Modern Banking
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most emerging market countries makes them reliant, to some degree, on external finance. Many incur external debt in the form of loans or bonds. The lending banks are often exposed to sovereign risk and there are special problems for a country with external loans. Section 6.6 concludes the chapter.
6.2. Financial Repression and Evolving
Financial Systems
6.2.1. Introduction
Banks in developing countries/emerging markets reflect diverse political and economic histories, but all share two characteristics. The first is that banks are the key (and in some cases only) part of the financial system by which funds are channelled from saver to investor. As noted in Chapter 1, banks in the industrialised world have evolved over the last two decades in the face of disintermediation. As a financial system matures, agents find there are alternative ways of raising finance, through loans, bond issues and the stock market. Banks find they are competing with other financial houses for wholesale customers by offering alternative means of raising finance through bond issues and/or going public – selling stocks in the firm to the public. One consequence of disintermediation is that while all banks continue to profit from offering retail and wholesale customers the core intermediary and liquidity services, universal banks have expanded into off-balance sheet activities, investment banking and non-banking financial services such as insurance.
In emerging market economies the fledgling bond and stock markets are very small, if there at all. Commercial banks are normally the first financial institutions to emerge in the process of economic development, providing the basic intermediary and payment functions. They are the main channel of finance. For example, in several socialist economies, the central bank also acted as the sole commercial bank. With the break up of the Soviet bloc and the introduction of market reforms in Russia and China (see below), the commercial and central bank functions were separated. Stock and bond markets have begun to emerge to varying degrees, but they remain small. This means traditional banking continues to dominate the financial systems of emerging market economies.
Developed economies constitute quite a homogeneous group. Emerging countries do not. For example, national income per head, at current exchange rates, is up to 100 times higher in the richest emerging countries than the poorest. In the most prosperous emerging economies, banking is extensive and sophisticated, sharing much in common with North American or Western European banking systems. In the world’s poorest societies, most people live on the land and have little use of money, let alone banks. Banking there is urban and very limited. These countries are at different stages of financial evolution. They also vary widely in their degree of financial stability. Some, such as Malaysia and Thailand, have experienced relatively short-lived periods of financial instability while others in Latin America (Mexico, Argentina, Brazil) and some former Soviet states suffer from chronic bouts of crises. Many of the transition countries (e.g. Kazakhstan, Estonia, Latvia and Lithuania) emerged from the post-Soviet era and quickly transformed their financial
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systems – with relatively stable banking sectors and reasonably liquid, transparent stock and bond markets. In China, financial reforms have encouraged the development of small stock and bond markets. Under the World Trade Organisation (WTO) agreement reached in 2001, all trade barriers, including those in the banking sector, are to be lifted by 2007. Yet China’s banking system is probably the only one in the world that is both insolvent and highly liquid, one of several issues to be examined in more detail later in this chapter. After reviewing the characteristics of financial repression, the banking systems of three key developing economies are assessed in terms of how far they have come by way of reforms aimed at eliminating features of financial repression, and many of the problems that accompany it.
6.2.2. Financial Repression
The term financial repression refers to attempts by governments to control financial markets. There are varying degrees of it, from complete repression at the height of the Soviet era, to much milder regimes. Nor is financial repression exclusive to EMEs, as will be observed below.
Beim and Calomiris (2001) provide an excellent summary of the characteristics of financial repression. These include:
1.Government control over interest rates, which usually take the form of limits imposed on deposit rates. This in turn affects the amount banks can lend. If the deposit rate ceilings reduce deposits, banks curtail their loans.
2.The imposition of high reserve requirements. If the reserve ratio (see Chapter 1) is set at, for example, 20%, banks must place 20% of their deposits at the central bank. Normally no interest is paid. Effectively it is a tax on bank activities, which gives the government a reserve of funds.
3.Direction of bank credit to certain (often state owned) sectors: the Soviet Union, China and India have all promoted these policies to some degree.
