion (or about one third of the stock of financial assets) for households c. DEVELOPMENTS IN 1990. By 1990, the economy and enterprises combined, with about two thirds faced increasing problems. The policies embod- of this total accounted for by household holdings ied in perestroika had failed to halt the secular de- of cash and deposits. This growing monetary terioration of performance, and official estimates overhang is the financial counterpart of the suggest that NMP may have fallen by 4 percent in worsening shortages. 1990. Most of the reduction in output was in According to official estimates, which could be industry, construction and transportation, while overstated because of hidden inflation, real con- value added in agriculture as a whole-despite a sumption is thought to have increased in 1990 by near record grain harvest-was estimated to be about3 percent, only slightly less than the average roughly unchanged from a year earlier. The ser- growth rate during 1986-89. Consumer goods vices sector continued to grow, however, leading imports continue to grow. However, supplies of the authorities to expect a somewhat smaller de- particular products have contracted severely and cline in GDP, of about 2 percent. Enterprise prof- shortages of basic consumer goods are a rapidly its were expected to fall in 1990 after annual in- growing concern. creases averaging well over 10 percent during The continued decline in petroleum output and 1986-88. Wages and salaries have increased by the fact that oil and other energy prices in CMEA about 12 percent, while total household incomes trade had been fixed for the year as a whole meant rose by even more (in 1990, per capita GDP using that the USSR was unable to take full advantage of the new commercial exchange rate was US$1,780). the sharp rise in world oil prices in the second half For the first time in post-war history, overall em- of 1990. Oil export volumes fell in 1990 by nearly ployment in 1990 appears to have declined and 20 percent, with CMEA countries taking the brunt "unemployment," while not yet an officially ac- of the decline in deliveries. Trade with the cepted concept in the USSR, was informally esti- nonconvertible area moved into a larger deficit on mated by officials at about 1.5 percent of the labor a transactions basis in 1990, largely due to the force. decline in oil exports. The current account deficit In 1990, the authorities made efforts to tighten (excluding gold) in convertible currencies is esti- financial policies. The state budget had been the mated at almost US$11 billion (Table 3). While drivingforcebehindmoneycreation, and emphasis receipts from gold exports amounted to nearly was therefore placed on fiscal measures, in par- US$4 billion, thecapital account recorded a deficit ticular on reducing state-financed investment and of US$7 billion because of a sharp decline in the on developing alternatives to the financing of the availability of short-term financial credits and 9 Table 2 USSR: Fiscal Developments (percent of GDP) 1985 1986 1987 1988 1989 1990 (estimates) (plan) State budget revenue 47.3 45.8 43.6 41.7 41.0 42.8 of which: From state enterprises 14.9 15.8 15.0 13.2 11.9 12.6 Turnover taxes 12.6 11.5 11.4 11.5 11.8 12.7 State budget expenditure 49.7 52.0 52.0 51.0 49.5 50.6 of which: Investment in the economy 8.2 8.3 8.7 8.7 7.2 4.4 Subsidies 8.9 9.4 93 10.1 10.6 11.8 Overall balance -2.4 -6.2 -8.4 -9.2 -8.5 -7.9 Adjusted balance' - - -8.8 -11.0 -9.5 -8.3 1. Includes cost of extrabudgetary agricultural price support, but excludes balance of centralized fund operations. Source Data provided by the Soviet authorities and staff calculations. because access to international capital markets of convertible currency imports (Appendix Table was only possible when guaranteed by creditor II). country governments. The overall balance of The traditional centrally planned system has payments deficit of US$14 billion in convertible largely collapsed, but has not been replaced by a currencies was financedbya sharp drop inforeign functioning market system. The progressive exchange reserves and accumulation of arrears to breakdown is perhaps most visible at the retail foreign suppliers (more than US$5 billion). Thus, level, with few goods to be found in state shops, despite the balance of payments deficit, gross barter becoming common and black markets and external debt inconvertible currencies isprojected the dollarization of the economy spreading rap- to decline slightly to some US$52 billion at the end idly. Meanwhile, policy making in the republics of 1990 while external reserves have fallen to some has been characterized by growing autonomy. In US$5 billion, equivalent to less than two months a climate of deepening shortages, republics have Table 3 USSR: Balance of Payments, 1986-90 1986 1987 1988 1989 1990 (staff projections) (billions of U.S. dollars) Convertible currencies Trade balance 4.1 8.3 4.8 - -5.7 Current account' 2.3 6.7 1.6 -3.8 -10.7 Gold sales 4.0 3.5 3.8 3.7 3.6 Capital account -5.7 -12.5 -6.1 -3.6 -7.2 Overall balance 0.6 -2.3 -0.7 -3.7 -14.3 (billions of rubles) Nonconvertible currencies Trade balance 3.2 2.1 -0.8 -1.0 -6.7 Current account 2.9 1.6 -1.5 -4.1 -7.3 Capital account -1.9 -3.3 0.5 -2.5 7.3 Overall balance 1.0 -1.7 -1.0 -6.6 - 1. Excluding gold. Source Data provided by the Soviet authorities and staff estimates. 10 become increasingly unwilling to trade with each The size of the republics is very uneven. The other except on a barter basis. By late autumn the Russian republic alone has 51 percent of the popu- formal rationing of a range of consumer staples, lation; Ukraine and Belorussia together comprise already quite widespread in some regions, was another 22 percent (Appendix Table 111). The being introduced in both Moscow and Leningrad. three republics account for an even larger share of There was mounting concern over the possibility NMP (82 percent). By contrast, the three Baltic of greatly increased internal migration by various republics account for only 3 percent of the popu- ethnic groups fleeing regions regarded as politi- lation and NMP. Despite the vast size of the cally unstable, but external migration was also country, the republics are highly dependent on thought to be a serious threat as people try to trade with each other and, with the exception of escape material deprivation. the Russian republic, the share of NMP of each In the course of 1990, there has been a growing republic delivered to the other republics ranges recognition of the need for a bolder, more com- from 31 to 67 percent of NMP; for the Russian prehensive and market-oriented reform program republic, the share is only 18 percent (1988). to halt the unraveling of the economy. This sense The republics are less dependent on foreign of urgency is put forcefully in the presidential trade. Exports as a share of republican NMP are guidelines "for the stabilization of the economy highest in the Russian republic (9 percent, when and transition to a market economy," of October foreign trade is valued at domestic prices) and 19, 1990: lowest in Armenia and Kirgizia (1 percent of NMP). "The position of the economy continues to Theexportofrawmaterialsisheavilyconcentrated deteriorate. The volume of production is in a few republics. The Russian republic accounts declining. Economic links are being broken. for 73 percent of the export of oil and gas and Separatism is on the increase. The consumer Ukraine and Belorussia for another 10 percent. market is in dire straits. The budget deficit Foreign trade by republics valued at domestic and the solvency of the government are now prices gives a distorted picture because oil, gas at critical levels. Antisocial behavior and and other raw materialsareunderpriced compared crime are increasing. People are finding life with other goods, measured on the basis of world more and more difficult and are losing their market prices. If traded goods were valued at interest in work and theirbelief in the future. world market prices, the Russian Republic would Theeconomyisinverygreatdanger. The old have a large trade surplus with the rest of the administrative system of management has world while virtuallyall theotherrepublics would been destroyed but the impetus to work un- reportedly record a trade deficit. der a market system is lacking. Energetic Ethnic and political differences in the USSR measures must be taken, with the consent of were largely suppressed during most of the post- the public, to stabilize the situation and to revolution period. However, during the last few accelerate progress towards a market years, the tensions have become more open and economy." thecallsforpoliticaland economic change stronger. By December 1990, all 15 union republics had 3. Union and republic relationships declared either independence or sovereignty. The trend towards autonomy and increased barter The union consists of 15 union republics which- trade between the republics has recently been according to the 1977 Constitution-have the right reflected in the establishment of border controls to secede and to enter into relations with foreign on trade, particularly for necessities such as food states. The second tier of government consists of products. 20 autonomous republics (16 of which are in the Russian republic); autonomous regions (oblasts), IV. The Present Course of Reform and districts (okrugs), all of which are directly re- sponsible to their respective union republics. The 1. The presidential guidelines third tier includes the towns and villages (rayons). Ethnic differences are immense. The USSR has During the first three quarters of 1990, no fewer more than 120 ethnic groups and one fifth of the than four alternative programs for transition to a total population of 288 million live outside their market economy were presented to the Supreme ethnic republics. Soviet. They differed in terms of the modalities, 11 timing and sequencing of the proposed reforms. wholesale level will be reduced administratively In mid-October, in an attempt to secure broad at the beginning of 1991. Although some 40 per- consensus on a reform program, the President cent of producer prices are to become subject to announced a framework for a reform program, negotiation between enterprises, these prices will "Guidelines for the stabilization of the economy remain under the surveillance of the authorities to and transition to a market economy", which were prevent profits from exceeding centrally-deter- subsequently approved by the Supreme Soviet. mined norms. The presidential guidelines state that "there is The picture is less clear for retail prices. Some 5 no alternative to shifting to the market." While the to 15 percent of these prices (mainly for "luxury ultimate goal is clear, the guidelines do not pro- goods") were to be liberalized before the end of vide a detailed plan or timetable for the transition, 1990, with the pace of further liberalization in 1991 partly because considerable freedom is envisaged to be determined in the light of progress in stabi- for the republics to choose the specific modalities lizing the financial situation and supply condi- and timing of various reform measures. A broad tions. Itisenvisaged that in 1991 responsibility for sequence of four stages is outlined, however, with consumer subsidies-and consequently the prices the first stage to be devoted mainly to stabilizing of subsidized commodities-will be partially the economy and beginning commercialization shifted to the republics. By the end of 1992 price and privatization of state enterprises. The second controls on consumer goods would be eliminated stage would emphasize the gradual liberalization except for a narrow range of essential goods. of prices, introductionofa social safety net and the Although the guidelines call for legislation to maintenance of tight financial policies. Further establish private property rights and promote structural reforms, including those of the labor privatization of state property, they are vague as compensation system and the housing market, to methods. No specific time horizon is provided wouldbecoveredinthethird stage,while financing but the presidential document suggests that the constraints would be eased as markets stabilize. privatization process-except possibly for the In the final stage, the preconditions would have retail and services sectors and small industrial been set for achieving the internal convertibility of businesses-is likely to be stretched out over a the ruble so as to enable Soviet and foreign com- long period. The virtues of competition are panies operating in the USSR to sell and buy freely stressed, but the guidelines provide few detailed foreign currencies at market rates. It is hoped that measures; and no mention is made of eliminating these four stages could be completed in 1 1/2-2 restrictions on the products which individual years. This transition presupposes an effective all- enterprises are permitted to produce, or the role union market under which a stable sharing of import liberalization should play in promoting power and responsibility will have been agreed competition. Financial accountability of enter- between the union and the individual republics. prises is emphasized, but the guidelines are silent While bold in terms of their medium-term ob- on such issues as the criteria for the selection and jectives, the guidelines-and the various specific evaluation of managers of state enterprises or the measures that have been taken or announced thus prospective role of workers' organizations in this far-suggest a relatively gradualist approach to process. the transition. Alarge share of output is to continue The presidential guidelines recognize that in- to be produced under state orders at least during dustrial restructuring will likely lead to job losses the firststage,and enterpriseshavebeen instructed in many enterprises. Estimates by government to maintain "stable supply links" through 1991. agencies of the foreseeable increase in unem- Both policies could be operated to retard the de- ployment in 1991 rangebetween 1 and 6 million or velopment of enterprise autonomy, managerial 1-4 percent of the labor force. The program calls initiative, and the restructuring of the economy. for steps-e.g., the creation of a state employment In any event, there is serious doubt whether these service-to facilitate retraining and the early in- policies will be realized in practice, given the troduction of unemployment compensation, as widespreaddisruptionsthathavealreadyoccurred well as a series of other measures, most of which to traditional economic links and the continued are currently underconsideration by theSupreme spreading of shortages. Soviet. The prospective role and instruments of Price reform is also to proceed cautiously. Dis- incomes policy are set out only in general terms, tortions in relative prices at the producer and but the authorities seem to envisage a revised 12 system for the taxation of wage increases deemed planned elimination-except on a temporary ba- "excessive", as well as a policy of limited index- sis under exceptional circumstances-of the fi- ation. nancing of budget deficits by Gosbank, and a The guidelines call for a major redirection of more active use of indirect means of monetary resources and investment towards industries control, including reserve requirements, refinanc- producing consumer goods. Certain ongoing in- ing policies and the establishment of at least non- vestment projects in non-priority sectors will, if negative levels of real interest rates. Legislation possible, be converted to other uses or halted hasbeenrecentlyapprovedbytheSupremeSoviet altogether, and unfinished construction will be to establish a full two-tier banking system, with a sold off to the extent feasible. The restructuring union reserve system. effort is to be fostered by tightening budget con- While the guidelines are nearly silent on ex- straints on enterprises, increases in interest rates change rate policy (with the exception of brief on investment credits, and the closing of several references to the objective of eventually establish- hundred unviable firms. The program also envis- ing ruble convertibility), important reforms have ages the creation of enterprise restructuring funds begun to be implemented. A new commercial ("stabilization funds"); support would be condi- exchange rate, three times the official rate, became tional on the reorganization of enterprises, changes effective on November 1, 1990. The commercial in management, and conversion to other activities. rate will be applied to the bulk of current account But again, little is said about the precise criteria for transactions, while a special rate (equivalent to ten the distribution or duration of the proposed sup- times the official rate) will remain in effect for port. Although no details are given on military tourists and variousnon-commercial transactions. conversion plans, the authorities have indicated The commercial rate will be pegged to the same that the production of civilian goods by defense basket of currencies as the official rate industries is targeted to increase by 30 percent The authorities also intend to create a free ex- over the period 1989-91. change market (possibly by expanding the scope The state budget deficit is to be contained to of the existing auction market) open to Soviet 2 1/2 to 3 percent of GDP, an amount thought to enterprises regardless of the extent of foreign be financeable largely through borrowing from ownership. The existing retention quotas for ex- the nonbank public. A major policy effort would porters will be raised and a joint union-republic be needed to achieve this target, since the draft foreign exchange fund will be established; it will budget for 1991 suggests a substantially larger be supplied with surrendered foreign earnings. It budget deficit (see section 2). is unclear at this time whether the republics will Measures are to be introduced to address both agree to the sharing of foreign exchange in the the "stock problem" of excess liquidity of house- proportions envisaged in the decree. There are holds and enterprises-the monetary overhang- also no clear indications regarding the extent to and the "flow problem" of overly rapid growth in which the authorities envisage intervening in the the money supply. To absorb the overhang, the free market; nor which institutions (e.g., the union guidelines lay emphasis on sales of physical and and republican central banks or the financial assets. A rise in interest rates is required Vneshekonombank) would be responsible for such to increase the attractiveness of bank deposits; a interventions. first increase in these rates (up to 9 percent) was The guidelines envisage a further weakening of announced by Gosbank at the end of October. the state's monopoly on foreign trade, but the There are also suggestions that household deposits general impression is one of relatively slow may be revalued to compensate for any loss of progress in trade liberalization. Export quotas for purchasing power entailed by large increases in the principal exports are likely to be maintained retail prices. Given the volume of these deposits, for sometime. A new tariff schedule, in line with such a move would carry heavy costs for either the the harmonized system, has been prepared but it budget or the banking system-in effect for the will continue to be supplemented by a range of Government-and would make the elimination import and export taxes,havingin some instances of the monetary overhang more difficult. quite high rates. The guidelines refer also-without quantifica- Liberalization of foreign investment is likely to tion-to measures to contain monetary growth in proceed much faster. A recent decree allows full 1991 and beyond. These measures include the foreign ownership for the first time, and a draft 13 foreign investment law is under consideration ties, which would be subject to rationing. which, inter alia, is intended to protect foreign Price policy will have major implications for the investors against future adverse changes in leg- budget outlook for 1991. The authorities have islation. recently submitted a draft budget for 1991 to the Supreme Soviet. In contrast to previous years, this 2. Macroeconomic policies and outlook for 1991 year only a draft union budget has been pre- sented, since agreement could not be reached with Prospects for the Soviet economy in 1991 are nec- some republics on their budgets. The document essarily uncertain. Economic policy remains in a also contains, however, forecasts for the consoli- state of flux as the debate between the union and dated state budget, based on current information the republics over the direction, pace and man- on the republican budgets. Accordingly, these agement of reforms continues. On the external forecasts are subject to great uncertainty. side, it is unclear whether the envisaged changes The draft budget assumes the maintenance of in CMEA trade and settlement will in whole or in retail prices of subsidized commodities at their part take place at the beginning of the year, and present level and the decontrol of a sizable share the price of oil in world market remains unpre- of retail prices of commodities subject to the turn- dictable. over tax, so as to avoid the loss of revenue that It is assumed that a political agreement will be would result from the planned increases in whole- achieved in the near future ensuring a unified sale prices. As a result, price subsidies would economic space, with a single currency, free almost double in nominal terms in 1991, while interrepublican trade and clear and mutually ac- revenue from the turnover tax would virtually cepted rules for the apportionment of revenues stagnate and decline sharply in relation to GDP. and expenditures among different levels of gov- Given these projected developments in two major emnment. Should this not occur, there would be a items of the budget, together with an expected risk of growing fiscal and financial indiscipline large increase in social benefits resulting from and increased open or repressed inflationary already enacted legislation, the deficit for the state pressures. budget (rub 59 billion) is projected to be almost It is further assumed that, in line with the presi- double the level envisaged in the presidential dential guidelines, efforts will focus in the near guidelines. term on re-establishing traditional supply links, But this target level for the deficit is only reached and that state orders will continue to account, on by relying heavily on a number of steps which average, for a large share of production, as pro- involve little fundamental improvement in the jected in the draft plan for 1991 currently under public sector finances, specifically: consideration in the Supreme Soviet. As indus- (a) the shifting to extrabudgetary funds (in par- trial restructuring-including the conversion of ticular to the stabilization funds) of large items of military industries-is expected to continue to be expenditures (notably most capital investment guided primarily by (increasingly ineffective) previously financed by the budget, transfers to administrative intervention, rather than by mar- less developed regions of the country, and sup- ket mechanisms, it is questionable whether it will port to restructuring programs for public enter- be as extensive as the authorities hope. prises); and Policy intentions on prices remain unclear. As b a trebling (from 12 percent to 37 percent) of regards wholesale prices, it is assumed that they the payroll tax to finance a pension reform as well will increase on average by 50-60 percent, while as some of the expenditures of the stabilization those agricultural procurement prices not already fund; the levying of a (one time) tax on the no- increased in 1990 would rise, on average, by about tional capital gains of enterprises on their "excess" 30 percent at the beginning of 1991. The debate on stocks, resulting from the planned wholesale price the reform of retail prices continues, with union