E-Notes

The Virtual Monetary Fund and Russia’s Current Industrial Expansion

by Stephen S. Moody

August 20, 1999

Stephen S. Moody is a trustee of the Foreign Policy Research Institute, with extensive business experience in Russia.

One year ago the Russian government defaulted on about $40 billion of short-term debt. The ruble plummeted to sixteen from six to the dollar; Russian inflation soared, Russian banks shuttered their windows and barricaded their doors, Russian stocks fell to damn near zero. Russia, headline banners screamed, had melted down. And in a fit of executive privilege, Boris Yeltsin fired his prime minister — a scene grown all too common through the ensuing months.

That was a year ago. Today, of course, the year’s third new prime minister is making headlines. But something far stranger is happening in Russia, and it’s not getting much press: Russia’s industrial economy is expanding. Russian industrial production grew 3.9 percent in the first seven months this year; it’s now some 11 percent above pre-crash levels. And, as if celebrating the anniversary of the August crash, government tax receipts are rising. A (former) First Deputy Prime Minister announced recently that tax receipts in July came in fifteen percent above target. And there are widespread reports of import substitution. Import substitution, as a rule, doesn’t make headlines.

Any sign of economic life in Russia would be welcome, of course, were it not for one perplexing fact: there are no banks. The Russian banking system collapsed a year ago in the August crash. How do you launch industrial recovery without the banks — or the money — to finance it? The money’s not coming from foreign investors; foreign investment was down 40 percent in the first quarter of this year. Nor is it coming from the IMF, which is suddenly shy about disbursing funds to Russia. More vexing still, the money’s not coming from the Russian Central Bank (RCB). If the RCB were wantonly printing rubles, as many have long feared it would, then inflation rates wouldn’t be falling. According to preliminary estimates, Russian inflation in June was 1.4 percent, down from 2.2 percent in May.

Absent banks, foreign investment and inflation, one is forced to conclude that the money (actually, the credit) financing Russia’s industrial recovery is coming from the “virtual economy” — the barterers. Russia’s current industrial expansion appears to refute the contention that barter simply masks deceptive pricing among enterprises, and that its primary benefit to practitioners is tax evasion. To the contrary, it appears barter has allowed Russian industry to capitalize on the economic benefits of the August devaluation, channeling redirected Russian consumer spending into real increases in capacity utilization and, as recent anecdotal evidence suggests, genuine import substitution — things the Russian commercial banking system, even in its heyday, was unable or unwilling to do. The “virtual economy,” it seems, isn’t quite as virtual as some thought. Virtual economies don’t spawn real growth.

Real growth notwithstanding, demonetization still cripples the Russian economy. Since 1994, at least, the broad measure of Russian money supply (M2) has never exceeded fifteen percent of GDP, compared with 56 percent in the United States and more than 100 percent in some West European economies. Likewise, commercial bank credits to the Russian economy have also remained at consistently low levels — ten to fifteen percent of GDP. Under the best of circumstances, such extraordinarily low levels of money and credit could never have adequately funded even half of reported Russian GDP. This observation led to the novel notion that, if money supply and credit are real, then the unfunded portion of reported GDP must be, well, virtual — a fiction. GDP, argue the virtualists, is really what money supply and bank credit imply it should be, and all the rest is phony barter transactions or phony barter prices which, after the dust hits the filter, result in dramatic shortfalls in government tax receipts — the acid test for real economic growth. The analysis may be flawed, but it adds a delightfully arcane phrase to the vocabulary of economics: “Virtual Economy.” Unfortunately, the phrase enjoys greater currency than the ruble.

The real explanation for the demonetized state of the Russian economy and the discrepancies among GDP, money supply and bank credit isn’t barter, anyway. It’s nonpayments (neplatezhi, in Russian). Nonpayments are essentially accounts payable. Currently, the total stock of nonpayments in Russia amounts to 3.1 trillion rubles — about 100 percent of GDP. Not all of the payables are commercial. About half are taxes arrears, penalties and interest due tax collectors; others are government pensions and wage arrears due civil employees (teachers, the military, et al.). Historically, purely commercial accounts receivable (payables’ counterparts) have run at 25 to 30 percent of GDP, roughly comparable to the level of commercial receivables in the United States.