4.Interfering with the day to day management of bank activities, or even nationalising them.
5.Restricting the entry of new banks, especially foreign banks, into the sector.
6.Imposing controls on borrowing and lending abroad.
In addition banks in EMEs have a number of problems, most of them the consequence of financial repression. In some emerging markets, the growth of an unregulated curb market becomes an important source of funds for both households and business. It becomes active under conditions of a heavily regulated market with interest rates that are held below market levels. In South Korea, it was estimated that in 1964, obligations in the curb market made up about 70% of the volume of total loans outstanding. By 1972, this ratio had fallen to about 30%, largely due to interest rate reforms. However, intervention by the monetary authorities in the late 1970s caused another rapid expansion. Since then, the curb market has all but disappeared, not only because of deregulated interest rates but also because business shifted to the rapidly growing non-bank financial institutions which
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offered substantially higher returns. In pre-revolutionary Iran there were money lenders in the bazaar who set loan rates between 30% and 50%. In Argentina, the curb market grew after interest rate controls were reimposed. Most of the credit was extended to small and medium-sized firms by the curb market and did not require collateral, probably because most lenders are reputed to have used a sophisticated credit rating system. As a conservative estimate, the average annual curb loan rate can be two to three times higher than the official rate.
Pay is lower in EMCs than in developed economies, and dramatically lower in some of the poorest. So bank operating costs should be correspondingly lower, too. But a number of factors mitigate this. In poorer countries, bank staff tend to earn incomes far above the local average. Banking is more labour intensive and much less computerised; and banks and branches are small, so economies of scale are not reaped as they might be elsewhere. Furthermore, government restrictions and regulations (e.g. interest rate ceilings, high reserve requirements) tend to raise bank operating costs.
Inflation rates vary widely among emerging market economies. In a few, it is both high and variable. To the extent that higher inflation encourages people to switch out of cash into bank deposits (where at least some interest is earned), it can strengthen bank finances, especially if reasonable interest is paid on reserves held at the central bank. However, variable inflation exposes banks to serious risks and rapid inflation is costly for them in other ways, not least because of the government controls that so often accompany it.
Another problem for many emerging markets is the percentage of arrears and delinquent loans, often because of state imposed selective credit policies, and/or named as opposed to analytical lending.
The financial sectors of developing economies and their rates of financial innovation are inhibited by poor incentives, political interference in management decisions and regulatory systems which confine banks to prescribed activities.2 In the absence of explicit documented lending policies, it is more difficult to manage risk and senior managers are less able to exercise close control over lending by junior managers. This can lead to an excessive concentration of risk, poor selection of borrowers, and speculative lending. Improper lending practices usually reflect a more general problem with management skills, which are more pronounced in banking systems of developing countries. Lack of accountability is also a problem because of overly complicated organisational structures and poorly defined responsibilities. Staff tend to be poorly trained and motivated. Ambiguities in property and creditor rights, and the lack of bankruptcy arrangements, create further difficulties.
Staikouras (forthcoming) looks at annual data on 20 emerging market economies between 1990 and 2000. He examines a number of questions, including testing for factors that affect a country’s probability of default and whether economic ‘‘jitters’’ can be shown to be a function of economic signals. One of his key conclusions is that emerging markets need to develop stable market oriented financial systems to minimise the number of credit crashes, raise their credit ratings and avoid excessive borrowing costs.
2 Though regulations can sometime encourage financial innovation, especially if bank personnel are well educated and experienced. For example, deposit rate controls in the USA led to the development of money market sweep accounts. Other restrictions encouraged the growth of the eurocurrency markets – see Chapter 1.
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6.2.3. Foreign Bank Entry: Does it Help or Hinder Emerging Financial Markets?