increases; and the appropriation to the stabiliza- authorities advocating relatively little liberaliza- tion fund of 20 percent of enterprise depreciation tion and an administrative pass-through of many charges; wholesale and procurement price increases to the There are also substantial increases in nominal retail level while others, in particular in certain terms (35 percent or more) for expenditures on republics, support rapid decontrol of most prices research and development, health, education and with the exception of a few subsidized commodi- welfare, and defense, but given the uncertainties 14 regarding prices, it cannot be judged whether or liberalization, and/or their administrative in- not any decline in real terms is expected. The creases, the rate of recorded inflation could well budget would appear to imply strong increases in rise to more than 40 percent. If inflationary pres- both the tax burden on enterprises-as revenues sures from adjustments in input costs, and espe- from taxes on the latter are projected to rise by cially from growing excess demand, were not over 70 percent-and net budgetary transfers to allowed to be reflected in price increases, short- households. This is likely to boost consumer ages and disruptions in internal trade would likely demand, while hardly fostering a positive supply intensify. This could well accelerate the current response. rate of decline of output, leading to a fall in net Moreover, there are serious risks that the overall material product of 5 percent or more. deficit of the state budget will exceed the projected In addition to the uncertainties relating to the level, as certain revenues appear to be overesti- outlook for oil prices, energy production and the mated (especially those from profit taxes), while reform of the CMEA system, the prospects for the certain expenditures (in particular those for inter- balance of payments for 1991 will be significantly est payments and unemployment benefits) may affected by developments in the domestic be underestimated, and there are as yet no provi- economy, by the growing decentralization of for- sions, such as limits on bank borrowing, to pro- eign trade and by the recent changes in the ex- mote financial discipline at each level of govern- change rate and the exchange arrangements re- ment. ferred to in the previous section. On balance, it In these circumstances, it is difficult to foresee would appear that the introduction of the new an adequate tightening of monetary policy. On commercial exchange rate for the ruble, coupled the one hand, monetary financing of the budget with the abolition of the differentiated foreign may well exceed the already relatively high level exchange coefficients, will not prevent a fall in of 1990, especially if interest rates on the govern- Soviet manufacturing exports, particularly to the ment debt were to remain well below the underly- CMEA area. Imports will, of course, be primarily ing rate of inflation. On the other hand, enterprise constrained by foreign exchange availability but demand for bank credit is likely to be boosted by alsobytheexpecteddeclineininvestmentdemand. the tax increasesandby a recently proposed freeze Alternative scenarios have been prepared, based of part of their bank deposits. Unless these de- on a range of assumptions regarding, in particular mands are effectively resisted, the rate of mon- the price of crude oil (US$20 or US$26 per barrel) etary growth may well accelerate in 1991, thereby and the decline in the volume of oil exports (17 or hindering the absorption of the monetary over- 25 percent). In both scenarios, foreign financing hang. gaps are calculated assuming a decline in the A firm stance of monetary policy would be volume of imports of 7 percent (which, given the essential to secure wage moderation, especially in foreseeable sharp drop in imports of equipment, conditions of an even partial price liberalization. would be consistent with a modest growth of The authorities'intentions with respect to incomes imports of food and consumer durables). Under policy remain unclear at the present time. In those assumptions, the current account deficit vis- particular, it is uncertain to what extent the index- A-vis the traditional convertible currency area (ex- ation mechanism envisaged in the presidential cluding gold exports) would range between guidelines would be applied to increases in prices US$10.1 billion and US$14.7 billion (Table 4). In of nonessential goods which are to be liberalized. addition, the Soviet authorities will face in 1991 The response of wages to these price increases, in large amortizations of medium- and long-term the absence of formal indexation mechanisms, debt (amounting to about US$12 billion). Given would be significantly affected by the tightness of the secured financinglamounting toUS$17 bil- credit policy. lion, and assuming no further decline in interbank Given the wide range of persistent uncertainties deposits, the financing gap in convertible curren- regarding price, incomes and financial policies for cies could range between US$5.6 billion and 1991, it is impossible to predict with confidence US$10.2 billion. But part of this gap will be filled the outlook for output and inflation. Neverthe- by the prospective surplus vis-a-vis the CMEA less, it appears very likely that economic perfor- area (estimated at between US$9.9 billion and mance will worsen significantly on both counts US$6.6 billion under the twoalternative scenarios) next year. Depending on the extent of retail price depending on the financing available to these 15 Table 4 USSR: Balance of Payments price reform in an environment of increased do- Scenarios for 19911 mestic and external competition, and ownership (billions of U.S. dollars) reform. The speed and sequence in which they Ofwhich:and the necessary accompanying legal and other L~ wich:measures are introduced will determidne the costs Convrtible CMEA of the initial adjustments, and the speed with Total currency area area which the benefits of reform come through. Attempts to restructure the economy coincide Base scenario with a major decentralization of political author- Trade balance 5.4 -4.1 11.1 ity and responsibility. Many aspects of the eco- Services balance -7.2 -6.0 -1.2 nonic reform depend upon prior, essentially Current account balaence ac. oldu1.n101 9 political, decisions: property can hardly be com- balance acol. mercialized and privatized until ownership is Current account balance (inc. gold) 1.7 -6.5 9.9 clarified, and rights to private property fully pro- Capital account, net ... -11.0 ... tected; fiscal reform cannot be planned until the Overall balance ... -17.5 .taxing authority and expenditure responsibilities Arrears -5.0 -5.0 -of the different levels of government are defined; Financing requirementO ... 22.5 .t.o. of which: Identified financing ... 16.9 ... prices of major inputs, such as energy, will be set in a more decentralized USSR. Hence, there is an Alternative scenario' urgent need for a new Union Treaty to determine Trade balance -3.6 -8.7 7.8 the allocation of powers and responsibilities or, at Services balance -7.2 -6.0 -1.2 least, for formal agreement between the union Current account and the republics on the most pressing issues. balance (excl. gold) -10.9 -14.7 6.6 The USSRs movement toward greater political Current account balance (ind. gold) -7.3 -11.1 6.6 decentralization and regional independence is Capital account, net ... -11.0 ... consistent with continuing economic interdepen- Overall balance ... -22.1 ... dence. Economic integration among sovereign Arrears -5.0 -5.0 states in other parts of the world has been increas- Financing requirement4 ... 27.1 ... ing, as the benefits of wider markets for goods and of which: Identified financing ... 16.9 ... factors of production are sought. The erection of 1. The balance of payments is broken down by the traditional intra-regional barriers to economic transactions convertible currency area, CMEA area (exct the former German should be avoided and where they already exist, Democratic Republic) and countries with which the USSR had they should be dismantled. This study assumes bilateral payments agreements in 1990 (which is not shown separately), although a large part of trade with the latter two areas that the republics will maintain an all-union mar- will also be conducted in convertible currencies in 1991. 2. The base scenario assumes a 17 percent volume decline in the exports of crude oil and oil products compared with 1990 and an oil tweenrepublics;acommoncurrencyandexchange price of US$26 per barrel. rate, and therefore a common a 3 The low export scenario assumes a 25 percent volume decline in the exports of crude oil and oil products compared with 1990 and an common external tariff; and an agreed division of oil price of US$20 per barrel. 4. Official foreign exchange reserves and gold reserves have in this presentation been projected to remain unchanged. different levels of government. Sourc. Staff projections. The key recommendations for systemic reforms in this study take into account the special charac- countries and on the disposition of their accumu- teristics of the USSR. These include important lated claims in transferable rubles on the USSR. differenceswithothercentrallyplannedeconomies in transition, namely the closed nature of its V. Alternative Approaches to Reform economy and its particularly distorted relative prices, a complete lack of experience with private 1. The essential requirements for successful reform ownership, little exposure to a market system, and unresolved constitutional questions. But the USSR The transformationof the Sovieteconomy is bound is in a better position than several other economies to be extraordinarily complex and will take many in terms of rich natural endowment and smaller years to complete. At its heart lie three closely external indebtedness. related elements: macroeconomic stabilization, Difficult and complex policy decisions have to 16 be made and implemented in each of the key economy is going to succeed, existing barriers to interrelated areas of reform. Macroeconomic sta- competition, including monopolies, must be bro- bilization, for example, requires that the budget ken down, and new enterprises and products deficit be reduced to a level that can be sustained encouraged. This will entail a dismantling of state without recourse to the inflationary creation of orders and of branch ministries. Competitive money. The reform effort also requires the impo- pressures can also be enhanced by the mainte- sition and maintenance of a tight credit policy and nance of a common economic space, and by trade a rise in interest rates to control the potential liberalization. inflationary consequences of price liberalization Many additional measures are needed to sup- and to ensure the imposition of a hard budget port policy actions in the three key areas. The constraintonenterprises,whichwillthenbeforced initial phase of the transition will involve consid- to respond to the market signals. Markets cannot erable dislocation, and a shift to market prices will begin to develop until prices are free to move in hurt those with low incomes. A social safety net, response to shifts in demand and supply, both including an unemployment compensation pro- domestic and external. The exchange rate, an- gram, will therefore be needed to protect the most other key price, needs also to be moved to market vulnerable from short-term adverse consequences clearing levels. Price decontrol is essential to of the reform process; over the longer term a ending the shortages that increasingly afflict the comprehensive system similar to that of other economy. In present circumstances the switch to market economies will have to be developed. market clearing prices should be seen as a short- These safety nets will need to be designed in ways term measure to bring an end to the economic that are compatible with the requirements of the disruption resulting from increased hoarding, budget. barter, the black market, dollarization and the In the early stages of the transition, stabilization restrictions onthe free internal movement of goods. policy should be combined with an incomes policy Indeed, the planned administrative increases in that guides wage developments and providesboth producer prices are unlikely to have the desired a floor and a cap on wage increases. It may also be incentive effect unless market clearing prices re- necessary for a short period to shield enterprises store the role of the ruble as a valued medium of somewhat from the dislocations caused by rapid exchange. With price subsidies now amounting changes in the prices of a few key inputs, espe- to more than 10 percent of GDP, price reform is cially energy, and in a few sectors from intense essential also to the attainment of macroeconomic competition of international markets. It is none- balance. In turn, macroeconomic stability is nec- theless essential to move as rapidly as possible to essary for the success of price reform. a transparent and decentralized trade and ex- Enterprises must be able to make decisions with change rate system, in order to hasten the inte- the guidance of price signals. This will require gration of the USSR into the world economy. financial autonomy, with owners and managers A market economy is underpinned by a legal taking responsibility for the full range of business and institutional infrastructure, with private decisions and for the financial benefits and costs property rights at its foundation. While it will of those decisions. Experience shows that this is take time to complete the necessary reform of the most likely to happen when assets are privately legal system, security of private property must be owned. Private ownership also creates opportu- assured from the outset in order to encourage nities for individuals and reduces political inter- private initiative. Even though the privatization ference in managerial decisions. In the case of oflargerstateenterprisesislikelytobeprotracted, larger enterprises, where privatization is complex rapid privatization of small enterprises and and likely to move slowly, ownership reform commercialization of larger enterprises will show should begin with prompt commercialization. commitment to this course. Ownership reform is therefore essential for the These steps represent a large initial undertak- full success of price reform. In addition, the sale of ing, but would still leave a vast amount of work state assets may contribute to macroeconomic unfinished. Completion of the legal infrastruc- balance, though not too much weight should be ture to provide for competition and combat mo- attached to the prospects of early, large-scale re- nopoly, the creation of a market system for bank- ceipts from privatization. ing and finance, the demonopolization and re- Steps should be taken to create and maintain structuringof manyenterprises, the reconstruction competitive markets. If the transition to a market of the transport and communication infrastruc- 17 ture, the development of a system of labor relations, broadly maintained. A recovery from the reduced the process of privatization of state enterprises level of output should be able to get under way and collective farms, and the addressing of serious within two years or so. If financial policies were environmental problems, are just some of the kept tight, inflation would by then be under con- major economic tasks that lie before the Soviet trol, and the conditions for a much more efficient government and people in the years ahead. And allocation of resources, guided by market prices, of course, since the economy evolves over time, put in place. A period of catching up with Western the process of reform is never finished, neither in standards of efficiency could begin, during which an economy going through radical change as in growth in productivity and output would likely the USSR, nor in established market economies. exceed that of most mature market economies. The remainder of the study examines reform Unemployment would be expected to decline as issues as they affect the major policy areas and the initial labor shakeout gave way to a strong sectors of the economy. The reforms described recovery in employment. Further strong growth will all have to be made during the transition to a of output and rising living standards could be market economy. No unique schedule of reform expected for the remainder of the decade and canbe prescribed, nor isitlikely that any predeter- beyond, and there would be a good possibility of mined schedule could be followed with any pre- significant financial flows from abroad. cision. Nonetheless, two broad alternative ap- The prospect of a sharp fall in output and rapid proaches to sequencing can be distinguished-a increase in prices in the early stages of a radical conservative approach, and a more radical ap- reform is daunting. The key question is whether proach which we recommend. hesitancy, of the kind implied by the conservative scenario, could mitigate the initial loss of output 2. Conservative versus radical approaches and still permit the transition to an operational market economy with sustained growth. In our In the conservative approach, reform starts with judgment, the conservative approach would al- some tightening of fiscal policy, while structural most certainly fail on both counts. There are two reforms proceed on a slow track. In the initial possibilities. In the first case, suppose policymak- stage, prices are adjusted, but remain to a large ers succeed in combining a partial tightening of extent administratively controlled. Macroeco- financial policiesand some hardeningof enterprise nomic stabilization would be attained gradually budget constraints with the maintenance of ad- with price decontrol taking place over a period of ministered prices on most goods. The absence of two to three years. The radical scenario, by con- fully-functioning markets would require that trast, begins with a strong macroeconomic stabi- significant resources continue to be allocated lization program, designed to reduce the budget primarily through administrative controls and deficit rapidly to or below the level of 2 to 3 the use of state orders, and the central allocation of percent of GDP, accompanied by immediate de- inputs. At best, however, this would delay the control of most prices and the start of privatization inevitable elimination of wasteful and unwanted of small-scale enterprises. productionand thesheddingof excesslabor. Given Given the changes in economic behavior and the prevalence of distortions, the surge in pro- the structure of the economy implied by these ductivity that market-determined prices and en- scenarios, it is not possible to quantify their effects terprise initiative could deliver would not be with any confidence. But a comparison in general forthcoming, output would still fall and inflation terms, that draws on worldwide experience of increase substantially. Lack of confidence could stabilization and reform programs, may help to become self-fulfilling as disappointing results illustrate the tradeoffs involved. discredit the goal of a market economy, and lead Despite the stronger stabilization measures as- to a loss of policy direction and collapse of the sumed in the radical program, the price level strategy at a fairly early stage. would be likely to rise immediately by more than Worse still would be a situation in which the under the conservative program. Output could authorities, in addition to holding back on struc- fall sharply as nonviable production was cut, and tural reforms, failed to implement sufficiently unemployment would rise. But since investment rigorous fiscal and monetary policies. This seems would be curtailed initially and inventories run particularly likely in the conservative scenario, in down, and with some availability of external as- which the warning signs from rising inflation sistance, aggregate consumption levels might be would be suppressed by price controls. The result 18 would be growing macroeconomic imbalances, might provide technical and financial assistance increasingly severe shortages and rising black to firms that were prepared to undertake well- market prices. The liberalization and restructur- designed restructuring programs and which ing of the economy could not proceed under these showed promise of being viable after the restruc- conditions, and as action was promised but not turing. And finally, procedures, including bank- delivered, the commitment even to the ultimate ruptcy, are envisaged that would facilitate the objectives would quickly lose credibility. reorganization of otherwise viable firms through In short, the chances of staying with a conserva- the write down of excessive past debts. These tive strategy through the medium term are slim. cushions should help reduce the losses in employ- The best that would have been achieved in the ment and output that will inevitably accompany meantime is the postponement of both the costs the restructuring program. However, they must and the benefits of restructuring. In the worst be managed with care if they are not to compro- case, the costs themselves would have risen, as the mise the longer term objective of restructuring administered supply system broke down, and enterprises to participate in a competitive market financial imbalances continued to mount. The economy. result may lie somewhere between these two outcomes, though in our view it would probably VI. Main Elements of a Recommended be nearer that of the worst case. Strategy In advocating the more radical approach we are well aware of the concerns of those who recom- 1. Macroeconomic policies mend caution. We are also aware that even the so- called conservative approach would until very All the reform plans emphasize the need for re- recently have been considered to be extremely strictive fiscal and monetary policies, supported radical. There are three main concerns about the by an effective incomes policy, in the early phases radical approach. First, it might impose unneces- of transition to a market economy. Stabilization sary hardships on consumers, particularly the measures, involving steps to absorb excess liquid- more vulnerable groups. For that reason, we ity, substantially reduce the budget deficit and recommend programs that will mitigate the ad- moderate credit expansion are essential to contain verse effects of the transition on consumers. We inflationary pressures in the wake of price liber- also recommend that controls be kept temporarily alization. A firm incomes policy would help on the prices of public utilities and housing rents. moderate the response of wages to price increases, Second, price decontrol in the face of macroeco- and lessen the risks of an inflationary spiral. On nomic imbalances, extreme concentration of eco- the external front, the achievement of a sustain- nomic power and supply shortages and inelas- able balance of payments position, within a con- ticities could lead to a serious wage inflation spiral text of a progressive opening of the economy to and large monopoly profits. Therefore, macro- foreign competition, requires the early establish- economic stabilization must accompany price ment of a realistic level of the exchange rate, as decontrol, all this in a climate of increased domes- well as a careful management of the external debt. tic and external competitiveness. Short run stabilization needs to be comple- Finally, there is a concern that undue burdens mented by a determined beginning of structural could be placed on enterprises that would be reform in the fiscal, monetary and external areas, viable if given time to adjust. We therefore recom- as well as systemic reforms, affecting, for instance, mend cushioning the impact of the transition to ownership arrangements, enterprise management, world market prices for a selected group of goods. prices and the labor market. The successful pur- Following a significant initial adjustment, the suit of these reforms would be instrumental