The severity of the Russian financial crisis of August 1998 came as a surprise to many foreign investors and Russia watchers. Its roots and inevitability, however, were detectable to anyone who cared to look beyond Moscow and observe closely the state of economic deterioration in Russian regions. An unreformed domestic industry, loss-making agricultural sector, and dysfunctional financial system were clear signs of what was to come. An ineffective tax system was not the only cause of the fiscal crisis that brought about the 17 August devaluation of the ruble, default on government short-term debt, and a moratorium on commercial foreign debt service. The crisis was the natural result of an unreformed and politically unstable economy that did not turn out taxable profits.
The extent of Russia's irresponsible politics and deteriorating economic conditions was most apparent in the regions. The financial crisis of summer 1998 exposed and exacerbated social and economic problems that had been mounting since the collapse of the Soviet Union. Prices for imported goods increased, collapsing banks halted wage and pension payments, suppliers ran low on food and medicine, and inflation corroded people's real income. Each region reacted differently, but none was able to shield itself completely from the crisis. The economic turmoil and Moscow's weakness encouraged governors' ambitions. As regional leaders reached for more political power, however, they inevitably confronted their own economic dependency on the shrinking federal budget. Thus, the crisis abruptly upset the precarious balance of power that had been evolving from the tug-of-war between center and periphery. At the same time, no serious threats to the integrity of the federation materialized, separatism remaining an unsustainable policy for most regions, which still depend heavily on federal subsidies.
Regions in Pre-Crisis Distress
Since the beginning of market reforms in 1992, regional economies have been subjected to structural changes that ripped apart the old functional and trade ties supporting the Soviet economy. The abolition of central planning, the liberalization of prices, and privatization were expected to create market conditions that would spur entrepreneurial activity and transform backward production facilities into competitive and modern firms. That did not happen. A misconstrued mass privatization scheme, a debilitating tax system, and delayed institutional and financial sector reforms created perverse incentives for economic agents across the regions. Enterprise and farm managers as well as private entrepreneurs were forced to or chose to focus on short-term gain and survival, instead of corporate restructuring, investment in production, and growth.
The government and the banking sector did little to help industrial reorganization. Taxes were kept high to provide subsidies to politically important, but unprofitable factories. Most banks financed energy exports (and vice versa), instead of production and preferred to speculate in government securities rather than engage in corporate lending. As a result, industrial production fell 60 percent since 1992 (to put things in perspective, during the Great Depression output fell 35 percent in the United States). Regions dependent on heavy industries, such as Sverdlovsk, Chelyabinsk, Vologda, Kemerovo, Krasnoyarsk, Orenburg, Volgograd, Omsk, and Lipetsk, suffered the most. Small and medium enterprises were choked by heavy and arbitrarily assessed taxes and by an oppressive and frequently corrupt bureaucracy.
The fate of the agricultural sector was even more distressing. Delay in land reforms, lack of financing for agricultural equipment and fertilizers, and depressed producers' prices (often manipulated by corrupt rings of middlemen) caused a 50 percent drop in agricultural produce. According to Agriculture and Foodstuffs Minister Viktor Semenov, the utilized arable land in the country declined by a quarter since early 1990s, the number of cattle was halved, mineral fertilizer use dropped to 15 percent of its former level, and the fleet of agricultural machinery decreased between 45 and 55 percent.(1) Making the situation even worse, a severe drought in 1998 brought the worst grain harvest since 1953 and left regions in the Far East, notably Chukotka, Sakhalin, and Khabarovsk, with limited food supplies for the winter.
Some Regions Open to the West, with Mixed Results
Several regions made an effort to attract foreign investments and tap into international capital markets to finance domestic economic growth. St. Petersburg established a special council on foreign investment, where the city's leaders and investors met to discuss everyday problems. In 1997, the city's government developed a package of legislation providing tax holidays for companies with large investments in the city economy. Property and other city taxes were lowered, and the city pledged not to raise tax rates in the next three years. Special support was promised to investors in the industries that were on the St. Petersburg government priority list: export-oriented production and import-substituting sectors (food and light industries), energy production, tourism, and the service sector. Other regions followed similar strategies to attract foreign investments. In Novgorod oblast, a holiday was declared on the payment of regional and local taxes until investors earned profits, and in 1997 four tax-free districts were created in which non-trade enterprises would be reimbursed for federal profit taxes. As a result of such policies and the climate they created, in 1996 and 1997 foreign investment constituted approximately 40 percent of all capital investment in the region.(2)
With the domestic banking system largely incapable of providing investment capital, several regions turned to the international capital markets to finance infrastructure and other development projects. St. Petersburg issued a five-year, 9.5 percent Eurobond in June 1997. The Republics of Komi, Tatarstan, and Sakha and the cities of Moscow and Nizhny Novgorod also borrowed on the international financial markets, with the explicit permission of the federal government.(3) The Republic of Komi adopted a law on foreign borrowing in August 1997, and in October it signed a $35 million credit agreement with Bank Societe Generale Vostok, a Russian subsidiary of the French bank. The money was then distributed among enterprises that had submitted business plans for investment. In January 1998, Komi received its second credit in the amount of $50 million for six months, with a 15 percent annual interest rate, from the German bank Schweizerischer Bankverein AG.(4)
When the financial crisis struck, many of the Russian regions and cities defaulted on their obligations. The Republic of Komi was supposed to pay $2.3 million to Societe Generale Vostok and $1.8 million to SBC Warburg, a representative of Schweizerischer Bankverein, before the end of 1998.(5) However, the ruble devaluation in August made it difficult for the enterprises that have received the foreign funds to pay back their hard currency debts, and the republic, which had taken the foreign loans in the first place, asked the banks to restructure the debt. In early December 1998, Moscow oblast defaulted on its 2.1 billion ruble ($60 million) debt and asked to restructure a 600 million ruble payment due on 10 December. Tatarstan defaulted on its short-term loan from ING Barings, and the city of Novosibirsk illegally restructured its foreign debt.(6) Regions such as Chita, Saratov, and Chelyabinsk defaulted on their agricultural bonds as early as the beginning of summer 1998.
In many aspects, regions offered a better environment for foreign investments than the center. Because the federal government had failed to pass a law that would permit the purchase and sale of land, many regions decided to fill in the legal vacuum with their own land laws. Saratov was a pioneer, adopting the first such land law in 1997 and subsequently holding land auctions.(7) Although Saratov's law was challenged by the procurator general in the Supreme Court, over twenty other …