The role foreign banks are allowed to play is an important differentiating characteristic of banking systems in emerging market economies. Branches and/or subsidiaries of foreign commercial banks dominate the banking systems in a variety of countries, such as the Bahamas, Barbados, Fiji, the Maldives, New Zealand, St Lucia, Seychelles, the Solomon Islands and, in recent years, Hungary, Mexico and Kazakhstan. The new banking systems in some of the former Soviet bloc economies have strongly encouraged the entry of foreign banks. In others, such as China (pre-2007) and pre-crisis (1997) Thailand, foreign banks have been prohibited from offering certain banking services (e.g. retail) and/or their activities are confined to certain parts of the country.
Terrell (1986), in a study of OECD countries, found that banks in countries which exclude foreign banks earned higher gross margins and had higher pre-tax profits as a percentage of total assets, but exhibited higher operating costs compared to countries where foreign banks are permitted to operate. He showed that excluding foreign bank participation reduces competition and makes domestic banks more profitable but less efficient. The entry of foreign banks is seen as a rapid way of improving management expertise and introducing the latest technology, through their presence. However, the presence of foreign banks can be an emotive political issue.
Clarke et al. (2001) conduct an extensive review of the literature on this issue, and summarise a number of findings based on these studies. First, foreign banks that set up in developed economies are found to be less efficient than domestic banks. The opposite finding applies to developing countries: foreign banks are found to outperform their domestic counterparts, suggesting that cross-border mergers will improve the overall efficiency of a banking system in emerging markets. There is also evidence indicating that in addition to following clients abroad, foreign banks seek out local business, especially lending opportunities.
Though foreign banks tend to be selective in the sectors they enter, empirical evidence from a number of studies finds their entry makes the market more competitive, reducing prices (e.g. raising deposit rates and lowering loan rates). However, the increased competition may give weaker home banks an incentive to take greater risks – a contributory factor to failure. Other inefficient domestic banks could lose business and fail. Both outcomes would be destabilising for the banking sector as a whole. The crisis could be aggravated if foreign banks react by reducing their exposure, and/or depositors switch to foreign banks perceived as safer. However, Clarke et al. report that tests using Latin American data show foreign banks are more likely than domestic banks to extend credit during a crisis. Another concern about foreign bank entry is that their presence will make small and medium-sized enterprises worse off because borrowing opportunities will be reduced. While it is true that larger banks have a smaller share of their loan portfolios in SMEs and foreign banks tend to be large, more recent studies suggest that technical changes (e.g. the development of risk scoring models for SMEs) will increase lending to this group. These authors call for more research in this area. Finally, tests on the organisational form of banks indicate that subsidiaries are likely to have the best impact in a developing country because they can offer a wider range of services, and enhance stability. Again, more research is needed.
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Even developed countries have had features of financial repression until recently, especially interest rate and credit controls. Until 1971 UK banks operated a cartel which agreed limits on deposit and loan rates. The UK government used the ‘‘corset’’ in the 1980s to limit the availability of credit. In the USA, regulation Q allowed the Federal Reserve Bank to impose ceilings on deposit rates paid to savers with accounts at thrifts and banks until as late as 1986. Canada differentiates between domestic and foreign banks, and subjects the two groups to different regulations. Britain did not eliminate capital controls until 1979. France has a long history of nationalising banks, and during the Mitterand years (1980s) all the major French banks were nationalised. Credit´ Lyonnais was not fully privatised until 2001 and only after the European Commission threatened fines if the French government did not sell off its shares. As the case study (see Chapter 10) shows, Credit´ Lyonnais was used by the state to fulfil a variety of objectives, including propping up state owned firms, such as the steel company. However, these economies normally have one or two features of financial repression and most have been phased out. By contrast many emerging market countries exhibit all six types of financial repression in varying degrees. Beim and Calomiris (2001) produce an index of financial repression and compare it to real growth rates for the periods 1970 – 80 and 1990 – 97. Part of their work is reproduced in Table 6.1.