in balance of the change to a world market price promoting sustainable growth with domestic and would be phased in over a two to three year external balance over the medium term. period. This could be done through border taxes which would give temporary protection beyond A. FISCAL ADJUSTMENT IN THE sHoRT RUN. The target that provided by the general tariff and which for the state budget deficit in 1991 set out in the would be reduced over time, and on the export presidential guidelines (21/2-3 percent of GDP) side through declining export taxes on a few basic would appear broadly in line with the require- inputs, particularly energy. In addition, the pro- ments of short run stabilization since, provided it posed union and republican stabilization funds were accompanied by an appropriate interest rate 19 policy, it would require little resort to monetary expenditures will also be needed, to reflect shift- financing. But the draft budget for 1991 envisages ing priorities at national and subnational levels. a deficit substantially higher than the presidential The tax administration will require extensive re- target, and, moreover, even this higher deficit organization and an overhaul of procedures to risks being exceeded by a sizable margin, in the adapt it to a market economy. Substantial reforms absence of further corrective measures. This is of the budgetary process, which to date has been regrettable. Substantial efforts would need to be tied closely to the plan, will also be required. made to secure an outcome for the state budget closely in line with the presidential program tar- (1) Intergovernmental fiscal relations. A new get. We would recommend the following steps. framework of intergovernmental fiscal relations (1) Existing turnover taxes, which are variable isexpected tobe included in the Union Treaty. But wedges between wholesale and retail prices, there are still important disagreements on the should be quickly replaced with fixed rate ad main features of that framework. One view is that valorem taxes, implying a full pass-through to the the primary authority in budgetary matters should retail level of any increase in wholesale prices of remain at the union level, with clearly defined taxed commodities. In the process, it would be revenue and expenditure responsibilities for most desirable to improve the turnover tax further subnational governments; the other is that the by streamlining its rate structure and broadening republics should be given virtual sovereignty over its base, inter alia to include imports, and to fiscal matters, with a limited set of spending re- complement it with excise duties on, for example, sponsibilities given to the union, and financed alcohol, petroleum products, tobacco and luxury through negotiated upward transfers of revenue goods. In addition to yielding additional revenue from the republics. in the short run, these reforms would lay the These issues will not be decided on economic foundation for the introduction of a VAT within groundsalone.Nevertheless,econon-carguments two or three years. (2) Price subsidies, which are and the evidence from other countries suggest projected to nearly double in 1991, should instead that a system of upward revenue sharing would be significantly reduced from their 1990 level, for have many disadvantages. It would severely limit example by limiting the quantity of subsidized the use of the union budget as an instrument of commodities. (3) The proposed levies on enter- macroeconomic management; and,dependingon prise depreciation charges and inventory the limits that can effectively be placed on the revaluation could be replaced with a uniform budget deficits of republican governments and mandatory dividend payout (a percentage of af- their financing, it might weaken budgetary disci- ter-tax profits) for state enterprises. (4) Existing pline at all levels of government. A system which tax preferences and exemptions should be further gave each level of government autonomous and reduced. (5) Sharper cutbacks should be made in well-defined revenue-raising powers would seem lower priority expenditures, including subsidies to strike a more reasonable balance between mac- to loss-makingenterprises, defense outlays (which, roeconomic management considerations and the even at the probably understated level of about 7 rights of subnational authorities, though such a percent of GDP, absorb a higher share of resources system would also have to include limits on the than in most countries), and expenditures on per- ability of each level of government to run deficits. sonnel and administration. (6) Adequate financ- The revenue sharing formula could assign differ- ing should be secured for the proposed new ent tax bases to different levels of government, or unemployment compensation scheme. make use of arrangements for tax sharing or tax overlapping that are used in other countries. B. STRUCrURAL FISCAL REFORMS. The evolution of Given the wide economic, social and demo- government finances over the next few years will graphic differences among republics, there are both reflect and influence the overall reform pro- likely to be significant differences in the level and cess in the economy. An early definition of the composition of taxation and public expenditures respective revenue raising powers and spending among subnational governments. The scope of responsibilities of the union and subnational such differences would, however, be circum- governments, in particular the republics, is es- scribed by the effective enforcement of an all- sential. As reforms proceed, the tax system will union market with free movement of goods and need to be changed further, and a restructuring of factors of production. Differences in taxing ca- 20 pacities will require some continued redistribu- of the tax laws and regulations should aim at tion of resources through the union budget. narrowing the scope for discretion by the tax administration. It will also be necessary to de- (2) Taxpolicyand administration. There havebeen velop modem procedures for tax collection, pro- several changes in the traditional revenue system cessing of rettims, enforcement and audit; and to during the reform process. The recent reform of reorganize the expanded National Tax Service, enterprise taxation, which has replaced most while beginning to computerize it. transfers from state enterprises to the budget with a company profit tax levied at a basic rate of 45 (3) Restructuring of government expenditures. percent, is a significant step towards more trans- Economic reform will require a substantial re- parent, predictable and neutral taxation of enter- structuringof government spendingover the next prises. Assuch,itismoreconsistentwithasystem few years. For instance, imposition of a hard of private ownership of enterprises. However, budget constraint will make it necessary to elimi- serious deficiencies remain in the definition of the nate various forms of budgetary and profits tax base. In particular, the treatment of extrabudgetary support to loss-making enter- depreciationanddeductionsforwagesandinterest prises. Programs to support enterprises under- costs needs to be reconsidered, as do the envis- taking restructuring, and individuals displaced aged confiscatory tax rate for "excess profits" and in the process, will need to be transparent, limited the granting of tax preferences to certain catego- in time and amount, and designed to facilitate, ries of enterprises. rather than slow, the process of adjustment. The reform of the individual income tax has The pension reform due to begin in 1991, which increased the progressiveness of its rate structure widens the coverage of the pension scheme, im- but has not touched its basically schedular nature, proves benefits and provides for their full index- with tax rates differing according to the nature of ation, canbe justified by the erosion of pensions in the income. The top marginal rate of 60 percent real terms during recent years and by the need to will deter taxpayer compliance, and the multiplic- protect the most vulnerable groups during the ity of brackets will complicate administration. transition period. It is intended that the reformed Over time, the tax base should be widened to pension system should remain on a pay-as-you cover other income categories (such as interest go basis without budgetary support. Medium receipts), which are likely to grow rapidly in a term scenarios based on demographic trends market-type economy. The replacement of differ- suggest that this may require substantial further ent schedules for various types of incomes with a increases in the payroll tax, with likely adverse global personal income tax will probably need to effects on employment growth. It would be wait for a substantial strengthening of tax admin- therefore advisable to tighten eligibility require- istration. Given the price increases expected in ments, in particular by gradually raising the re- 1991, it will soon be necessary to make appropri- tirement age for most occupations, to lengthen ate adjustments for inflation in both personal and the service period over which pension benefits enterprise income taxes. are calculated, and to limit multiple pensions. The reforms of the turnover tax discussed in the Pension and disability programs ought not to be previous section, leading to an eventual shift to a used as hidden unemployment compensation, VAT and complementary excises, would help es- especially as an unemployment insurance pro- tablish a broad and neutral revenue base, which gram is to be introduced shortly. would keep adequate pace with the growth of the A more integrated approach to manpower and economy. Taxation of foreign trade will need to be wage policies for the government sector is desir- reconsidered as the trade and exchange system is able, includingan adequate differentiation of civil reformed and as exchange rate policies are modi- servants' salaries and a containment of the gov- fied. Changes will have to balance revenue con- emient payroll. Such changes could yield sig- siderations with those of speeding up the nificant budgetary savings, and improve the integration of the economy into the world trading quality of the public service. system. The higher interest rates that will be needed for It will be advisable to move as quickly as pos- effective monetary control will have important sible to a more arm's length relationship between implications for the budget. A part of the impact the tax adm-tinistration. and taxpayers. Revisions of higher interest rates on bank deposits can be 21 absorbed by the banking system or passed on to would run counter to the desired objectives of borrowers or both. However, as government debt enterprise reform. represents the main counterpart to savings depos- A preferable method to absorb excess liquidity, its, an increase in interest rates on outstanding in particular of households, without risking an debt seems all but inevitable, if adequate profit- inflationary spiral, could be sales of government ability of the banking system, and in particular of assets, including land, buildings, shops, small the Savings Bank, is to be ensured. The budget businesses and eventually shares in large enter- will also have to bear the full cost of market prises. While the portfolio of government proper- interest rates on new government paper. ties that could eventually be privatized is, indeed, While there may be a valid rationale for the very large and much in excess of any measure of creation of extrabudgetary funds for certain well- the overhang, privatization is likely to proceed defined and limited programs financed from ear- slowly, particularly in advance of the clarification marked revenue (notably contingent liabilities of ownership rights. It might be useful, therefore, such as the Social Security Fund) the proliferation to launch quicklya program of sales of government of such funds that is now foreseen could seriously bonds with the principal indexed and convertible undermine the stabilization role of fiscal policy. It in due course to shares in privatized enterprises or would also weaken the scope for unified scrutiny housing. and control of the budget by policy makers. In More generally, efforts need to be made to particular, it appears inappropriate to shift capital broaden the menu of financial assets, and to in- investments of the government to an off-budget crease their attractiveness through a flexible and fund. realistic interest rate policy. The recent increase in interest rates is a step in the right direction. How- C. MONETARY POLiCY. A priority of monetary ever, interest rates remain well below the true rate policy at the outset of the reform program will be of inflation, and-by a much wider margin- the absorption of excess liquidity in the economy below the inflation rate expected next year. At the (currently estimated at about one third of the stock outset of price liberalization, interest rates should of financial assets). In principle, the "monetary be raised further, to a level that provides the overhang" can be tackled through alternative ap- prospect of a positive real return on financial proaches (or some combination of them): (1) assets. Higher real interest rates would also dis- through a monetary reform, which would confis- courage stock accumulation, and go some way to cate or freeze a part of financial assets held by help ensure a more efficient allocation of credit. households and enterprises; (2) by letting the real Although full liberalization of interest rates may value of existing financial assets be reduced by have to await the development of a more cor- price increases; (3) by sales of financial assets of petitive banking system and the strengthening of longer maturity (bonds or shares) or of physical central bank supervision, early steps could be assets. taken in that direction. For example, administra- A monetary reform would be the most sure and tive control overbank interest ratescould be limited effective instrument, and it could distinguish be- to setting a floor on deposit rates and a ceiling on tween the assets of households and those of enter- lending rates. prises. It would also provide an offset for the In the near term, it will be advisable to continue writing down of loans that will become essential to set quantitative ceilings on bank credit, sup- during the reform process. But, as the authorities ported by adequate and firmly enforced penalties stress, it could undermine popular support for the for excesses. Such controls, if successfully en- reform effort and future confidence in the cur- forced,canlimitthetotalvolumeofcreditflowing rency, and clearly it should not be considered from financial intermediaries to firms and unless the budget deficit had been sufficiently households, and thereby help harden budget reduced as to avoid the need for borrowing. constraints. Inter-enterprise credits typically will The authorities have recently proposed a partial rise in any period of credit tightening, partially freeze of enterprise deposits, to be eventually offsetting the impact of restraint. Ways will have converted into shares and distributed to workers. to be found to control the increase in these credits. These steps, while useful in reducing liquidity of Beyond the credit ceilings, we recommend the the enterprise sector, may boost consumer de- imposition of reserve requirements at a uniform mand, through a wealth effect, and may give a rate for all banks and types of liabilities. This weight to workers'ownership in enterprises which would not only reduce the amount of credit that 22 banks would extend on any given deposit base, in the currency and reverse a growing trend to- but also would begin to put in place indirect wards "dollarization" of the economy. mechanisms of credit and monetary control. The The recent introduction of a new, substantially use of market-oriented instruments of control depreciated, commercial exchange rate and the should be expanded over time. These would announced intention to begin operating a free include short-term refinance and rediscount fa- foreign exchange market, represent steps in the cilities (atrates higherthan thoseonbankdeposits) right direction. A dual exchange rate system, and sales to the banks and others of government however, will continue to provide incentives for a or central bank paper. variety of distortionary practices, so long as a The Supreme Soviet has recently approved new significant gap remains between the commercial banking legislation, establishing a full two-tier and the free market rates. For this reason, an early banking system, with a union reserve system, move-certainly within one or two years-to- consisting of the State Bank and republican cen- wards unification of the exchange rate is needed, tral banks, responsible for the definition of mon- which is likely to require a further depreciation of etary and credit policies and the framework of the commercial exchange rate, supported by ad- bank supervision for the whole union. This ap- equately tight financial policies. Unification could proval, which had been delayed by controversy be promoted by channeling an increasing share of over thesharingofresponsibilitiesinthemonetary transactions through the free market. To this end, area between the union and the republics, should the proportion of foreign exchange receipts that represent an important step towards the mainte- exporters are required to surrender to the au- nance of a single currency within the union, and thorities at the commercial rate should be made towards a more independent and less accommo- uniform and progressively reduced. Exporters dating conduct of monetary policy. The actual should be required to tender within a set time the extent of coordination of monetary and credit foreign exchange that they are not obliged to policies across union and republican central banks surrender to the foreign exchange market, and not and of their independence from political influ- be allowed to hold balances indefinitely in reten- ence-they are in principle accountable to their tion accounts. All enterprises should have free respective Supreme Soviets-will, however, only access to the market; and increasingly government become evident over time. Financial discipline imports should also be financed through it. Ex- would certainly be strengthened by a ban on change rate policy after unification (floating or recourse by the union or the republics to central pegging) is best left to be decided at that time bank financing. Financing by other banks, in- taking into account, in particular, the stance of cluding the savings banks, should be contained financial policies, and the availability of resources within strict limits, defined annually in the re- to defend a particular level of the rate. spective budget laws, and should be consistent It has been suggested that there will be a sepa- with the overall targets of monetary policy set by rate foreign exchange market in each major repub- the union reserve system. Experience in other lic, fed by both the surrender of currencies by countries also suggests that limits should be set on enterprises and the republic's own reserves. It is foreign or domestic borrowing by subnational natural, given the size of the USSR, that there governments with union guarantees. should be several foreign exchange markets, but the efficient allocation of foreign exchange re- D. ExrERNAL PouciEs. As discussed in section sources will requirearbitrageacross those markets. VI.2.c. below, the opening up of the Soviet economy The division of foreign exchange reserves be- to foreign competition through trade liberalization tween the union and the republics is also at issue. would be an important part of a comprehensive Given controls over access to foreign exchange, reform program, and one that would promote and their desire to set up their own exchange efficiency in resource allocation and moderation markets, individual republics each wish to obtain of inflationary pressures. Liberalization must be as large a share of the exchange reservesas possible. accompanied by a realistic exchange rate-as well As the ruble becomes convertible, a unified in- as by financial stabilization-if it is not to lead to tervention policy will be required, and any justi- unsustainable deficits in the balance of payments. fication for the fragmentation of reserves will no Rapid progress towards a unified exchange rate longer exist. and current account convertibility of the ruble Responsibility for the servicing of outstanding would also be necessary to reestablish confidence and future external debt is also debated between 23 the union and the republics. A recent presidential population, require that wages be to some extent decree calls for the establishment of a joint union- protected from inflation by building in a floor for republican fund to manage the bulk of foreign wage increases. These are both to be seen as exchange surrendered by exporters. The fund temporary expedients to be phased out as soon as will, inter alia, service outstanding and future debt possible. of the USSR, and in 1991, 40 percent of export The stated intentions of the authorities are only proceeds are to be used for this purpose. In the partially in line with this approach. It is intended future, individual republics will be allowed to to protect the purchasing power of incomes borrow abroad, and will then be responsible for through indexation. The presidential guidelines the service of that debt. For this purpose, the call for 50-70 percent indexation of wages (with decree proposes that 10 percent of surrendered the degree of indexation declining with income foreign exchange-net of the amount for the ser- levels), and for 100 percent indexation of pensions vice of external debt of the union and retention by and family allowances to the price of a minimum exporters-would be transferred to the republics consumer basket. If, as might be required by and local bodies. Given the impact that creditwor- budgetary considerations, the prices of the mini- thiness problems in one republic would be likely mum consumer basket were to rise by more than to have on the ability of others to borrow, some the average increase in prices, then the proposed mutually agreed safeguards would need to be put mechanism could become an engine for wage in place. inflation. The authorities intend to use tax instru- The proposed decentralization of foreign trade ments to support incomes policy by levying very activities, albeit welcome in itself, raises the risks high taxes on enterprises which grant wage in- of a further loss of central control over external creases in excess of increases in their value added. financing, and of a proliferation of arrears in However, in an environment of still soft budget payments to suppliers. While a decentralization constraints, liberalized prices, and substantial of foreigncredit operationsisnecessary to promote monopoly power, the tax as formulated may not a market-based trading regime, an effective prove effective in deterring excessive wage in- mechanism to monitor all external financing ob- creases, as enterprises would be able to expand tained by enterprises engaged in foreign trade is the room for wage increases by boosting prices of also necessary, because failure by a few borrowers their products. to service their debt could easily give rise to gen- The wage tax could therefore be supplemented eralized refusals to lend to Soviet enterprises. by a ceiling on wage increases, in the form of a uniform limit for all state enterprises on the growth E. INCOMES POUCIEs. Wage policy poses a critical rate of either the total wage bill or the average problem during the transition period. The USSR wage. The delinking of wages from enterprise has no developed industrial relations system and revenue under either of these approaches would no tradition of decentralized wage setting in help prevent a wage-price spiral. The choice competitive labor markets. There is clearly a risk between the two forms of wage limit is not clear thattheinitial spurtof prices inevitably associated cut. The advantage of a cap on the growth of with price liberalization will give rise to wage average wages is that it would not penalize enter- demands that could contribute to a wage-price prises which expand employment, while its risk is spiral. This risk would increase if state enterprises that it may encourage firms to replace higher paid continued to have easy access to credit, or if inter- with lower paid employees, possibly at a cost for enterprise credits emerged as an important alter- productivity. By contrast, the wage fund approach native financing mechanism, and if the practice of might encourage labor shedding, but would also management being elected by workers continued. discourage expanding enterprises from increasing As a hard budget constraint on enterprises is employment. more effectively enforced, wage determination can increasingly be left to collective bargaining. 