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. …