The higher the financial repression index, the more liberalised the country is. Beim and Calomiris define a severely repressed economy as one with an index of <45; a highly liberalised one has an index >70. None of these economies are classified as severely
Table 6.1 Financial Repression and Growth, 1990–97
|
FR index1 |
Growth2 |
Income3 (US$) |
|
|
|
|
Industrial countries |
67.8 |
1.5 |
18 518 |
East Asia |
58.7 |
4.7 |
4 779 |
N-Africa & M-East |
52 |
2.1 |
5 736 |
Latin America |
51.3 |
1 |
755 |
Transition countries |
47.2 |
−3 |
543 |
Africa (Sub-Saharan) |
46.2 |
−0.9 |
775 |
South Asia |
45.7 |
2.1 |
238 |
UK |
77.2 |
1.2 |
16 827 |
USA |
70.7 |
0.8 |
21 989 |
Hungary |
66.7 |
−2.6 |
2 191 |
India |
54 |
4.4 |
216 |
Indonesia |
52.6 |
6.4 |
503 |
China |
49.3 |
9.2 |
na |
Russia |
48.4 |
−7.3 |
na |
Note: 1. The financial repression (FR) index is constructed by Beim and Calomiris (2001, p. 78), averaging the indices of six measures of financial repression such as real rates of interest, liquidity, bank lending, etc. 2. Growth: the mean annual growth rate in real GDP, 1990–97. 3. Income: GDP per capita in 1997, in dollars, converted by the year-end exchange rate.
Source: Beim and Calomiris (2001), table 2.A2.
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repressed, though South Asia and Latin America were in 1990. A better negative correlation is found between the wealth measure and the index: In a formal regression, the wealth coefficient is found to be highly significant. The R2 is low, which is not surprising, since there are other factors contributing to a country’s GDP per capita. However, the test does show more repressed economies have much lower levels of income. The causation could run from income to financial liberalisation,3 but Beim and Calomiris reject this argument because of the lack of correlation between GDP growth (which would create income) and financial repression. Countries such as China illustrate the point: it is the most repressed but has one of the highest growth rates. This is partly explained by the fact that China’s financial and other sectors were repressed but at the same time, sheltered from competition by the authorities.
Beim and Calomiris acknowledge the limitations of their work, and cite more sophisticated econometric research that makes a similar point. The classic works by McKinnon (1973) and Shaw (1973) are cited to back up the case that financial liberalisation promotes growth. The main argument is that by depositing money in a banking system (rather than hoarding it under a mattress or keeping it in gold), wealth is generated because all but a fraction of deposits are loaned out, as explained in Chapter 1. Financial institutions try to overcome information asymmetries and other market imperfections, which should contribute to higher growth. Most of the evidence shows that financial liberalisation promotes economic development.4 This is not to say it is all plain sailing. If the legal system and human resources are deficient, financial reform can cause serious problems, as a review of the country cases will demonstrate.
Below, the attempts to liberalise the financial sectors in Russia, China and India are reviewed. The theme throughout is the extent to which these countries have liberalised their financial systems, the positive and negative aspects of the changes, and the policy lessons to be learned.
6.3. Banking Reforms in Russia, China and India
6.3.1. Russia5
Most readers are familiar with the collapse of communism throughout Eastern Europe in the late 1980s and early 1990s. The USSR6 (with 15 republics) was dissolved and Russia became an independent state in 1991. After the creation of the Commonwealth of Independent States (CIS) in the early 1990s, separate banking systems emerged in each of the new countries. All the former Soviet bloc countries had used a socialist banking model. In the Soviet Union, the USSR State Bank had been a monopoly which undertook
3 Greater income implies higher tax receipts and less pressure on government to contain their debt charges through financial repression; it might also imply a better educated electorate, more aware of costs of distortionary financial policies, and more suspicious of politicians’ competence and motives.
4 For more detail on the evidence, see Beim and Calomiris (2001), pp. 69–73 and Fry (1995). 5 I should like to thank Olga Vysokova for her helpful input in parts of this section.