2. Systemic policies But, at the start of the reform process, an incomes policy that would seek to cap wage increases will A. PRICE FoRm. Nothing will be more impor- be needed for a time to contain wage pressures. At tant to the achievement of a successful transition the same time, the need for social support for the to a market economy than the freeing of prices to reform process, and concern for the welfare of the guide the allocation of resources. Early and com- 24 prehensive price decontrol is essential to ending correction early in the reform process may weaken both the shortages and the macroeconomic im- the incentive for more efficient use of the inputs balances that increasingly afflict the economy. concerned. Once resource allocation is based on market clear- An announced timetable for the transition to ing prices, the ruble will become an effective me- world prices and the initial price increase would dium of exchange; this should largely eliminate have to be established. Drawing the balance be- the economic disruption resulting from the growth tween thebenefits and disruptions stemming from of hoarding,barter, theblackmarket, dollarization very rapid price changes is a matter of judgment. and imposition of restrictions on the free internal We would tend to favor a faster rather than a movement of goods. As the integration of the slower pace. For energy and a few other basic raw economy into the world economy proceeds materials, a transitional mechanism could be en- through trade liberalization and current account visaged involving the imposition of a temporary convertibility, domestic relative prices for traded export tax set initially at a level which makes a goods should be aligned with the structure of large step toward world prices (e.g., 50 percent in world market prices. the case of petroleum) and declining to zero by the We see only a few areas where a case for state end of three years as full convergence is achieved. intervention in price setting might remain, but The impact of price increases for food and other even in these instances prices should be raised basic consumer goods is a matter of particular substantially at the start of the reform process. concern. While current subsidies encourage First, public utilities (including public transport) wasteful consumption of some goods such as are likely to remain public monopolies as in many bread, and some initial decline in the real incomes other countries. Therefore, their prices are likely of households will be an unavoidable cost of the to continue to be regulated administratively. Sec- reforms, price increases should not be allowed to ond, in the housing sector, rents are currently place an unacceptable burden on the more vulner- minimal. They will have to be raised to cover able segments of the population. The preferred maintenance costs and to create an incentive for approach to mitigate this effect would be a combi- construction and the purchase of dwellings. Money nation of increases in pensions and other transfers wages will also have to be adjusted to reflect the to individuals not active in the labor force and monetization of in-kind payments for housing. supplementary income transfers to targeted But present distortions are very large and the full groups (e.g. households below a particular-re- set of supporting measures, including the legal gionally adjusted-poverty level). and financial reforms needed for a properly If, as some have cautioned, means-tested in- functioning housing market, cannot be put in come support is too cumbersome to be put into place immediately. Thus, rents (only for existing effect in the near term, an alternative would be to housing) will have to continue to be set adminis- give each person ration coupons carrying the right tratively, with the intention of moving as swiftly to purchase a fixed quantity of certain essential as possible to a market system. goods at a specified price. Those wanting more of Third, intervention through border taxes might such goods would be able to purchase them at the temporarily be warranted for a small set of basic unsubsidized market price. A variant of this inputs, especially energy products, extensively approach would be to provide each person with a used in industry and to provide protection to given amount of food stamps which could be used enterprises that could be endangered by sudden as money in buying eligible foods at regular mar- import competition despite good prospects for ket prices. Since the stamps would have a fixed medium term viability. The use of export taxes monetary value, an individual's real consump- would avoid the need for administered price con- tion would vary with the market price of the trols, central allocation of these inputs, and export goods concerned, but the budgetary cost of the controls. The rationale for making this a phased subsidy would be fixed. rather than a sudden transition to world market Because of the special importance of food prices, prices is to provide enterprises time to adjust to we further recommend that, in the early stage of the new situation. Indeed, unless the rise in such reform, the government use imports to stabilize prices is constrained, the solvency of much of the retail prices of the most sensitive basic consumer industrial sector might be jeopardized. However, goods-bread, milk, and meat. To be effective, it is equally true that a failure to allow price however, a strengthening of the distribution net- 25 work would be essential. Such imports should be management and control structure-will be nec- only a temporary device for the USSR should essary for most large firms. Prior to privatization, quickly be able to feed itself. commercialized firms should be managed in ac- cordance with the procedures outlined in the B. ENTERPRISE REFORM. The industrial sector section on "Management of State Enterprises un- consists almost entirely of huge state-owned firms. der state ownership" below. Average employment in the 47,000 enterprises Rapid privatization would not only hasten the exceeds 800 workers; an estimated 30-40 percent benefits of private ownership but can also yield of total industrial output is accounted for by prod- revenue at a time when both the budget deficit ucts for which there is but a single manufacturer. and the monetary overhang need to be cut. How- Even when there is more than one producer, in- ever, there are also disadvantages in trying to dustrial branchministries cartelize their activities. move very fast in this area. When relative prices Seventy-five percent of production orders and are still unsettled, the value of enterprises is diffi- inputs come from the state, while prices are ad- cult to assess. Firms might be acquired at far ministered rather than market-determined. below (or even far above) their actual values, and Alongside these giant enterprises are a growing ownership might become concentrated in the number of much smaller firms operating largely hands of a relatively few individuals with money outside the state planning system and having an or connections. Moreover, the state's productive unclear legal status. By October 1990 there were assets are valued at a sum far in excess of the approximately 215,000 cooperative enterprises savings available to the private sector, so that employing about 5.2 million workers. Many co- even for small enterprises, provision may need to operatives have leased whole plants or operate be made for buyers to pay in installments. units of on-going state enterprises. Individual An alternative approach would be to assume ownership in the industrial sector is limited to that since these complications cannot be quickly artisan activities involving no employees. resolved, the prospective revenues from Managers of state enterprises have been given privatization should be forgone in the interests of increasing responsibility for decision-making over speed and distributive equity. This could for the past three years, and there hasbeena prolifera- example be accomplished through a voucher tion of new forms of enterprise. A process of scheme that gave shares to citizens. But such spontaneous privatization is taking place in large giveaways have a number of disadvantages. Most sectors of industry through the leasing of facilities importantly a voucher system would result in to cooperatives consisting of the managers and widely scattered ownership which would be un- workers of state enterprises. Given the uncer- likely to result in effective monitoring and control tainty of ownership rights, including the right to of enterprise managers. If use were to be made of sell enterprise assets, the incentives of new man- the voucher system its disadvantages could be agers tend toward short-term income maximiza- reduced by transferring the ownership of enter- tion at the cost of enterprise decapitalization. prise shares to holding companies that would The present setting is one of confusion and exert effective ownership control. The shares of strain that can only be satisfactorily resolved by the holding company could then be distributed to moving as fast as feasible to clarify and change the public. ownership and enterprise goals so that firms be- To strike a balance between the desirability of gin to base their decisions on commercial criteria moving rapidly and the practical impossibility of in a competitive environment. This will involve doing so effectively on a large scale, it is necessary procedures for ownership reform, demonopoli- to use a flexible approach that varies according to zation, and the enforcement of a hard budget the type of activity and size of enterprise, and, if constraint onenterprises that continue under state necessary, the preferences of the different repub- ownership. lics. The need for revenues to help cover some of the costs associated with the econon-dc reform- (1) Ownership reform: privatization and commer- among them the costs of restructuring potentially cialization. While the ultimate goal of ownership viable enterprises, of cleaning up the balance reform is to privatize almost all enterprises in the sheets of banks, and beginning to catch up on the USSR, an intermediate step of commercializa- backlogofnecessaryinfrastructureinvestments- tion-moving effective control away from the argues for sales rather than give-aways. How- bureaucracy to a more commercially oriented ever, there may well be advantages to giving 26 away some shares in some of the larger enter- prise over time. Accordingly, substantially less prises. than a controlling share might be made available We support the rapid privatization of small on a preferential basis to an enterprise's own work enterprises through outright sales to individuals, force, and these shares should be distributed to cooperatives, and others. Assets should be sold workers on an individual rather than collective through open and well publicized auctions and as basis. Workers would enjoy the same ownership quickly as possible. Payments in installments rights as other shareholders, including the right to should be permitted to promote both rapid sales sell their shares (as well as to acquire new shares) and a wide distribution of assets. It is of special in the market. importance to privatize transport, storage, and Another issue that needs to be resolved con- distribution services rapidly. These are sectors cerns the treatment of debts of existing enter- where assets--e.g., trucks, warehouses, retail prises. Debt should be written down to below the shops-are easily sold off in small units, and value of a firm's assets (with consequences for where existing service monopolies can therefore banks considered in section VI.2d. Asset valua- be broken quickly. Privatization in these areas is tion is, of course, exceptionally difficult; review vital to overcoming bottlenecks that otherwise procedures for sales and leasing contracts, vested slow supply responses, especially in agriculture. in independent government agencies answerable The privatization of larger enterprises will neces- to the union and republican Parliaments, could sarily take longer and could proceed along essen- help ensure that valuation is neither arbitrary nor tially either of two paths: the direct sale or leasing opportunistic. Such reviews should be limited to of divisible product lines, stages of production, or the most questionable cases which could be service activities; or alternatively, in two stages. brought to lightby ensuring widespread publicity First, commercialization through conversion into for all such arrangements. joint stock companies under the initial ownership of stateholding companies created for this purpose (2) Management of enterprises under state owner- and second, the sale of shares directly or through ship. Large enterprises should be commercialized mutual funds. and operated as joint stock companies so long as Direct sales would be by open and well publi- they continue under public sector ownership. cized auctions and should require a significant Enterprises should be accorded no preferential equity down payment by the new owners, allow- treatment from the state by virtue of their public ing the balance to be financed on normal market ownership. State-owned shares should be held terms. Leasing arrangements could be used for all initially by state holding companies that would be sizes of enterprises. To ensure that lease holders organized and operated in a very different man- have an adequate interest in protecting the value ner from the present branch ministries. A board of of leased assets, they should be able to sell lease directors for each holding company would be contracts, subject to antimonopoly laws and regu- appointed by the government and charged with lations. Over time, as financial savings and mar- operating the entities for which the holding com- kets develop, shares remaining with state holding pany was responsible as commercial, market- companies could gradually be sold to individual oriented enterprises. To encourage competition, and institutional investors, including pension ownership of enterprises producing the same funds and insurance companies. Alternatively, or goods or close substitutes should not be concen- in addition to selling off their holdings enterprise trated in the same holding companies. Thus, there by enterprise, the original holding companies would be a number of holding companies, rather could, in effect, convert themselves into mutual than a single state property fund, at both the union funds, selling shares in their portfolios. and republican levels. Each holding company It has been proposed that preferential treatment should be responsible for the liquidation of any in the buying of property and shares be given to chronic lossmakers in its portfolio and for ar- labor collectives. Experience of labor-managed ranging restructuring, including the reduction of enterprises in other countries, however, has been vertical integration, where this would strengthen disappointing. Workers in control of their own profitability. enterprises have tended to concentrate on the These state holding companies should follow relatively short-term maximization of their own the model of a private sector holding company. incomes thereby limiting the employment of new Dividends on shares held by the holding compa- workers and running down the assets of the enter- nies would flow to the budget; although some 27 profits could be retained to finance new invest- opportunities. The hard budget constraint should ments, a minimum dividend payment could be be implemented as rapidly as possible, both as an specified in advance as a fixed share of after-tax incentive for enterprise reform and as a contri- profits. Thus earnings retained by the holding bution to macroeconomic management. company could be reallocated among its firms to Because it will take time for many enterprises to finance investments meeting normal commercial adjust to the new economic conditions, the presi- criteria. However, holding companies should not dential guidelines propose the creation of union keep chronic loss-making firms in operation by and republican stabilization funds,,with indepen- cross-subsidizing continual operating losses of dent adninistrations, to provide financial sup- some enterprises with the profits from others. port for properly justified restructuring efforts. Holding companies, while monitoring and as- There is a risk that such funds become substitutes sessing enterprises' performance, should not in- for, rather than a complement to, the needed terfere in their day-to-day management. The restructuring. A strict budgetary constraint on the holding companies would exert ownership rights resources available to them and rigorous criteria through the boards of directors of the individual governing both their activities and their financial enterprises; it would appoint the members of these results should limit this danger. boards and then hold them responsible for their performance. The boards, in turn, would be di- (3) Demonopolization. Finally, there is also an rectly responsible for setting enterprise policies, urgent need for an effective framework of monitoring performance, and hiring and, as nec- antimonopoly laws and regulations, along with essary, dismissing enterprise managers. The lat- the institutions to enforce them. The framework ter would have the full responsibility for the day- should abolish so-called "profile restrictions" that to-day management of the enterprise, including limit the range of goods that a firm can produce, the power to determine the organization of pro- assure the rights of new entrants, help prevent duction; to set the offer price, quantity and com- collusion among enterprises and discourage position of output; to hire, reward and dismiss predatory behavior that would lead to the mo- workers; and to manage the enterprise's finances. nopolizationofanindustry. The current tendency The main weakness of such a system is that, in forenterpriseswhicharenowinaparticularbranch practice, it might prove difficult to insulate hold- ministry, to join together in trade associations is a ing companies from political pressures or to pre- matter of concern, since it may favor oligopolistic vent those who now run the branch ministries rather than competitive behavior. One major from taking their traditional management cul- barrier to the entry of new firms is the highly tures with them to the holding companies. A monopolized state supply system. The breakup possible way around these difficulties would be to and privatization of wholesale trade should thus establish very strong management incentives at be among the first priorities of economic reform. both the individual enterprise and holding com- Because production in some sectors is concen- pany levels tied to the medium-term success of trated in a single or very few enterprises, it will be their companies. Another important weakness is desirable to split up such firms in order to increase likely to be a shortage of trained and experienced competition. While state action is necessary to managers and management courses will need to support demonopolization, markets can provide be set up. powerful pressures against monopoly. The re- Whatever their ownership, enterprises will re- moval of quantitative restrictions on imports, spond to market signals and to the pressures of coupled with reasonable tariff levels, would put competition only if their owners and managers an effective ceiling on the ability of domestic en- are truly held responsible for the financial results terprises to raise prices of tradeable goods. Dur- of their decisions. Such responsibility requires the ing the transition period, monopolistic firms would imposition of a hard budget constraint, which inevitably be able to reap higher than normal means that losses should not be covered by trans- profits. But provided there is free entry, and fers from other enterprises, the budget, or auto- sanctions against monopolistic practices, these matic credits from the financial system. Financial profits themselves will eventually encourage new autonomy needs, of course, to be accompanied by entry into the industry and consequently more general managerial autonomy which permits demonopolization. enterprises to adjust to changing constraints and 28 c. EXTERNAL TRADE REFORM AND FOREIGN DIRECT These interrelated aspects of reform require a iVESrMENT. range of actions. Rights to engage in foreign trade have in prin- (1) External trade reform. The conditions under ciplebeen extended to all enterprises. But to make which foreign trade takes place are heavily dis- these effective, licensing and other quantitative torted, and this situation cannot change funda- restrictions on trade need to be lifted, and access mentally until domestic prices are liberalized. Due to foreign exchange liberalized. At the same time, to the continuing existence of state-trading ar- trading operations should be demonopolized, so rangements, licensing, quotas, multiple exchange that the gains from trade are not captured by rates, border taxes of various kinds, and prohibi- trading companies with dominant market posi- tions on "middleman" activities, incentives to tions in specific goods, at the expense of the ulti- engage in trade are largely unrelated to inherent mate producers or consumers. An important step comparative advantages or underlying cost-price would be to abolish the branch ministries, so that relationships. Initial reforms have created a situ- the trading associations they sponsor would di- ation in which trading rights are in principle versify the range of goods that each handles and widely distributed, but in practice limited by per- the foreign trade organizations would become vasive quantitative restrictions and inadequate independent trading companies. Competition access to foreign exchange. would also be strengthened by the ending of This state of affairs reflects in part the fact that present widespread prohibitions on "middleman" reform efforts to date have attempted to pursue operations in international trade, the rationale for too many, and often contradictory objectives: in- which disappears with domestic price liberaliza- sulating domestic prices from pressures coming tion. from abroad; encouraging higher value added Even after domestic price liberalization, the exports while protecting the domestic availability structure of relative prices will differ significantly of scarce goods; assuring balanced trade while from the structure of prices on world markets. maintaining an overvalued exchange rate; and One reason is that the commodity arbitrage that preventing decentralized decision makers from characterizes market economies cannot be ex- reaping "undue profits" by exploiting the distor- pected to play its full role overnight. Another is tions that the system has created. Most of these the existence of the present jumble of quotas, objectives have not been achieved. border taxes and other restrictions. While allow- Trade performance, especially the lack of dyna- ing enterprises to be abruptly exposed to the full mism of exports of manufactured goods to West- difference between