The essential difference between Russian accounts receivable and receivables anywhere else in the world is that only a tiny fraction of Russian receivables are financed by Russian commercial banks. As a rule, Russian banks don’t make working capital loans to Russian industry, nor do they discount its receivables. Russian industry, in fact, finances itself … with the result that its receivables aren’t backed by bank loans and don’t show up as demand deposits in banks. Therefore, obviously, they don’t get counted in Russian money supply. And since they don’t get counted in the money supply, the Russian Central Bank is under no obligation to fund them. Thus, industrial expansion does not naturally trigger a commensurate expansion of the money supply. Unfortunately, the reverse is also true: expanding money supply doesn’t necessarily beget industrial growth. For barter and the stock of nonpayments also mean that the RCB long ago lost control over credit formation. A central bank that doesn’t control credit formation isn’t a real bank at all; and the rubles it prints aren’t real money. In fact, as Russia’s August Crash revealed, the fiction wasn’t barter; it was “ruble stabilization,” the Russian banking system and IMF-led monetarist reform. What good is a stable currency if nobody uses it? If banks don’t make loans and manufacturers barter and citizens stuff dollar bills into socks for savings, how effective can monetary policy — tight or otherwise — be? And what good is a monetary fund that doesn’t know real money when it sees it?

Compared to barter, central banks are relatively recent innovations. So is the IMF. And neither was created solely to fight inflation. In fact, if you credit the Federal Reserve Act, a central bank’s primary mandates are “to furnish an elastic currency, [and] to afford means of rediscounting commercial paper."

By elastic currency, the Act’s authors had in mind a money supply that expands or contracts to accommodate seasonal and cyclical variations in business activity. The underlying principle obtains in Russia as it does everywhere else: business activity will go on regardless of the form of payment — dollars, rubles, wampum or barter. If the government wants people to use its currency, the central bank has to make it available in quantities sufficient to fund all transactions in the economy, and keep the cost of holding it (i.e., interest rates) reasonably low. Under IMF tutelage, of course, the RCB has done neither.

Nor has it encouraged member banks to discount commercial paper, though the paper indeed abounds. The barter system teems with commercial bills of exchange (veksel, in Russian) which banks won’t touch because the federal government, on IMF instructions, refuses to accept them in payment of taxes. Oddly, commercial paper in Russia is deemed a “monetary surrogate” and considered a threat to the commonweal. Of course, the IMF didn’t prevent the government from issuing its own “commercial paper” — the $40 billion or so GKOs (Russian treasury bills) Russia defaulted on last year — even though there clearly weren’t sufficient tax receipts to back them. Industry can’t pay taxes if there’s no money.

Russian enterprises use barter for cash and nonpayments for credit because the supply of rubles — cash and credit — is too tight. Russian banks can’t make loans to enterprises if there isn’t any money to lend, and enterprises can’t pay taxes if there isn’t any money to pay them with. There are no exotic mathematical formulae for this. As theory goes, it’s not much more than common sense. In Russia, of course, the only thing in shorter supply than rubles is common sense.

Russia needs rubles — not dollars. The essence of economic reform in Russia is remonetization: the RCB has to grow the money supply, even if it risks inflation — which it shouldn’t, since production and productivity are rising. The government has to get Russian banks out of the business of collecting taxes and into the business of discounting commercial paper. And, in spite of explicit IMF covenants forbidding it, the government has to take veksel in payment of taxes; if the Treasury takes them, the banks will buy them, and nonpayments will start showing up where they rightly belong — in the money supply. Veksel aren’t monetary surrogates; they’re the real money. Enterprise “nonpayments” are not, as the IMF contends, the root cause of Russia’s poverty; they’re its primary source of wealth. If nothing else, Russia’s current industrial expansion is testimony to that.

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The Virtual Monetary Fund and Russia’s Current Industrial Expansion

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