6 USSR: Union of Soviet Socialist Republics, also known as the Soviet Union.
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all central and commercial banking operations. The central government channelled all available funds into the central bank. The USSR State Bank was responsible for allocating these funds in a planned economy consisting of 5-year economic plans announced by the government. In 1987, five state controlled banks were created from the existing system, and linked to specific sectors. The new banks were USSR Promstroybank (industry), USSR Agroprombank (agriculture/industrial), USSR Zhilsotzbank (housing and social security), USSR Vnesheconombank (foreign trade) and the savings bank, USSR Sberbank.7 Existing loans from the portfolio of the central bank were transferred to these commercial banks, hence, they commenced operations with an overhang of doubtful assets, highly concentrated by enterprise and industry. Banks were confined to doing business with enterprises assigned to them, stifling competition.
In 1990, a new law ‘‘On Banks and Banking Operations’’ created a two-tier banking system. The Central Bank of Russia (CBR) was established with the sole right to issue currency, and a statutory obligation to support the rouble. In the early 1990s, Agroprombank, Promstroybank, Sberbank, Vnesheconombank and Zhilsotzbank became universal joint stock commercial banks, which were supposed to diversify across all sectors of the economy but most remain concentrated in their specialist areas.
In July 1996, the number of Russian commercial banks peaked at 2583. Most were created after 1990. One reason for the rapid proliferation was the near absence of a regulatory framework until 1995, and a desire to dismantle all parts of the old communist economic system as quickly as possible, to reduce the chance of it being resurrected. The amount of capital required for a banking licence was several hundreds of thousands of dollars8 – compare this to the UK minimum of at least £5 million.
By 1998, the number of banks had dropped to 1476 and, as a result of numerous reforms, the system consisted of the following.
žState owned/controlled banks: Sberbank, Vnesheconombank, Vneshtorgbank, Roseximbank, Eurofinance and Mosnarbank. Some have other shareholders, but are state controlled. For example, in 2003, 61% of Sberbank was owned by the CBR, 22% by corporates, 5% by retail, and the rest by smaller groups.9 There is a potential serious conflict of interest because the CBR is both a major shareholder and acts as supervisor/regulator. Though the state, via the CBR, is the majority shareholder, Sberbank, with assets of $34.2 billion, is the only joint stock state bank with shares traded on the stock market. The next two largest banks, by asset size, are Vneshtorgbank ($7.3bn) and Gazprombank ($4.9bn). Overall, the state (including the central bank) has a majority holding in 23 banks.
In 2002, Sberbank had 1162 branches (18 980 ‘‘sub-branches’’), compared to a total of 2164 branches for the rest of the commercial bank sector. Sberbank’s share of household deposits has varied considerably, from a low of 40% in 1994 (newly licensed private banks offered more attractive rates) to a high of 85% in 1999 (after a large number of bank failures/closures). Since then, deposits have levelled off somewhat, but by any measure are still extremely high. In 2002 Sberbank had 75% of household deposits, and 25%
7 Source: World Savings Bank Institute and European Savings Banks Group (2003). 8 Gros and Steinherr (2004).
9 Source: World Savings Bank Institute and European Savings Banks Group (2003).
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($34.2 billion) of Russia’s banking assets. With its unique combination of an extensive branch network, a state deposit guarantee and a near monopoly on pension payments,10 Sberbank has major advantages over other banks. For example, in 2004 it paid a deposit rate of 7%11 for 12-month term deposits, when other banks are paying 12 – 14%. Its large pool of funds means it can make long-term loans more easily than other banks. In 2003, 50% of Sberbank’s loans exceeded a year, and another 48% of loans were granted for a period of 3 to 12 months. The other top 20 banks have a portfolio consisting of loans with a maturity of more than one year (35.5%), short-term loans (i.e. one month to a year) (50%), ‘‘call loans’’ (13%)12 which Sberbank does not offer, and 1.1% in overdraft credit.13 Most of these banks are carrying the bad debt of the old state owned enterprises, and for this reason are proving difficult to sell, to either domestic or foreign investors. In 2002 the government assumed ownership of Vnesheconombank (VEB) and Vneshtorgbank (VTB). VEB’s banking activities were transferred to VTB, leaving VEB as the government debt agency.14 In 2004, VEB assumed responsibility for managing the entire state pension fund.