domestic and foreign prices ern markets and continued reliance on exports of could be disruptive, neutralizing such differences energy products and raw materials, has been through administrative intervention would pre- unsatisfactory. In addition, the growing disrup- vent price signals from playing their key role in tions and shortages in thedomestic economyhave improving resource allocation. A middle way is been spilling over into the trade sector through necessary during the transition. the failure to complete contracted deliveries, a The recommended approach is to establish a set scrambleforimported inputsand consumergoods, of tariffs averaging not more than 30 percent, with and a resultant sharp deterioration in the overall a minimal degree of dispersion, that would serve trade balance. as a guide to enterprises concerning longer-run There are three essential elements in shifting price relativities. In exceptional cases, temporary from a system of centrally administered trade to border taxes could also be imposed to allow do- one in which the determination of exports and mestic firms more time to adjust to the relative imports is achieved through the decentralized price changes required in the reform process. If it operation of market mechanisms: first, enter- is desired to restrict consumption of luxurygoods, prises must be able to decide freely in a competi- for example, this should be done through excise tive environment what to buy or sell and on what taxes rather than high import tariffs or quotas. markets; second, appropriatepriceincentives need Indeed, quotas should not be used at all, because to be allowed to operate in guiding these deci- inter alia, the resulting quota-rents are likely to be sions; and third, a system must exist whereby captured largely by foreign suppliers. firms are freely able to obtain the foreign ex- In principle, there might be a parallel argument change they need to carry out their transactions. for providing temporary subsidies to exporting 29 enterprises that were non-competitive in foreign negotiating bilateral agreements with its CMEA markets. However, it is not persuasive for two partners. It would not be in its economic interest reasons. First, if the exchange rate is at a market- to delay the proposed shift to world market prices clearing level, only a few enterprises are likely to or to convertible currency settlement (though this find themselves in this situation after price liber- would intensify foreign exchange constraints on alization, and the export sales of such non-com- some other CMEA countries). Neither would it be petitive firms should not be protected. Second, desirable to direct a large share of trade with these most firms' exports account for only a small pro- countries through state orders. Rather, efforts portion of their total sales, which suggests that the should focus on facilitating decentralized and loss of unprofitable export markets would not be market-driven trade among enterprises in the the determining factor in the success of their re- CMEA countries. One step in this direction would structuring. be to develop export credit arrangementsby which Price signals can be effective in shaping trade enterprises could compete on equal footing with only in conjunction with a mechanism that makes Western enterprises in the credit terms offered for foreign exchange available to firms on a competi- trade, especially in the area of capital goods. tive basis through a foreign exchange market, rather than through administrative allocation. A (2) Foreign direct investment. The impact of substantial increase in transactions taking place foreign direct investment has so far been minimal through the free exchange market, the avoidance in terms of both foreign capital infusion and over- ofanyquantitativerestrictionsonimportsfinanced all contribution to economic development. A through the free market, and a rapid unification of severe limitation has been the inadequacy of the exchange rates, are therefore essential. legal and institutional structures. Other major Over the next several years the demand for obstacles stem from the risks and practical diffi- imports arising from economic restructuring and culties of conducting business in the USSR, espe- from meeting consumer needs could potentially cially given the persistence of centralized alloca- be high relative to the foreign exchange available tion mechanisms. Under these circumstances, to meet these demands. The essential task of joint ventures have largely operated in quasi- maintaining equilibrium in the external accounts enclaves concentrated in the services sector, and in these circumstances will fall on a tight macro- specialized operations where high returns are economic policy and appropriate relative prices possible with low levels of capital commitment as well as the exchange rate; but there is clearly a through exploitation of loopholes and inconsis- premium on identifying those areas where incre- tencies in the existing regulations. mental foreign exchange can be earned most Notwithstanding the lackluster performance to rapidly, either by raising exports or substituting date, foreign direct investment could potentially for imports. Whatever the long-run comparative make a major contribution to the structural trans- advantage of the USSR (and considerations of formation of the economy through capital infusion, dynamic comparative advantage suggest that the transfer of technology and managerial skills, manufactured goods will over time come to play and, equally important, by exposing domestic an increasingly important role in Soviet trade) it is enterprises to market competition. A substantial probable that increased energy exports and re- increase in foreign direct investment, however, duced agricultural imports represent the most can be expected only once fundamental improve- promising near-term approaches to easing the ments have been made to the political, economic, foreign exchange constraint. Domestic reform to and regulatory environment. The reform efforts raise efficiency in these sectors (including a sub- should concentrate on three main areas: the broad stantial increase in the cost of petroleum to do- constitutional aspects and legal system; the eco- mestic users) would thus have a particularly high nomic setting; and the specific regulatory structure priority from a balance of payments perspective. applying to foreign investment. In addition to higher oil prices, the intended First, as stressed earlier, there is a need for an shift in CMEA trading relations to convertible unambiguous determination of the legal status of currency settlement at world prices is also likely to private sector activity and a clear definition of the ease the foreign exchange constraint in the short regulatory responsibilities of the different levels run even if, as expected, intra-CMEA trade vol- of government. Foreign investment may well be umes decline sharply. The USSR is at present regulated under laws, rules and regulations ema- 30 nating from different levels of government and they should be clearly limited in terms of budget- full compatibility is imperative. Given the present ary implications and time frame. political and economic uncertainties, an amend- Duringthe transition to a marketbased economy, ment to the property law which protects foreign there may be considerable scope for mobilizing investors from confiscation and expropriation large scale foreign investment in particular sec- should be considered. tors through self-contained arrangements, such as Second, the economic conditions for conduct- capital-intensive projects in energy and natural ingbusiness should be extensively improved. This resource exploitation and in certain segments of is as essential for domestic enterprises as for for- the reconverted military industries. But these will eign investors. The latter need to see a rapid make sense only in very few sectors and cases. development of domestic wholesale markets and They should be limited to these, and notbe seen as liberalization of trade so that they canhave readier an alternative to the fundamental reforms needed access to needed inputs. The development of to attract investment across a wide range of eco- domestic credit markets is essential and convert- nomic sectors. ibility of the ruble would help enterprises manage their foreign exchange needs. In addition, poten- D. FINACIAL SECFOR REoRm. The banking sys- tial foreign investors will be affected by the extent ter comprises the State Bank, the State Savings of competition permitted in the domestic market Bank (which collects household deposits), the as well as the extent to which the all-union market Vneshekonombank (which carries out all foreign remains intact. exchange transactions of the government) as well Third, regulatory requirements applying spe- as three specialized banks? and a number of small cifically to foreign direct investment should be banks. The system is currently evolving on two simplified and legal protection strengthened. tracks: the division and commercialization of the Authorization procedures need to be liberalized three specialized state banks set up to act com- and streamlined. Investment screening policies mercially in 1987, and the rapid proliferation of shouldbebased on transparent and unobstructive small commercial and cooperative banks, which criteria, and confined to a very few sectors. Im- followed the enactment of the Law on Coopera- pediments to investment in service activities tives in 1988. The specialized banks currently should be removed. Administrative as well as account for some 95 percent of total credit, and the legal guarantees are needed for the repatriation of more than 400 commercial and cooperative banks investment income and the proceeds from liqui- for the remainder. The specialized banks are to dation, and for the extension of full investment become universal banking institutions organized protection. Adequate arbitration and dispute as joint stock companies. They are also to be settlement procedures should be put in place. In completely responsible for mobilizing their own all these areas, regulatory mechanisms and proce- resourcesand for their own financial performance. dures should conform closely to internationally Their shareholders are initially expected to consist agreed principles and understandings. The draft largely of state organizations, but the situation is foreign investment law presented to the Supreme complicated by conflicting ownership claims by Soviet represents a step in the right direction but different levels of government, and it is possible still falls short of international standards. For that they will be broken up along geographical example, profit remittances and capital repatria- lines. tion continue to be restricted to what can be self- A well functioning banking and payments sys- financed fromretained foreign exchange proceeds. tem is an essential element of a market system. This might preclude investment in domestic sec- The banking reforms, which started by encourag- tors such as distribution and trade where foreign ing the development of quasi-private commercial participation could make an important contribu- banksandtheconversionofspecializedstatebanks tion to the establishment of competitive markets. into universal joint stock banks, should be carried Policies should aim at treating domestic and forward as quickly as possible to support the foreign investors equally. Similarly, environmen- growingprivate sector. Banking legislation should tal regulations should be applied without dis- be enacted without further delay, establishing, crimination. If, as a transitory device, the present inter alia, a strong banking and supervisory au- discriminatory tax treatment or other incentives thority and setting a common regulatory frame- in favor of foreign investors are to be maintained, work for the specialized state banks and the new 31 commercial and co-operative banks. Of equal hold savings. As the government's financing importance are measures to modernize the pay- needs are reduced, and the residual financed ments system. through a growing securities market, and as the The recently introduced prudential regulations specialized banks are progressively commercial- are a positive step toward Western standards. ized, the SSB could expand its own lending activi- However, the Banking Supervisory Department ties through the interbank market and increas- of the State Bank should be strengthened to ensure ingly move away from its role as a passive inter- compliance with prudential regulation. Intensive mediary. Its major credit activities would then be training of bank inspectors is required for effec- lending either through the interbank market or, tive on-site inspections, notably at republican and increasingly, directly to private sector customers. local levels. Furthermore, banking regulators and The proposal to retain one specialized bank examiners should pay increased attention to the under state ownership as a vehicle for channeling danger of conflict of interest situations and inad- preferential credit to state-designated activities equate risk management. To the extent these ac- should be reconsidered. Experience in other tivities fall within the competence of the republics, countries suggests that subsidized state directed efforts should be made to ensure that central and lending easily becomes subject to special interests, regional regulatory frameworks and supervisory is frequently inefficient and can ultimately under- practices are fully harmonized. cut the soundness of the bank itself. A better and The pace of commercialization and subsequent more transparent procedure is to provide such privatization of the specialized state banks is con- fundsto theextenttheyareneeded through explicit strainedby thequalityoftheirloanportfolios. The subsidies from the state budget. amount of bad debts is unknown but probably The issuance and trading of government debt large given past lending practices, and likely to instruments should be encouraged. It will assist increase as economic reforms in the real sector efforts to finance the budget deficit and to mop up proceed. Existing bad debts should either be excess liquidity. In the present uncertain environ- written off or shifted to a special state agency for ment, a shift of focus from the long-term end of the collection or liquidation. The treatment of doubt- market to that for medium-term and short-term ful loans, including provisioning, must be defined instruments could heighten the appeal of gov- to provide a sound basis for managers, regulators, ement paper to savers. The Government also and depositors to assess and protect bank sol- intends to support the creation of stock and vency. In addition, accounting standards need to commodities markets as well as brokerage com- be upgraded to enable bank managers to engage panies, insurance companies and other institu- in adequate profit planning and cost control as tions found in developed financial markets. A well as risk management. More generally, there commodity exchange has already been opened in is need for large-scale training of professional staff Moscow, and securities exchanges are being at all levels of bank management. opened in Moscow and Leningrad. This is poten- As essential reform of infrastructure and orga- tiallyimportant, although here too thereare serious nization within financial institutions is imple- gaps in the legal and regulatory framework; efforts mented, their full commercialization and in this area should not in our view take priority privatization can follow the principles envisaged over the strengthening of the banking system. The for state enterprises. This will, of course, take informal issuanceand tradingof securitiesis likely some time; in the interim, the ill effects of inad- to grow. These new instruments can play a useful equate competition could be partly offset by en- role in mobilizing risk capital and in providing couraging the banks to diversify their lending and liquidity to the ownership claims arising from other financial service activities. Meanwhile, bor- enterprise commercialization. The authorities rowers and depositors can begin to make more should neither endorse nor prevent such activities; intensive use of their already established rights to but the risks involved in the absence of a satis- select banking partners freely. Product and terri- factory regulatory framework should be ad- torial competition can eventually be intensified by equately publicized. allowing foreign banks to enter the market in joint ventures with privatized Soviet banks. E. SOCIAL SAFETY NET, LABOR MARKET, EDUCATION During the transition, the State Savings Bank AND TAININ. The structural reforms will create (SSB) could remain under state control as the great stress in labor markets during the transition principal mobilizer and intermediator of house- period. Unemployment will almost certainly rise 32 before the economy turns around. Thus, transi- settingof wagesduringthe transition. Someform tional policies must be concerned both with ofincomespolicyisrequired to support monetary adapting labor market practices to a market and fiscal policies in preventing the initial adjust- economy, and creating an effective affordable so- ment of prices following liberalization from be- cial safety net. coming an inflationary spiral. The medium-term objective should be that enterprises and workers (1) The social safety net. Short- and long-term arrive at a wage consensus. aspects of the social safety net should be consid- Presently, wage rates ("tariff wages") are set on ered. In the short term, policies would need to a statutory basis for several thousand individual deal with the increasesin unemployment that will occupations and have been left unchanged over certainly accompany the economic reform pro- an extended period of time. The tariff structure is gram as well as the impact on low-income earners topped up by bonus payments, a whole array of of rising inflation (which is described above). The fringe benefits and preferential access to goods in new Employment Law presented to the Supreme short supply. This system of remuneration has Soviet provides some social protection to the un- little, if anything, to do with labor supply and employed by providing unemployment benefits, demand conditions. Consequently, a proper in- training and public works. This package of mea- centive structure and an allocative role for wages sures is similar to those offered in Western econo- to direct labor to its most productive and reward- mies, though its implementation may give rise to ing use do not exist. It would be desirable to difficulties. It is essential to have in place a work- dismantle the tariff structure and to transform able systemof unemploymentbenefitsbeforehard fringe benefits into wage payments. This would budget constraints are imposed on state enter- make the relationship between pay and work prises. Expected higher levels of unemployment more transparent, and would allow for a widen- and present weaknesses of funding arrangements ing of sectoral, occupational and regional wage make some financing from general budgetary rev- differentials. enues a necessity in the near term. Over a longer Current policy intentions are to simplify the time period, arrangements should be made to present structure of tariff wages and redefine finance the normal unemployment compensation them as wage minima, thereby giving enterprises program through contributions from both em- freedom to differentiate actual wage increases ployers and employees. above this floor so as to reflect differing scarcities A longer term concern involves the need for a and performances. This would be a first step permanent social security system targeted towards towards wider wage differentials. But it is only a specific vulnerable groups. This is easier said than beginning. More thorough reforms of the wage done. Means testing by income levels may be tariff system are clearly necessary. particularly difficult, given regional differences, and the importance for real income of housing, (3) Industrial relations. In most market econo- subsidies and other benefits. Targeting could be mies, wage agreements are reached through free achieved, for instance, through the provision of collective bargaining. In order to ensure that this milk for infants and school feeding. occurs at the plant or enterprise level, workers Proposed reforms of the pension system, child should be free to choose their representatives. In benefits and other allowances go in the right direc- this connection, the responsibility for providing tion from the standpoint of interregional and in- social support that is now entrusted to the official ter-generational distribution consequences. trade unions should revert to the public authori- However, over the longer term, the growth of ties, so that benefits remain available to all work- benefits must not exceed that of contributions so ers regardless of their union affiliation. as to avoid the need for budgetary support. More- In our view, the structure of collective bargain- over, the pooling of pension funds across repub- ingmustbe adapted toa wide range of conditions. lics could degenerate into 15 separate funds with Decentralized collective bargaining at the idi- limited redistribution of resources. Were this to vidual enterprise level, although a flexible instru- happen, the recently established system of uni- ment, can lead to leap-frogging wage settlements versal minimum pensions could unravel. in situations in which enterprises compete among themselves in accommodating labor demands. (2) The role of government in wage determination. Centralization of bargaining may therefore be The government should reduce its role in the beneficial in limiting wage price spirals but may 33 notbe practical in a country as large and diverse as environment can be developed to support eco- the USSR. To provide market signals and incen- nomic restructuring. Most citizens join the labor tives,wagesmustreflectproductivityperformance force with at least ten years of schooling, and the and regional differentials in cost of living. More majority of them receive higher education or appropriate, therefore, would be regional or eco- training in a vocational or technical institution. In nomic branch negotiations between employers' addition, extensive retraining and upgrading of organizations and federations of workers' repre- skills are provided for those who have already sentatives to establish guidelines for plant-based joined the labor force. The present vocational negotiations. training system is responsive to the changing needs of enterprises. Rapid structural change will (4) Labor market policies. Open unemployment put this system to the test. is a recent development in the USSR. Official There may be some areas where training capac- estimates of the increase in the number of unem- ity should be developed in anticipation of future ployed in 1991 range between 1 to 6 million. The demands-computer-related skills, for example. incidence of unemployment is likely to be concen- However, in general, training should take place in trated in regions with obsolete industrial struc- parallel with physical investment. This calls for tures and on vulnerable groups. Beyond eco- close involvement of enterprises in identifying nomic considerations, during 1991 the labor mar- skill requirements. The most important needs for ket will be affected by regional migration, emigra- new training are likely to be in the areas of finance tion abroad and military demobilization. The and management, where existing expertise is in- authorities estimate that some 600,000 people alone adequate and the requirements in a decentralized might be forced to leave their present homes be- market economy are great. cause of political instability. This concerns par- ticularly Russians living in Central Asia and the F. LEGAL RFoRm. The most serious legal prob Caucasus, as well as ethnic groups leaving un- lem facing the Soviet economic reform