žFormer state specialised banks: The privatisation scheme (see below) included a number of banks. Agroprombank (which was bought by the SBS Argo group – now called SBS Argo Bank), Promstroybank, Moscow Industrial Bank, Mosbusinessbank and Unicombank. They were specialised banks serving the loss making agricultural and industrial sectors (e.g. machinery, steel) of the economy. The consequent debt overhang has made it difficult to diversify because their customers are the previously heavily indebted state owned enterprises (SOEs).
žBank oligarchies or bank industrial groups: Some of the banks (e.g. Alfa-Bank) hold controlling shares in industrial groups. Their main function is to provide services to the firms under their control. Other banks were founded and owned by large industrial groups such as Gazprom bank, Guta Bank, NRB and Nikoil (recently merged with UralSibBank). MDM Bank provides a good example of the way these banks are structured. It is part of the MDM Group holding which is involved in energy and coal mining and metallurgy. The connection with industrial/commercial sectors is similar to German and Japanese bank practice. The banks manage the cash flows of their shareholders, which include the large commodity exporters in Russia. None of them offer intermediary services to the public, apart from the banking services for employees of the firms. Many of the original banks including Oneximbank, Rossijskij Credit, Incombank Menatep, Mapo bank lost their licences due to insolvency.
žMunicipal banks: These banks are owned and controlled by municipal governments, and include the Bank of Moscow and the Industrial Construction Bank in St. Petersburg.
10Sberbank is involved with the non-state pension fund (established in 1995). It receives pension payments, invests them and distributes payments to the pensioners.
11Effectively, a negative real rate, with an annual inflation rate of 11% in 2004.
12In April 2004, the CBR declared that call loans would not be treated as assets, making them unprofitable for banks, so they are likely to disappear. Call loans were short-term loans (e.g. 7 days) which were continually rolled over, thereby disguising what were effectively long-term loans.
13Source: World Savings Banks Institute and European Savings Banks Group (2003), p. 17.
14Source: Barnard and Thomsen (2002).
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Their sole function is to provide banking services to their respective local government owners, managing their budgets and revenues.
žSmall unit banks: Owned and controlled by a few individuals, they offer services to small private firms.
žBanks with a high proportion of foreign shareholders: These include Autobank, Tokobank, International Moscow Bank and Dialog Bank. They offer personal and corporate banking services.
žSubsidiaries of foreign banks: Since 1995, foreign banks have been allowed to operate in Russia after a delegation from the European Union persuaded the former President Yeltsin to lift the decree restricting their operations. By 1998, there were 29 foreign banks. In 2001, their overall market share stood at 10%, though their operations tend to be confined to the major cities. They include Credit Suisse First National, Deutsche Bank, ABN Amro, Raiffeisen Bank and Citibank. Their main function is to supply banking services to foreign corporations operating in Russia. They are also active in trading Russian government securities and foreign exchange.
Between 1996 and 1998, the concentration of the top 50 banks increased from 63% to 74%. Since then, it has remained largely unchanged, as can be seen from Table 6.2. Note the tiny share of the market held by the 1000 or so banks which, in 2003, account for about 76% of the total number of banks.
Effectively, the centralised communist system was abandoned overnight before anything replaced it. It proved a disaster. The macroeconomy collapsed. GDP fell steadily between 1991 and 1994 (an annual average of 14.5% per year); the annual inflation was 2510% in 1992. This rapid economic collapse prompted further government action. A massive privatisation scheme was launched, even though, at the time, there was no clear concept of property rights in Russian law. In June 1992, the government announced a voucher scheme, to sell off state enterprises – with the exception of oil and some other natural resource based industries. Every adult was given a free voucher worth 10 000 roubles (then $14) to bid for shares in state enterprises. Obliged to change their corporate structure, most of these
Table 6.2 Russian Banks’ Share of Assets in
the Banking System
Banks |
1996 |
1998 |
2003 |
|
|
|
|
|
|
Top 20 |
51.3 |
60.2 |
62.6 |
|
21 |
–50 |
11.6 |
13.8 |
10.9 |
51 |
–200 |
18 |
14.5 |
15 |
201 – 1000 |
16.4 |
10.6 |
11.2 |
|
From 1000 |
2.6 |
0.9 |
0.3 |
|
The number of banks stood at 2029, 1097 and 1319 in 1996, 1998 and 2002, respectively. Source: World Savings Bank Institute and European Savings Banks Group (2003), p. 19.
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state-owned firms opted for a scheme whereby employees would own 51% of the firm, and another 29% could be purchased by vouchers. In a country where most citizens had no knowledge of how firms operated in a capitalist system, the majority failed to appreciate how the vouchers were to be used. Most were sold at deep discounts to managers of the state firms, who used them to buy up more of their enterprises. Roughly 16 500 SOEs were sold off between 1992 and 1995, but insiders obtained between 55% and 65% of the shares.
A second phase of privatisation took place after 1994, which, in the opinion of most experts, was more distortionary than the first stage. It involved a loan for shares scheme (collateral auctions) and resulted in fraud on a large scale. In the face of a growing budget deficit, the government took out loans worth about $1 billion. The collateral was state shares held in the 12 profitable firms operating in the energy and other natural resource sectors. The banks, in the event of non-repayment, could sell the shares and keep 30% of the capital gains. The value of the shares far exceeded that of the loan, and there was virtually no chance of the loan being repaid in the stipulated nine months. The banks making the loans were close to the government and ended up with the shares – which they were obliged to sell. To maintain control of them, the shares, held in trust, were bought by either the trust holders or some front company – all were linked to the banks. Other outsider bidders found themselves disqualified for technical reasons. The result was a number of large conglomerates, each with an oligarch and linked to certain banks. In return this group supported the re-election of Mr Yeltsin in 1996.15
For some Russians the privatisation scheme had benefits: private property is recognised and tradable, whereas before the state owned everything. However, the privatisation programme failed to achieve broader objectives. Most state enterprises were sold too cheaply to the ‘‘oligarchs’’. Managers used their political influence to avoid taxes and other obligations, and therefore lacked the usual incentives to maximise and distribute profits. The concentration of economic power in a few conglomerates exacerbated the problem.16
In 1995, though inflation was still high (120%), it was falling, the rouble had stabilised, and the CBR implemented closer supervision of the banking sector. However, the economy, with the exception of a few export led industries (e.g. oil), had ground to a halt. The government found its debts rising, and needed to borrow. Bonds were issued to the banks via the Finance Ministry and CBR. Banks bought these bonds, safe in the knowledge that it was government debt. State securities investments rose by 171% between 1996 and 1998, compared to a 33% increase in loans. Commercial banks were also active in foreign exchange operations. The problems began in late 1998. Throughout 1997, prices in world commodity markets had been falling. Oil prices declined from $25 per barrel in January 1997 to less than $12 by August 1998. The worsening outlook for the Russian economy together with the Asian financial crisis (see Chapter 8) caused the rouble and short-term government bonds (GKOs) to come under intense speculation – the catalyst for a severe crisis in Russia. The return on GKOs reached 120%. The government could not protect
15This account is from Gros and Steinherr (2004), p. 239.
16Beim and Calomiris (2001) are of the view that the presence of Russia’s nuclear arsenal prevents the IMF (which by 1999 had loaned Russia $18 billion) from exercising its normal tough line on countries that fail to adhere to its loan conditions (see Chapter 8). This judgement may be too harsh: the IMF did impose tough monetary targets which, for example, led to salaries not being paid and rising social problems.