effort is the stable regions within the Russian Republic. Fur- lack of a general accord concerning the location of thermore, the Government is considering chang- authority to legislate, the nature and extent of the ing the emigration law so as to permit Soviet legislative and executive powers, and the appro- citizens to leave the country freely. This could lead priate bodies and methods for implementation of to a considerable outward migration to countries the law. The primary and most publicized source with which Soviet citizens have special ties. of dispute is the current debate between the cen- A more radical reform program might give rise tral government and various subordinate territo- to even higher increases in unemployment which rial governments concerning the proper relation- would underscore the need for active labor mar- ship between and among the constituent parts of ket programs. These programs might include the union. Some resolution of this conflict, even if placement, mobility and training which mitigate temporary or subject to gradual evolution, is clearly frictional unemployment, but in the case of large required before an economic reform program can scale redundancies more effective measures are be successfully implemented. needed. Nevertheless, efforts to strengthen the The problem of uncertainty concerning state necessary infrastructure, in particular a network authority is not solely related to political relation- of public employment offices, should remain a ships. The traditional Soviet legal theory envi- priority. Special measures for the unemployed sioned an organic and indivisible state power, like training and public works, if economically and, although change is occurring in this area, meaningful, should be pursued with the objective there is a continuing lack of clear boundaries of reintegrating displaced workers as quickly as between the powers of various bodies. While a possible into gainful work and to prevent the constitutional and/or legislative redefinition of occurrence of long-term unemployment. The de- the power of Soviet state bodies will require a velopment of small-scale private enterprise might substantial amount of time, improvements could also be an effective way to mitigate unemploy- be made in the interim by increased provision in ment. legislation of clear limitations on the discretion of executive and lower bodies in implementing the (5) Vocational education and training. A sound law. personnel and institutional base exists in the USSR, Technical and organizational problems also on which skills that will be in demand in a market contribute to legal uncertainty and particularly to 34 lack of uniformity in implementation of the laws. interfere with dispute resolution. In order for the As political power and responsibility for eco- civil courts and state arbitrazh to function effec- nomic regulation are becoming decentralized, in- tively together in resolving economic disputes, creasing amounts of responsibility for economic the relationship between the two bodies and their regulation and enforcement will fall into the divisions must be clarified, particularly where province of local bodies that may not have insti- jurisdictions overlap. If jurisdictional overlap is to tutional structures designed to fulfill these func- be permitted, some appropriate method must be tions or the resources to adequately interpret, found to ensure a uniform standard of interpreta- refine and enforce economic law and that may tion among bodies, by the provision of a single also be subject to strong local political pressures. highest instance of review or by another means. Localization of control should proceed with cau- The Soviet Procuracy, another unique institu- tion during the transition period and should not tionwithresponsibility forthegeneral supervision be permitted to substitute for resolution of diffi- of legality, aswell asinvestigation and prosecution, cult political and economic issues. currently has nearly unlimited rights to review Market-based systems are strongly dependent business records and other information and to upon an adequate civil law foundation, i.e.,clearly conduct "fishing expeditions" for legal violations. defined property rights, the ability to exchange The most effective means for limitation of the property through enforceable contracts, and a Procuracy's role in private business affairs would system for enforcement of those rights. With be to amend the statute governing its activity to respect to property, current reform programs call eliminate or restrict powers of general supervi- for substantial expansion of property rights and sion over private activities. the equalization of the rights of individuals and As a matter of urgent attention, there are still a other entities to own and use property and to number of articles of the criminal and administra- pursue business activities. Implementation of tive codes of most republics that prohibitbehavior such proposals will require significant legislative that is both rational and economically beneficial. changes. The Fundamental Principles of Legisla- While it appears likely that many of these articles tion on Ownership may need to be amended to will be eliminated in the next major revision of the equalize the ownership rights of individuals and criminal codes, steps need to be taken to repeal or those of juridical persons and, in order to avoid strictly limit the reach of the most destructive confusion and uncertainty, the use in legislation articles. In particular, laws punishing commercial of permissive lists of the objects of ownership middleman activities need to be eliminated im- rights and of the means by which the property of mediately, and laws concerning speculation must specific organizations may be formed should be either be eliminated or, at a minimum, amended discontinued. With respect to contracts, many of to restrict application to the most destructive cases the basic principles of Soviet civil codes are not of abuse of rationing and subsidy systems. inconsistent with market relations, but articles of Current reform proposals call for the creation of the codes which provide special rules for state equality of economic opportunities in an environ- enterprises and mandatory transactions will need ment in which market forces are able to operate. to be eliminated and existing principles updated Perhaps the most important step that could be to support complex commercial relationships. taken in regard to the equalization of conditions Until the codes as a whole can be updated, certain for business activity would be the passage of a types of contracts which are not adequately pro- clear and detailed law concerning the relationship vided for in existing civil codes (e.g., pledge, in- between the state and its employees and agencies surance) will need to be addressed through the and any business, enterprise, or commercial orga- existing practice of passage of specific legislation nization in which the state has an ownership in- defining and developing such contracts. terest. Such a law could clearly define the permis- Changes will also need to be made in the sys- sible and impermissible relationships between tems of civil dispute resolution and law enforce- state-owned entities and state bodies, providing a ment. With respect to the unique system of state management structure with specific safeguards arbitrazh, which has performed dispute resolu- against interference (whether helpful or harmful) tion, rule making, and law enforcement functions in the financial or business affairs of the enter- for state enterprises and planned transactions, its prise. Properly drafted and enforced provisions functions will need to be separated so that law of this type could be of great assistance in elimi- enforcement and rule making functions do not nating some of the most troubling inequities in the 35 current conditions for market activity, including government administrators, inspectors and tax subsidization and the absence of a hard budget auditors needs to keep pace with education and constraint for many state enterprises and reform at the enterprise level. anticompetitive behavior by state bodies. Present economic statistics are limited and suf- Reliable sources of information concerning new fer from various methodological and definitional laws and regulations must be available to partici- deficiencies that restrict their usefulness in moni- pants in market activity, as well as systems for toringandmanagingamarketeconomy. Particular efficient registry of businesses, property, and le- problems exist in areas of the national accounts gal encumbrances. A bankruptcy law defining and in thebalanceof payments. Price indicesused procedures and specific legal standards for the to aggregate output in NMP bear no relationship liquidation of failing businesses, temporary pro- to production costs or consumer demand. Statis- tection from creditors where appropriate, and tics on services which are used to calculate GDP registration and publication of such proceedings are also inadequate. On the balance of payments, would also be of assistance. the authorities record only transactions on a Before substantial privatization can be imple- settlements basis, thus excluding a large part of mented, the locus of ownership of state property foreign transactions such as barter trade and trade mustbe conclusively determined, whether through credits. The authorities acknowledge many of the conclusion of a new union treaty or some other these problems, and steps have been taken to means. In the interim, privatization might be correct some of them. Forinstance, efforts are now facilitated by the creation of a process by which a being made to compile national accounts statistics prospective purchaser could obtain the explicit on an SNA basis; and technical assistance has also agreement of all relevant government bodies, been requested in a number of areas, such as union and republican, to the transfer of the balance of payments compilation. Rapid progress property by a particular State Property Fund. will be important both to aid domestic decision Whatever the pace of privatization, legislation makers, and to encourage foreign investment. At requiring and protecting competition will be re- the sametime the secrecy still accorded toanumber quired in order for markets to function properly. of economic and financial statistics requires re- examination and care will need to be taken to G. AccouNnNG, AUDITING, AND STATISuCs. Accu- make sure that as private sector activities increase rate and timely information is an essential input to they are caught by those who compile the statis- economic decision making in a market economy. tics. In the USSR, vast quantities of information are gathered in forms intended to be of direct use to 3. Sectoral issues the planning authorities but of little use for other purposes. Improvements in both the accounting Many of the reforms proposed in this study apply system and in government statistics are required in principle across the entire economy, but must to facilitate the transition to a market economy. be implemented sector by sector and industry by The accounting system will need to be revised. industry. They will lead, more or less rapidly, to It must provide the information necessary to important shifts in the structure of the economy. present a full and fair view of the financial posi- Indeed, their principal purpose is to begin to tion of an enterprise or bank and to allow manag- correct the enormous cumulative misallocation of ers to evaluate performanceand take keydecisions, resources that central planning has produced. for instance on investment. Audited financial The following sections describe the distortions accounts, incorporating a proper valuation of as- and costs that have emerged over the years in the sets and liabilities, will need to be published for main sectors of the economy and a range of mea- the information of shareholders, creditors, and sures which could be taken to begin the process of those entrusted with supervisory authority. This rationalization and restructuring. In every case will require a number of relatively straightfor- the most pressing problems are related directly to ward changes to the present accounting regula- a serious misalignment of prices, giving force to tions, perhaps promulgated by a new central pro- our view that early price reform is of paramount fessional body. Getting managers to apply the importance. Together with commercialization new concepts may take time and effort, and it will and privatization, which are essential for the de- be necessary to train accountants and auditors as terminationofan appropriate price structure, price well as financial commentators. Training of reform can deliver substantial efficiency gains 36 even before a major reshaping of the economy has of output will lead to reductions in some pollut- begun. Waste can be discouraged in the storage ants. It will not eliminate the threat from the and distribution of food, and in the use of energy, extensive use of inherently polluting technolo- metals and other inputs. Demand for goods and gies. Becausemarketsby themselves cannot inter- services, priced well below their true cost, can be nalize environmental costs, it is necessary to es- curtailed. Pressures on the environment and natu- tablish appropriate environmental laws, institu- ral resources can be reduced. And sectors such as tions and policies to do so. housing, distribution and transportation-tradi- The allocation of responsibility among levels of tionally starved of resources by the planning government is an important issue. Experience in system-can begin to develop by using their own other countries suggests that there are benefits to investable surpluses. be gained from assigning the following responsi- The capital requirements for a comprehensive bilities to the union level; managing trans-repub- renovation and reorganization of the Soviet lican environmental problems; establishing economyare clearlyenormous. Butitmustimme- minimum ambient and other environmental stan- diately be said that over past years the USSR has dards; harmonizing environmental measures and poured enormous amounts of capital into several product standards that might otherwise distort of these sectors. The investment ratio of the USSR inter-republic trade and investment; international has long been one of the highest in the world. The environmental co-operation; and burden sharing weakness lies not in a shortage of capital, but in across regions. Other aspects of environmental how it has been allocated. Capital, like any other authority, in particular the application of union- resource in the market sectors of the economy, wide standards to local conditions and the cannot be allocated efficiently or effectively until implementation and enforcement of policy mea- a rational set of prices (including real interest sures, should be devolved to the republics or to rates) has been established. Even with rapid price regional and local levels. Public bodies will need liberalization, it will take time for the new patterns to be held accountable for the environmental of demand and supply to emerge and thus for consequences of their policies. investment to begin to grow again on a broad The creation of effective institutions will take front. The measures proposed therefore focus time and require training, particularly at the re- primarily on creating the conditions for sound gional and local level. The institution-building future investment. effort should be accompanied by a range of instru- ments concentrating on: pollution fees and fines A. ENviRoMEN. Environmental concerns cut which will help finance administrative costs; user across all sectors. Many of the industrial and charges on environmental services like water and agricultural regions of the USSR are on the verge sewage treatment to fund future environmental of ecological breakdown, posing an imminent investments;amonitoringsystemtoassistinpolicy threat to the health of present and future genera- design and implementation; effective procedures tions. Environmental health risks in some regions for establishing standards and, most importantly, areup to l0to 100 timesgreater than thoseaccepted enforcing them;and implementing demonstration in most OECD countries. Severe ecological con- projects in priority areas, e.g., river basin and ditions affect 16 percent of the total land area. The airshed management. economic costs of environmental degradation, The design of environmental institutions also including its effects on health and natural re- needs to take account of the emergence of sources, are substantial, and according to the So- environmental groups which have forced the viet authorities reduce GDP by about 10 percent. closure of dangerously polluting factories and Well-functioning markets can contribute to im- blocked new investment projects. Greater access proved environmental conditions by spurring to environmental information, participatory efficiency in resource use, includinga reductionof decision-making processes and effective waste in production inputs (e.g, energy and other procedures for assessing the environmental impact raw materials). Industrial restructuring should would provide the best means of securing the contribute to the closure of inefficient plants, and support of these groups. in so doing, impact favorably on resource use. If There is a danger that the severity of budgetary new investments incorporate advanced Western constraints might push environmental issues to technology, pollution will be further reduced. the margins of the reform debate. But if environ- Increased efficiency in the use of inputs per unit mental problems are allowed to accumulate, they 37 become more expensive to correct and impose a (2) Transportation. The USSR is the world's greater burden on later generations. Policies most freight-intensive economy, but it is at the should therefore be focused on a limited number opposite end of the spectrum in terms of passen- of priority problems, emphasizing inexpensive, ger mobility, which is far below Western norms. cost-effective approaches such as accident pre- The structure of transport services in the USSR is vention and emergency response at ageing facili- also very different from that in most Western ties; environmental audits at production facilities; economies. Railways and pipelines dominate enhancing reduction of particulate, toxic and heavy freight movements, together accounting fornearly metal air pollution; the design of toxic waste man- 80 percent of ton-kilometers, while roads carry agement facilities; and improvements in nuclear only 13 percent and waterways less than 8 percent. safety policies. The number of passenger cars per capita is only one eighth that of Western Europe, so that public B. DISTRIBUTION, TRANSPORTATION AND TELECOMMU- mass transit accounts for at least 75 percent of NICATIONS. passenger-kilometers, in contrast to 18 percent in the E.C. countries. (1) Distribution. Both retail and wholesale trade Intense utilization of existing equipment results continue to be dominated by the state, mostly at in low costs, and, despite low tariffs, all modes republic and local levels. Private activity that is except urban passenger services report healthy legal is still confined to the collective farm markets, profits-although profits appear to be exagger- accounting for no more than 2.5 percent of retail ated due to underrecording of true capital costs sales in 1988, and trade cooperatives, whose share and underpriced fuel. Capacity constraints, par- is probably smaller still. The designation of such ticularly in vehicles and rolling stock, have become trade as a nonproductive activity has made distri- one of the sector's main problems, aggravated by bution a neglected sector of the economy. Em- outmoded technologies, inadequate maintenance, ploying around 7 percent of the work force, the and shortages of spare parts. The prevailing mo- sector is less than half the size of comparable nopolies provided little stimulus to modernize sectors in the main market economies. Retail the system or otherwise respond to the need for markups are one-fifth to one-quarter of those pre- improved quality of transport services. vailing in the G-7 economies, and distribution as Major tariff increases, particularly for rail and a whole receives only 3 percent of total invest- urban mass transit, would help rationalize and ment, compared to roughly 4-9 percent in France, reduce demands on the transport system, thereby Germany, the United Kingdom and the United providing additional resources for moderiza- States. In a system characterized by central alloca- tion, maintenance, and capacity expansion. The tion and chronic excess demand, there is no in- creation of competitive market conditions would centive to develop a modern marketing infra- also stimulate greater responsiveness to transport structure: advertising, packaging, self-service re- users' needs as well as efficiency gains. Govern- tailing and financial services are rudimentary or ment barriers to entry of new companies, whether nonexistent. Worsening shortages have encour- public or private, should be promptly removed aged enterprises to produce their own inputs and for all modes. Private road and water transport to bypass the distribution system by resorting to could quickly become a dynamic new force on the barter. market, and tariffs should be market-determined. Initial reforms might usefully focus on three For railways and, to a lesser degree, aviation, aspects: the elimination of legal and licensing where natural barriers to entry of new firms are restrictions which prohibit or discourage new more formidable, privatization is arguably less entrants; the privatization of small-scale distribu- important than decentralization, introduction of tion operations, including the bulk of the retail competition, and other measures to strengthen sector;and the commercialization of larger, mostly incentives and accountability. Until such time as wholesale, distributors along the lines suggested a significant degree of market competition is es- for other state enterprises. Additional resources tablished, the government should retain some could be used in the first instance to develop control over tariffs for railways and aviation. financial and marketing information services, and Investment resources should be concentrated to upgrade storage facilities (refrigeration capac- on technological modernization where large gains ity in particular) in food distribution, in efficiency and/or service quality are attainable (e.g., improved information and operating sys- 38 tems, heavier freight trains, retrofitting of aircraft expansion and upgrading of capacity both for and buses with fuel- and pollution-efficient en- international calls and for fax facilities. Tariffs gines, air navigation systems); in expanding the should be rationalized and, on average, raised supply and range of more modem vehicles, roll- substantially. ing stock, aircraft, and ships; in the most critically congestedinfrastructure(particularlyrailwaysand c. AGRICULTURE. Agriculture is a key sector in aviation); and in extending all-weather farm ac- the Soviet economy, contributing about one quar- cess roads. Of particular importance is the estab- ter of GDP and employing one fifth of the work lishment of high-standard integrated intermodal force. At about 230 million hectares, the area transport services, which could reduce the need cultivated in the USSR is the most extensive of any for inter-city highways and enhance the com- country in the world. Most of the land is planted petitiveness of Soviet industry on world markets. in grains and fodder crops; overall, half the value of production comes from livestock products. (3) Telecommunications. The Ministry of Post Ninety-seven percent of the agricultural land is and Telecommunications (MPT) controls the divided almost equally between large state and manufacture, installation and operation of most collective farms. The remainder is farmed in civilian telecommunications systems, including household plots of up to one half hectare. These radio and television. A few key sectors-energy, plots are used for high value products; essential rail and aviation-have theirownnetworks, partly inputs and services are obtained from the state or because MPT's service is regarded as inefficient collective farms. Both crop and livestock yields and unreliable. Thereare an estimated 10 telephone show great regional variation, as production has lines per 100 inhabitants-roughly 25 percent of been undertakenand maintained inareasill suited the average density in Western Europe. Large for the purpose. cities are relatively well-equipped, the rural areas The USSR is the world's largest producer of much less so. There are 15 million people on the wheat. Soviet wheat yields, at 1.7 metric tons per waiting list for a telephone. Capacity is particu- hectare, lag significantly behind those of the E.G. larly low for international calls: except for official countries, but are comparable to North American users, international direct dialling (IDD) is avail- yields; input usage per unit of output is high. Milk able only in Moscow, and is limited to 2000-3000 yields per cow in the USSR are relatively low, just lines. The use of advanced technology is uneven: half those of the E.G., and 40 percent of American satellite communications are being introduced levels. rapidly, yet there are very few digital exchanges, Despite favorable resource endowments, the mainly because imports have been limited by USSR is a net importer of food. Imports average COCOM restrictions and a lack of hard currency. just under US$20 billion per year, about half of The tariff structure bears little relation to costs. which is grains and sugar. The need to import The prices for outgoing international calls are arises in large part from the inability to process three times those for incoming calls, and are used efficiently and distribute the very substantial do- partly to cross-subsidize low domestic long-dis- mestic production of food and fiber. Wastage and tance rates and provide free local calls. Average losses are roughly equal to imports. Substantial revenuesperlineareroughlyone-seventhof those food losses arise because of shortages of packag- in Western Europe. ing material, storage facilities, outdated process- There is scope for substantial decentralization ing technology and inadequacy in, and disruption of MPT's project operations, including the devel- of, transport. In addition, environmentally in- opment of business services, data transmission sensitive production methods have lowered pro- and new exchanges. Strategic and coordinating ductivity through the degradation of soil and functions, however, should be retained at the water resources, and led to the contamination of national level. In the longer run, a number of food. Waste of perishable foods, such as fruits, private operators could compete for the long- vegetables, and potatoes, is estimated to be as distance and international business which the much as 40 percent of the crop. Losses of wheat authorities currently propose to pass to a new are estimated to be approximately 20 percent of monopoly (Sovtelcom). Local services could be the crop, compared to an estimated 2 percent in provided by regulated regional monopolies. The the United States. first priority, however, should be to improve the Agriculture shares with other sectors chronic quality of service to the business user, through an problemsof distorted prices, inefficiententerprises, 39 waste and pilfering at all stages, and ill consid- Thedeteriorationduring1990inmarketingand ered investments with poor returns. Trade is distribution throughout the economy, and the under tightstatecontrol: severerestrictionsaffect, resulting rise of autarky and barter between re- inter alia, protein feeds imports, giving rise to an publics has been particularly damaging for agri- inefficient use of grains, while cooperatives are culture. Efforts to shift the costs of subsidies to the banned and individual producers severely re- local level, together with increased local control stricted in retail trade. over retail prices, has led to barriers to deliveries Base prices for producers vary widely by re- from particular regions and to local procurement gion. For instance, the basic procurement price prices below harvest costs. Waste of perishable for milk varies across republics by as much as 75 food has increased. Meat is being held in inven- percent. Prices also tend to be lower for private tory in the form of livestock. The deterioration in producers than for state farms. In addition, bo- transportation and distribution has aggravated nuses, which are largely based on costs of pro- food shortages in major cities. In a wider sense, duction, tax efficient producers and subsidize however, the shortages are a consequence of inefficient producers. Consumer prices for many growing price distortions and macro-imbalances. food items in official outlets have been held con- Reform in the agricultural sector must above all stant since the early 1960s, despite accelerating address the critical areas of price liberalization, inflation and rising production costs, thus re- and of enterprise and land reform; large new quiring growing subsidies. Meat and dairy investments should be deferred until significant products account for three quarters of food subsi- progress is achieved in these areas. Priority needs dies; consumption patterns vary by region, with are for investment in small scale production, tech- higher subsidies in wealthier regions. Excess nology, construction of all weather farm access demand at subsidized prices has resulted in roads, and food processing capacity to reduce shortages and fostered corruption while at the wastage. Once the transition to a market economy same time products are used wastefully. Costly is underway, many important issues, including alternative distribution channels have replaced research and extension, and supportive financial much ordinary retail trade in food. The poor and services will demand attention. the state budget both fare badly under these dis- The overall strategy for the agricultural transi- tribution schemes. Rural inhabitants have more tion must also include the termination of agricul- limited access to subsidized food from official turalstateorders;phased withdrawal of thestate's retail outlets and must pay the higher prices for role in direct provision of agricultural inputs and foods bought from other outlets or the parallel rural construction materials; privatization (with market. individual, joint shareholding or cooperative As in the enterprise sector, the present agricul- ownership) of processing, of wholesale and retail tural system provides workers and managers with trade in food, and of small-scale transport (mainly little autonomy to make decisions and few in- trucks). Land and enterprise reform involves the centives to boost efficiency. Whatever costs were, disbanding of state and collective farms and the they have been covered by rising procurement establishment, on the basis of local choice, of prices, production subsidies and debt. The role of private individual or cooperative farms with full theAgriculturalBankhasbeenthatofcashtransfer private ownership of land. Nondivisible ma- agent rather than lender. In December 1989 half of chinery and buildings should be held by a service outstanding farm debt was written off, but even cooperative, with services sold to managers of after this event, the bequeathed assets of the ag- land, both cooperative and individual. Reform of ricultural banking system which has recently been agricultural credit and establishment of new cri- put on a commercial basis are of questionable teria for agricultural investment are also urgently quality. Agriculture and related activities (rural needed. joint ventures could play an important infrastructure, food processing, and the supply of role, inter alia, in the food processing industries agricultural inputs) haveabsorbed approximately where introduction of moder technologies is one third of total investment over the past 25 particularly needed. years, and yet agricultural and rural infrastruc- ture are underdeveloped, food processing tech- D. ENmGY SECTOR. The USSR is generously en- nology is outdated, and input supplies are of poor dowed with energy resources. Oil and gas pro- quality. duction accounts for 22 percent and 40 percent 40 Chart 4 USSR ENERGY PRODUCTION AND TRADE (millions of tons oil equivalent) 670 6.0 220 -15.0 Production of Oil Net exports of Oil c level 210 - = level -annual percentage change 4.0 -annual percentage change 650 - 9.0 200- 2.0 190 - 630- - 3.0 0.0 180- -2.0 610- - -3.0 170 -4.0 160 590 - -9.0 -6.0 150 5701* -8.0 140 * -15.0 1985 1986 1987 1988 1989 1990 1986 1987 1988 1989 1990 800 9.0 100 20.0 Production of Gas Net exports of Gas c level 8.0 95 -m level 750 _-annual percentage change -annual percentage change - 16.0 7.0 90 700 - 6.0 85 - 12.0 5.0 650 - 80 - 4.0 8.0 75 - 600 - 3.0 70 - 2.04. 4.0 550- 1.0 65 - 500 10.0 60 0.0 1985 1986 1987 1988 1989 1990 1986 1987 1988 1989 1990 Source: Norkhoz 1989, lEA estimates. MVES and staff calculations. 41 respectively of world output. Energy exports centives to promote efficiency are virtuallynonex- account for about 40 percent of Soviet hard cur- istent. Investment is centrally allocated and does rency earnings. However, the energy industries not take sufficient account of conditions prevail- are presently in a precarious position. Coal and oil ing in individual enterprises. Performance idi- output are falling, the growth of gas output is cators for environmental protection are based on decelerating and domestic energy shortages are money spent, rather than on the effectiveness of developing (Chart 4). Although the energy sector expenditures. accounts for a substantial part of investment (15 Atwo-stageapproach to reform is needed. First, percent of total gross fixed investment and nearly in the near term, efforts are urgently required to half of industrial investment) outdated technolo- restore oil production and exports to previous gies, obsolete equipment, and poor maintenance levels, giving particular emphasis to improving are endemic in much of the fossil energy sector. field management practices and secondary recov- Energy-related air pollution, water and land ery techniques. Efforts are also urgently required degradation have grown largely unchecked. to shore up the faltering electric utility system. In Exploitation of fuel reserves has often relied on this regard, timely completion in conformity with techniques that result in the rapid short-term ex- generally recognized international environmen- pansion of production at the cost of longer term tal and safety norms of power plants under con- recovery prospects; production inefficiencies struction, including nuclear ones, is vital. Bring- abound. One consequence has been the eastward ing on stream additional electricity generating movement of production to new but more remote capacity will also be critical. Priority should also and costlier to exploit reserves in order to main- be given to rehabilitating fuel processing plants, tain output levels. Coupled with the inappropri- and to improving system flexibility, safety, effi- ate location of some refineries and power generat- ciency, and environmental performance. Better ing plants, this has led to increases in both trans- public understanding of energy issues and needs port requirements and production costs for coal, will be essential to the achievement of these near petroleum, natural gas, and electricity. Energy planners seek to use coal, gas and nuclear power more extensively to meet domestic demand in order to free up oil for export. However, the short Table 5 USSR: Domestic and World Energy run scope for increased use of gas is constrained Prices by poorly constructed and maintained pipelines (wholesale prices to industrial consumers) and processing plants. Increased use of coal faces 1990 19911 serious transport shortages and poses environ- (rub 0.58 per US$ (rub 1.80 per US$1) mental problems if emissions are uncontrolled. And more use of nuclear power is constrained by Oil pulcopsto.in rubles per m.t. 30.0 70.0 public opposition. in US$ per m.t. 52.6 38.9 One salient characteristic of the Soviet energy in percent of world sector today is its lack of flexibility. Oil and gas market price2 26.3 19.4 storage capacityis insufficient to cope with marked Coal changes in demand, refinery shutdowns or pipe- rubles per m.t. 27.0 50.0 line bottlenecks. Electricity generating capacity is in US$ per m.t. 46.6 27.8 in percent of world strained and new construction is delayed. Exist- market price 93.1 55.6 ing port and pipeline capacity could handle oil Gas exports up to the equivalent of the 1988 peak level in rubles per th.cm. 25.0 50.0 which was about 25-30 percent above the 1990 in US$ per th.cm. 43.1 27.8 actual level. Refinery capacity is not matched to in percent of world the structure of demand. market price' 33.7 21.4 Energy pricing has also been inflexible. Con- 1. The ruble prices refer to officially announced new domestic sumerenergy prices for oil, coal and gas, effective from January 1, 1991. Sume prcesare elo prducton ost andwel 2.World market prices are assumed to be US$200 per million metric below world market prices (Table 5). Conse- tons (mt.) in 199 and 1991. quently energy is used very inefficiently, with 3. Worid market prices are assumed to be US$50 per million metric energy use two and a half times as high relative to 4. World market prices are assumed to be US$130 per thousand GDP as the average for OECD countries. Pro-1991. Sour Data provided by the Soviet authorities and staff calcula- duction is subsidized and cross-subsidized; in- tions. 42 term goals. Second, commercialization and price output is used primarily domestically, and those reform, coupled withinvestment in more advanced whose output is exported. technology, are essential for development and The export-oriented subsectors, consisting of energy conservation over the longer term. the gold, platinum and diamond, and nickel in- A substantial increase in relative prices of en- dustries, have been generously treated in terms of ergy products is likely to reduce the waste in the investment allocations. Worker motivation may short run and encourage supply in the longer run. also have benefitted from retention rights to for- Conservation can have potentially powerful ef- eign exchange-albeit modest-that have been fects on export earnings: a 1 percent reduction in used to acquire consumer durables. The identified domestic consumption would increase export resource base is sufficient to support production potential by nearly US$1 billion (assuming oil at present levels in the medium term, notwith- prices of US$26 per barrel). Over the longer term, standing the apparent decline in gold production capacity expansion will still be required as domes- over the last decade. In contrast, domestically- tic demand expands as a result of income growth, oriented subsectors are characterized by anti- and this will require new investment incorporat- quated machinery and technologies with virtually ing advanced foreign technology. no computerization, and a resource base that is The Government has made a commitment to rapidly dwindling. As in the case of energy, implement a range of extraordinary measures to difficulties of access characterize many mining reverse the drop in oil production. Foreign invest- activities, leading to high transport requirements ment and know-how will be critical to this effort. becauseofthedistancebetweentheminesandthe To attract foreign capital, a favorable investment processing units. climate is required. Fundamentally, this means While the demand for minerals, other than gold implementing the restructuring sketched out ear- and nickel, tends to be excessive because of low lier. In addition, legal and regulatory concerns of domestic prices, energy use in mining production potential foreign investors will need to be ad- is extremely high. Most of the metal industry, dressed. Proposed reform plans to lease fuel moreover, is characterized by severe environ- deposits are a step in that direction. The royalties mental problems. and other taxes paid by foreign companies en- Presently, the enterprises of the metal mining gaged in the exploration of energy resources could and smelting operations typically fall under the provide a welcome boost to budget revenues over control of the Ministry of Metallurgy. The ex- the medium term. However, the issue of owner- ceptionsincludethosedominantingoldandnickel, ship of energy resources has to be resolved before which are responsible to the Council of Ministers foreign companies can be expected to enter into and are accorded preferential treatment in the significant long-term contractual arrangements, allocation of investment funds and equipment. and clearly defined environmental standards will For the most part, semifabricating is not under- need to be established. An internationally agreed taken by the metal mining enterprises but is rel- investment regime with international arbitration egated to enterprises under other ministries. With would also help to strengthen confidence of for- the liberalization of trading rights, large organi- eign investors. zations have taken the opportunity to establish contacts directly with foreign purchasers for the E. METAL AND MINING. The USSR is the largest sale of large tonnages outside of state orders, producer in the world of iron ore, zinc and nickel; rather than going through the industry's foreign the second largest of gold, aluminum (for which it trade organization. A new trading company has is heavily dependent on imports of bauxite) and recently been established to handle sales of small lead; and the third largest of copper. Domestic spot lots of various materials produced in excess prices for metal mining products consumed inter- of planned production. The proceeds are used to nally are severely distorted, having a price (in purchase consumer goods for the workers. terms of heavy machinery) of perhaps one third of Looking ahead, price liberalization will have a that on world markets; such prices have also major impact on the metal industry as input and limited the possibilities of generating internal output prices are highly distorted in relation to funds for investment or encouraging economy in world market prices. But liberalization is essen- the use of inputs. And with increasing needs for tial for efficiency and should encourage recycling foreign exchange in the economy, a clear distinc- which is presently totally neglected. Producers tion has emerged between those industries whose are likely to face a sustained decline in domestic 43 demand for most metals. Efficient producers could are critically dependent on imported raw materi- then seek markets abroad, but there would in any als and imports. This was evident in 1990 when case be widespread need for restructuring and the decline in industrial production was largely rationalization. While additional investments are attributed to constraints on certain imports (e.g. likely to be needed in modem technologies and cold rolled steel sheets for the auto industry; dyes for purposes of environmental protection, there and lacquer for the furniture industry and pack- might nonetheless be a decline in overall net in- aging material for the food industry). vestment. Managers will need to acquire the The central planning system has created a mis- necessary skills to function in a market environ- match of demand and supply resulting both in ment, although present standards of technical shortages of inputs for enterprises and finished training appear high. As in other industries, the goods for consumers and in excessive present large bureaucracy controlling the sector stockbuilding. A recent survey at the consumer should bedramatically streamlined and reoriented level showed that nearly 90 percent of the basic away from directing investment and production, industrial goods reviewed were judged to be in toward general policy issues that arise in a market short supply. While shortages have persisted for environment such as demonopolization, com- many years, they have become more severe re- mercialization and privatization. cently because of the persistence of price controls and rising excess demand. At the same time, F. MANUFACTURING SECTOR. The Soviet manufac- stocks of some goods are very high, as enterprses turing sector accounts for about 26 percent of do not necessarily produce goods in demand and GDP, which is roughly the same share as in East- the interest cost of holding stocks is low. For em Europe (25-30 percent) and industrial coun- example, in 1990 stocks in machine tool plants tries (20-25 percent), but employment in that sec- were equivalent to six months sales, compared tor is higher in the USSR than in some market with one month or less in market economies. economies (Chart 5). Enterprises are typically The move to a market economy will require the very large, with almost three fourths of the em- end of most of the administrative controls, the ployees in firms with over 1,000 workers and one- establishment of market signals, and the provision fifth in firms with over 10,000 workers. Exports of of basic services such as transportation, commu- manufactured goods represent only a small part nication and financial services. Branch ministries of output, with exports to non-socialist countries should be dissolved and one Ministry of Industry accounting for less than 1 percent of output and at each union and republic level should support exports to socialist countries less than 2 percent. and regulate manufacturing activity, while being The systemic weaknesses in the manufacturing totally separated from production. Their roles sector are readily apparent: the rise in the capital should be to formulate and administer industrial output ratio from 2 in 1975 to 3 1/2 in 1987 re- policy; review and monitor long-term trends and flecting the diminishing return from large-scale international developments; disseminate techni- investment; excessive use of raw materials and cal and market information; promote Soviet in- energy (the use of energy in steel-making is nearly dustry abroad; elaborate and update product half above that in Japan and a quarter above that standards; work with concerned agencies in ap- in the United States); low labor productivity; and plying safety and environmental standards; and overmanning (reaching 100 percent in many assist regulatory agencies to develop and monitor plants). controls on monopolies and anti-competitive Another weakness is the great concentration of practices. productionina single ora few verylargeproducers In addition to commercialization and (e.g. refrigerators and T.V. tubes), which has made privatization, the transition to a market economy the manufacturing industry highly fragile to will require the elimination of the restrictions on temporary disruptions in production or trans- the permitted range of products that currently portation. An example is the recent shortage of prevent competition, and a removal of other li- cigarettes which was due, in part, to the shut- censing requirements that pose undesirable bar- down of monopolistic glue and filter manufac- riers to competition. It is particularly important to turing facilities in Azerbaidzhan and Armenia. facilitate the growth of the small business sector. Moreover, despite the relative closedness of the In large firms, especially in heavy industries and economy, some of the manufacturing industries producer good industries, the units that produce 44 Chart 5 USSR EMPLOYMENT BY SECTOR a. Agriculture 70 70 (as percent of total employment, 1989) China 1/ 60- 60 50 - 50 40 - 40 Poland 1/ 30- 30 USSR 20- U 20 Japan 10 -- 1 United States W. Germany 10 0 aaII 0 b. Industry 70 70 (as percent of total employment, 1989) 60- 60 50- 50 40- 40 W. Germany USSR Poland 1/ 30- 30 Japan China 1/ United States 20 20 100 10 Source: Goskomstot, national sources and staff estimates. 1/ 1988. 45 consumer goods should be split off as autono- minimal required levels. This gap significantly mous firms. Certain subsectors, such as steel, contributes to the steady deterioration in the qual- petrochemicals and machine building, will face ity of the housing stock. Both production and rent particularly difficult adjustment problems, given subsidies are linked to the housing unit, and not to the expected drastic switch in demand to services the means of those who live in it. and consumer goods in the wake of price liberal- The introduction of a market-oriented housing ization and the reduction in military production system will require reforms in four areas. First, and procurement. For these industries, down- property rights-the core component of any sizingor liquidation rather than enterprise specific housing system-need to be clearly established restructuring may be required. through a strengthening of ownership rights, Adequatebusiness infrastructure would require, conversion of "permanent and guaranteed" ad- for example, development in telecommunication, ministrative tenancy rights to fixed-term renew- transportation, and financial services. Training able rights, and the free and unrestricted exchange for managers who have a good basic education of existing units and leases, with monetary com- but are completely unfamiliar with conducting pensation permitted. Second, subsidies and al- business in a competitive environment is critical. lowances should be channeled away from the The scope of such training is enormous considering construction industry to households, and targeted the existence of 46,000 industrial enterprises and as far as possible; moves toward full economic the need for the training of several employees in rent should be coordinated with both wage reform each of these enterprises. and the privatization of various segments of the The conversion of military industries to civilian state-owned stock. This process should begin at production, and the transfer of technology from an early date. The sale of newly produced units military to civilian industries, are of particular should be started very quickly. In 1989 financial concern to the authorities. There are over five assets per household averaged only one third of million workers employed in the military indus- the official construction cost of a standard urban tries and the level of technology is high. While the housing unit so the potential for absorbing resources of these industries are increasingly be- household savings is considerable. ing shifted to production of civilian goods, past Third, housing finance must be developed and conversions have sometimesresulted in inefficient become an integral component of financial sector product mixes. The potential for further conver- reform. Subsidy elements should be separated sion remains large. However, greater exposure to clearly from finance credit, so that funding is market forces will be required if these industries transparent. Particular attention must be given to are to become competitive. A detailed examina- ensuring that finance is available to carry long- tion of these matters was beyond the scope of the term mortgage instruments. During the transition present study and would need to be undertaken at toward market determined wages and rents- a later stage. The authorities have indicated their characterized by the conversion of in-kind pay- interest in foreign investment in conversion ac- ments such as housing into wages-special tivities. mechanisms may be needed to improve affordability while minimidzing subsidies. c. HousNG. The unsatisfied demand for hous- Finally, increased competition is needed within ing is very large, with 18 percent of all families the housing industry. This will become easier as having been on waiting lists for more than 10 households gain greater control over financing years. Individual housing constitutes only 22 decisions, subsidies are redirected, markets for percent of city floor space, and its quality is very building materials develop, and access to land is low. Per capita living space is below half that of facilitated by local governments. Preferential West Europe. The housing situation is a major treatmentforlargestatefirmsshouldbeeliminated. obstacle not only to labor force mobility, but also Revised urban planning and changes in building tomacroeconomicstabilization. Rentsarebasically codes are needed to accommodate greater diver- unchanged since 1928 and households now spend sification of housing types and smaller, more less than 3 percent of their income on rents and flexible housing projects which could also absorb utilities. This is equivalent to about one tenth the labor shedding by other sectors. It is estimated share in some major market economies. Mainte- that such reforms could cut the costs of providing nance is heavily subsidized, yet actual expendi- housing by 30-40 percent. tures cover less than 40 per cent of the cost of even 46 VII. Criteria for, and Forms of, External external imbalances have arisen and the mecha- Assistance nism for administrative control has fallen into disarray. This section describes the criteria for, and forms The elaboration and implementation of the of, external assistance which could support a re- necessary reforms will inevitably be a protracted form program. In our view, the criteria for such a process whose success will depend above all on program should be the adequacy and mutual the efforts and determination of the Soviet people consistency of the major structural reforms and themselves to transform their economic system. financial policies. We would stress, in particular, But the international community can play an ef- the need for a significant and broad-based liberal- fective supporting role in the period during which ization of prices in an environment of increased preparations forreform arebeing made, and while domestic and external competition, supported by the reforms are being implemented, such as a clarification of property rights and encourage- technical assistance, food aid and selected projects. ment of private ownership along with the com- More general balance of payments assistance mercialization of the larger state enterprises. This would only be effective if a comprehensive pro- in turn requires that the necessary legal framework gram of macroeconon-c and structural reform and a judicial system be put in place as rapidly as were to be implemented. possible. Initially, the development of a private During the preparatory period, a primary focus sector should be fostered by the sale of small of aid would be technical assistance. Union, re- enterprises and the encouragement of small-scale publican and municipal authorities all indicated market activities. The commercialization of large their interest in technical cooperation and advice. state-owned enterprises would bring them under Assistance is needed in the design of policies, the the discipline of a hard budget constraint, and establishment of new institutions and the devel- would be a step towards both more efficient opment of a legal framework. Work has begun in management and privatization. these areas but it will need to be extended to cover These efforts need to be buttressed by tighter laws affecting contracts, property rights, mo- financial policies and a more realistic exchange nopolistic practices and bankruptcy. Assistance rate policy so as to contain inflationary pressures would also be helpful in developing statistical and andpreventmajorexternalimbalances. To cushion accounting systems and in setting up accounting the effects of the reforms on the poorest segments firms so as to facilitate the transition to a market of the society, these measures should be supported economy. Technical assistance is also needed in by an incomes policy and by an effective social the fields of fiscal and monetary policies, foreign safety net (including an adequate system of un- exchange and banking. employment compensation). Limited assistance Beyond these specificareas,a major contribution insupportof restructuring should alsobeprovided could be made to the easing of inevitable transi- to viable firms facing severe transitional problems. tional difficulties by providing expertise in such Time will be needed to complete this process but sectors as labor markets, management and mar- the initial changes have to be sufficiently deep and keting. A large and widespread international wide that they are seen to mark an irrevocable effort is justified, but to be effective it would need break with the past and to establish a climate in to be closely coordinated primarily by the USSR which private economic activities are encouraged itself. As everything cannot be done at once, and protected. priorities have to be set; and a decision is needed In a revolutionary departure from earlier asto how technical assistance canbestbechanneled thinking the Government of the USSR has com- to the republics and other territorial administra- mitted itself to move to a market economy. The tions. A large part of this technical assistance presidential guidelines set out broad intentions should be provided by the private sectors of that go in that direction. The specific measures Western countries with the role of public sectors that have been adopted do not yet constitute the being limited to filling any important gaps. coherent and comprehensive program which, in A more immediate problem, due largely to the our view, is necessary if the transition is to be breakdown of the state procurement and distri- successful. Experience suggests that measures bution system, is that food shortages haveemerged that are less than comprehensive have but a poor in some parts of the USSR, and especially in large chance of success, and this is particularly likely to cities. Food aid, if targeted and successfully de- be true in the USSR where major domestic and livered to the regions most affected, could allevi- 47 ate present distress. An early implementation of percent or 25 percent respectively. They yield a economic reform would make the single largest range of estimates for the current account deficit contribution to alleviation of shortages. with the traditional convertible currency area of Substantial foreign investment could be expected between US$10.1 billion and US$14.7 billion (ex- when a more comprehensive reform program had cluding gold exports which might be estimated at been put in place which would require the re- $3.5 billion). In addition, a large amortization sponsibilities of the union and the republics to be (amounting to about US$12 billion) of medium more clearly delineated. The effectiveness of and long term debt in convertible currencies will widespread project assistance is subject to the fall due in 1991, and there will be a need to repay same prerequirements but the energy and envi- sizable overdue trade credits (of the order of US$5 ronment sectors may be the exceptions, for in billion). theseareasimmediatenew investmentcould have Given the already secured financing and al- a quick pay off for the USSR and the rest of the lowing for gold exports, the ex ante financing gap world (in particular the modernization of existing in convertible currencies could range between nuclear plants, the improvement of oil extraction US$5.6 billion and US$10.2 billion. But part or all technologies and capacities, and the updating of of thisgap willbe filled by the prospective surplus the gas pipeline and distribution systems so as to vis-A-vis the CMEA area, which can be estimated favor energy savings). Early support for the re- at between US$9.9 billion and US$6.6 billion un- moval of bottlenecks in economic infrastructure der the two alternative scenarios depending on (e.g., telecommunications and distribution) may the financing available to these countries, and on also be justifiable. the disposition of their accumulated claims in A comprehensive reform program could benefit transferable rubles on the USSR. If there were to from financial assistance, including project assis- be large settlements in convertible currencies by tance. Project assistance could make contributions CMEA partners to the USSR this would aggravate in many sectors, but immediate attention should the balance of payments problems of these coun- be directed toward infrastructures where invest- tries, and could require a reassessment of the scale ments (both public and private) are of strategic of assistance to be provided to them. importance for the transition to a decentralized However, the date on which far-reaching re- market economy in which autonomous units will form will be introduced is not now known and the need to establish direct horizontal relationships. requirements for balance of payments assistance Furthermore,these infrastructureinvestments will will have to be re-evaluated in the light of the be essential to encourage foreign direct investment prospects at that time. Such assistance might and privatization. Retailing and distribution are include consumer goods and food to increase two areas where foreign assistance can be par- supplies at the outset of price liberalization. As- ticularly useful: these areas will be critical in the sistance through a stabilization fund could also transition to a market economy and, in both, re- provide important support for an early move structuring and privatization can take place towardsthefullconvertibilityoftheruble. Butwe somewhat faster than in sectors which require must stress that balance of payments assistance heavy investments. Telecommunications is an- should accompany the introduction of a major other sector in which new investment would and comprehensive reform program. Without support decentralization and marketization. sucha reform, additional financial resourceswould Equally project assistance in transport, in agri- be of little or no lasting value. With it, assistance culture (where the need is for new investments in could provide important support during a time of small scale production technology), in food pro- a difficult transition to integration of the economy cessing, and in banking will be important. The of the USSRinto the world economy, withbenefits opening of the economy would benefit also from for all partners. a reconsideration of existing trade barriers im- posed by Western countries, including the present COCOM restrictions. VIII. Endnotes In regard to balance of payments assistance several scenarios could be constructed. For illustrative 1.The term commercialization is used in this purposes two have been chosen. They are based study as shorthand covering the establishment of on assumptions of: crude oil prices of US$26 or an enterprise as a financially and managerially US$20 per barrel and declines in oil exports of 17 autonomous entity without necessarily implying 48 private ownership (see section VI.2.b.(1) for de- is adequate to support the policy analysis and tails). recommendations made in this study. 2. The evaluation of economic developments is 3.External debt comprises debt contracted or of necessity conditioned by the available statistics. guaranteed by the Vneshekonombank (the For- Soviet economic statistics are subject to well- eign Trade Bank). It therefore excludes financial known methodological problems, uncertainties debt (relatively small) of enterprises and suppli- of interpretation, and various systemic biases ers' credits (including arrears). tending to overstate economic performance. Cer- 4. This concept includes an allowance for that tain problems, most critically the evaluation of part of the increase in household and enterprise aggregates compiled on the basis of prices that holdings of cash and deposits that is estimated to may reflect neither use values nor production be held involuntarily. costs, are insuperable. These limitations need to 5. The official rate remains in effect only for be kept in mind throughout the study. Data on ruble-denominated credits of the USSR. external debt and debt service were broadly of the 6. Including, in particular, substantial new cred- same order of magnitude as those compiled its and grants from France, Germany, Italy, Saudi through external creditor sources, but the com- Arabia, South Korea, Spain, the United States, and parison of trade data compiled in the USSR and by the European Communities. partner countries was handicapped by method- 7. The Industry and Construction Bank, the Ag- ological differences between the two sources. riculture Bank, and the Social Investment Bank. Nevertheless, it is our view that the statistical base APPENDIX TABLE I USSR: Incomes and Prices (annual growth in percent) 1986 1987 1988 1989 1990 (estimates) Retail price index 2.0 1.3 0.6 2.0 4.8 Average monthly wage 2.9 3.7 8.3 9.4 10.0 Household money incomes 3.6 3.9 9.2 13.1 14.5 Household purchases of goods and services 2.8 3.1 7.2 9.5 13.7 Saving rate (percent of disposable income) 6.9 7.6 9o2 12.0 12.9 Sourcet Data provided by the Soviet authorities. USSR: Money and Credit (annual avrage growth in percent) 1981-85 1986 1987 1988 1989 1990 (estimate) Currency 6.0 6.1 7.8 13.6 19.5 21.5 M o 6.8 7.6 15.7 15.4 14.3 13.4 M2 7.5 8.5 14.7 14.1 14.8 15.3 of which: Households 7.2 9.4 9.8 11.3 15.0 13.5 Enterprises 8.7 5.5 32.6 22.5 14.5 20.0 M2 (percent of GDP) - 51.2 56.9 61.2 65.5 725 Total credit 8.7 4.2 6.6 11.3 11.2 10.9 of which: to firms 8.7 -13.3 -5.0 -6.8 -3.8 -4.3 to government 8.7 18.8 40.3 46.0 30.0 17.2 Source: Data provided by the Soviet authorities. 49 APPENDIX TABLE II USSR: External Trade (annual average percentage change) 1986-89 1986 1987 1988 1989 Export volumes 4.5 10.0 3.3 4.8 - of which: CMEA 1.7 3.9 0.9 - 1.9 Nonsocialist' 6.5 15.5 6.0 6.3 -1.0 Import volumes 1.3 -6.0 -1.6 4.0 9.3 of which: CMEA 1.0 0.7 1.5 - 2.0 Nonsocialist' 1.8 -14.3 -2.8 8.6 18.5 Terms of trade -5.2 -10.5 -2.0 -9.0 1.1 of which: CMEA -3.7 1.9 -5.6 -6.3 -4.5 Nonsocialist' -6.4 -22.4 7.8 -11.2 3.3 1. Nonsocialist countries comprise all countries except CMEA countries, the People's Republic of China, Democratic People's Republic of Korea and Yugoslavia. Source Data provided by the Soviet authorities. USSR: External Debt and Reserves (billions of U.S. dollars) 1985 1986 1987 1988 1989 1990 (staff projections) External debt2 28.9 31.4 39.2 43.0 54.0 52.21 of which: Short-term 6.9 7.4 8.6 11.2 17.7 10.0' External debt service' - 7.8 8.8 8.2 9.4 13.4 (percent of goods and services)4 (-) (27.7) (26.5) (23.1) (24.2) (33.0) Foreign exchange reservess 12.9 14.7 14.1 15.3 14.7 5.1 1. June 1990. 2. External debt contracted or guaranteed by the Vneshekonombank. 3. Total debt service on debt contracted or guaranteed by the Vneshekonombank, excluding repayments of short-term debt. 4. In convertible currencies. 5. BIS data excluding end-1990 which are staff projections. Source: Data provided by the Soviet authorities, the Bank for International Settlements (BIS) and staff projections. 50 APPENDIX TABLE IUI USSR: Distribution of Population, NMP and Budget Revenue by Union Republic NMP Population Total Industry Agriculture State Budget Revenue Deliveries to Exports (percent of (current prices, Retained by Republic Other Republics Abroad total in percent of total (percent of total, (percent of republican NMP 1989) in 1988) 1990 plan) in current domestic prices) Armenia 1.1 0.9 1.2 0.7 1.4 63.7 1.4 Azerbaidzhan' 2.5 1.7 1.7 2.2 1.8 58.7 3.7 Belorussia 3.6 4.2 4.0 4.9 4.7 69.6 6.5 Estonia 0.5 0.6 0.6 0.7 0.8 66.5 7.4 Georgia2 1.9 1.6 1.4 2.1 1.8 53.7 3.9 Kazakhstan 5.8 4.3 2.5 6.1 6.1 30.9 3.0 Kirgizia 1.5 0.8 0.6 1.3 1.2 50.2 1.2 Latvia 0.9 1.1 1.1 1.2 1.3 64.1 5.7 Lithuania 1.3 1.4 1.1 1.9 1.7 60.9 5.9 Moldavia 1.5 1.2 1.0 1.8 1.4 62.1 3.4 RSFSR3 51.4 61.1 61.9 18.0 55.3 18.0 8.6 Tadzhikstan 1.8 0.8 0.5 1.2 1.1 41.8 6.9 Turkmenistan 1.2 0.7 0.4 1.2 0.9 50.7 4.2 Ukraine 18.0 16.3 16.7 17.1 15.9 39.1 6.7 Uzbekistan' 6.9 3.3 2.3 5.2 4.7 43.2 7.4 Residual - - 3.0 4.4 - Total 100.0 100.0 100.0 100.0 100.0 - 1. Includes 1 autonomous republic. 2. Includes 2 autonomous republics. 3. Includes 16 autonomous republics. 4. Includes 1 autonomous republic. Source* Data provided by the Soviet authorities. USSR: Social Indicators USSR Eastern Europe' OECD Population (millions) 288.0 113.0 832.0 Per capita GNP (U.S .dollars, 1989) 1,7802 2,465 17,606 Life expectancy (years, 1987) Male 64.2 67.2 71.6 Female 73.3 74.4 78.0 Infant mortality (deaths per 1,000 live births) 25.1 17.6 8.4 1. Data are for Bulgaria, Czechoslovakia, Hungary, East Germany, Poland, and Romania, except for life expectancy and infant mortality figures, which exclude Hungary. The per capita GNP figures are converted to U.S. dollars at official exchange rates. Since these rates are not market- determined, GNP comparisons derived from them must be regarded as subject to wide margins of error. 2. Converted at rub 1.8 per U.S. dollar. Source: Data provided by the Soviet authorities, national sources, and staff calculations. 51  A President Gorbachev and other leaders of the Soviet Union have indicated their intention to transform the USSR into a market-oriented economy integrated into the world economy. At the July 1990 "Houston Summit" the heads of state and government of the seven principal industrial democracies and the president of the Commission of the European Communities, in agreement with the Soviet Union, requested the Inter- 0 national Monetary Fund (IMF), the World Bank, the Organisation for Economic Co-operation and Development (OECD), and the designated president of the European Bank for Reconstruction and Development (EBRD) to undertake a joint study of the Soviet economy, make recommendations for its reform, and establish the criteria under which Western economic assistance could effectively support such reforms. This study, 0 which in December 1990 was submitted to the participants in the Houston Summit and to the Soviet government, summarizes the analysis and recommendations prepared by the staffs of these four international organizations. The more detailed background papers prepared as part of this study are being published by the OECD on behalf of these four organizations. The transformation of the Soviet economy is bound to be extraordinarily complex and will take many years to complete. Three closely related areas require action at the outset of the process: macroeconomic stabilization, including fiscal, monetary, trade and payments, and incomes policies; price reform in an environment of increased domestic and external competition; and ownership reform, involving the rapid privatization of retail trade and small enterprises, along with the commercialization of large, state-owned enterprises. Many measures are needed to support policy actions in these three areas. A social safety net, including an unemployment compensation program, will be needed to a protect the most vulnerable from the short-term adverse consequences of the reform process. Other measures include completion of the legal framework for a market economy, the creation of a market system for banking and finance, the demonopoliza- tion and restructuring of many enterprises, the reconstruction of the transport and communications infrastructure, the development of a system of labor relations, the process of privatization of state enterprises and collective farms, and the addressing of Un serious environmental problems. These and other issues, and the close relationships between them, are discussed in the study. The authors consider the conservative, or gradualist, approach to economic reform and conclude that the chances of staying with a conservative strategy through the medium term are slim. Consequently, they advocate a more radical approach. Recog- nizing the possible problems with this approach, however, they propose measures to mitigate the adverse effects of the transition on consumers and to cushion the impact of rapid adjustment upon enterprises, thus helping reduce the temporary losses in employment and output that will inevitably accompany the restructuring program. ISBN 0-8213-1768-7