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Fixing Russia's Banks: A Proposal for Growth

Fixing Russia's Banks: A Proposal for Growth

by Michael S. Bernstam, Alvin Rabushka


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Fixing Russia's Banks documents how Russia's financial system is built on what Michael S. Bernstam and Alvin Rabushka call ersatz banks. These inferior imitation banks have served largely as tools of the government to redistribute public funds to favored firms. The highly vaunted achievements of privatization, removal of price controls, and foreign trade liberalization have failed to produce growth because of a lack of private financing. National income has declined nearly 40 percent since 1992, with no recovery in sight.

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Product Details

ISBN-13: 9780817995720
Publisher: Hoover Institution Press
Publication date: 07/01/1998
Series: Publication Series
Pages: 114
Product dimensions: 6.00(w) x 9.00(h) x 0.30(d)

About the Author

Michael S. Bernstam, a research fellow at the Hoover Institution, Stanford University, is an economic demographer who studies economic systems in their relationship with income, population, financial development, natural resources, the environment, conflict, and other social change. Alvin Rabushka, the David and Joan Traitel Senior Fellow at the Hoover Institution, works in the public policy areas of taxation in the United States and abroad, economic development in the Pacific Rim countries, and the transition economies of Central and Eastern Europe, notably Russia.

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Fixing Russia's Banks

A Proposal for Growth

By Michael S. Bernstam, Alvin Rabushka

Hoover Institution Press

Copyright © 1998 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
ISBN: 978-0-8179-9576-8


Russian Economic Conditions


Since its establishment as a separate state in 1991, Russia's economic performance has been vastly below its productive potential. Per capita income stands at about $4,200 in world market prices, which is lower than the world average of $5,200 and less than one-sixth that of the United States. Per capita income in Russia falls beneath that in Tunisia, Algeria, Botswana, Costa Rica, Colombia, Panama, Brazil, Mexico, and other economies, all of which, at least in the popular image, are relatively poor countries. In Russia, which is the landlord of a space station for American astronauts, something is amiss.

What separates Russia from these other third world countries is its enormous, immediate, current growth potential. Russian income is three, perhaps as much as four, times lower than it could and should be.

First, Russia has the productive capacity in place to double its output of goods and services (its gross domestic product, or GDP). Indeed, just nine years ago, Russian GDP was nearly double current levels. By official and international counts, the economy contracted by 43 percent during 1990–1997 (see figure 1). This accounting may exaggerate the decline in output, as many firms underreported production to reduce their tax liabilities. Offsetting this potential undercounting, however, is the gain that accrued, equivalent to 15 percent of Russian GDP during 1992–1997, when Russia terminated $58 billion in annual energy subsidies to Eastern Europe and the former Soviet Union.

Second, even before the great contraction of the 1990s, Russian industrial investment allowed for a much higher level of output than that produced under the country's faulty, inefficient, socialist economic arrangements. Western estimates show that the Russian level of capital stock per worker should have produced some 44–52 percent more goods and services than it did.

Third, Russia has a highly educated workforce. Western estimates imply that countries with the same number of years of education per employee as Russia enjoyed in the late 1980s had about 35 percent higher income per capita.

Fourth, and perhaps most important, Russian industry produced, and continues to produce, a large amount of negative value added as a result of the application of arbitrary, artificial, distorted, subsidized, and cross-subsidized prices that determine the real cost of production inputs. In other words, a dollar's worth of raw ingredients emerges from the production process as finished merchandise worth less than a dollar. In 1994, the middle year of Russian reforms, Russian industry subtracted 34 percent from the global market value of natural resources alone, without accounting for subtracting the additional value from the intermediate goods used in their production. The mere introduction of true market prices, coupled with the elimination of subsidies, cross-subsidies, cross-debts, and other distortions, would eliminate negative value added in production. The whole country would be better off if the workers in these value-subtracting enterprises were paid full wages to stay at home until sufficient reforms were put in place to add value to production. By itself, the cessation of value-subtracting economic activities would substantially increase GDP, without any additional investment or other effort.

Taking all four factors together, a three- to fourfold increase is a ballpark estimate of Russia's real productive potential under true private markets in the near term. To this can be added the potential gains from the application of recent Western technological advances to the exploitation of Russia's vast untapped natural resources, assuming that Russian politics can tolerate a much larger role for foreign enterprises.


A key factor in Russia's failure to develop real banks has been the institutional legacies of socialism. Long decades of socialist rule resulted in deep and pervasive state penetration of the economy and society. Under central planning, the Russian economy was highly centralized, monopolistic, protected from foreign competition and exposure; it was also structurally anomalous. It lacked most of the social, legal, and institutional infrastructure taken for granted even in underdeveloped market economies.

The old Soviet banking system was a monobank system, centered on the state bank, Gosbank, which covered the entire Soviet Union through its many branches and collection systems. All monetary transactions went through Gosbank or one of its affiliated banks. The primary purpose of the banking system was to support the economic system of central planning, in which government bureaucrats allocated inputs (raw materials, labor, investment), outputs (told enterprises what to produce and where to ship goods), set prices and wages, determined incomes, and rationed consumption. The banking system mirrored the real economy by recording financial flows that tracked the flow of goods and by supplying credit to aid plan fulfillment and finance investment. It also supplied cash to enterprises for wages to employees to facilitate daily transactions.

In 1987–1988, during perestroika, a two-tiered banking system was created. The state bank split into three branch state banks for (1) industry, (2) construction and utilities, and (3) agriculture. Private, nominally commercial banks emerged in 1988–1990 and mushroomed thereafter. In 1991, Gosbank became the Central Bank of Russia (CBR), which held responsibility for monetary policy, commercial bank supervision, and facilitating interbank settlements. Other state banks were reformed into joint-stock banks owned by enterprises, government agencies, and government-connected private groups. All these commercial banks, however, remained dependent on subsidized credits from the CBR and, thus, were its de facto branches.

Moreover, in 1992 the government established a secretive body named the Credit-Monetary Commission, chaired by a senior deputy prime minister. The chairman of the Central Bank of Russia was the ranking member of this commission, but he does not exercise the influence and power that Alan Greenspan enjoys at the U.S. Federal Reserve Board. The commission sets targets of monetary expansion and credit for commercial banks, thereby replacing the Politburo of the Communist Party, which had set monetary and credit targets during Soviet times. In practical terms, the Credit-Monetary Commission made an independent central bank impossible, despite the existence of legal statutes that promise autonomy.

The reason the government could not let the CBR be independent is that the commission required individual commercial banks, which sought subsidized credit from the CBR, to allocate that credit to specific enterprises in accordance with commission directives. Once these credit allocation targets were satisfied, banks had some discretion in reselling unallocated central bank credit. As most banks were owned by, or connected to, enterprises, the banks basically serviced their founders or subsidiaries with government money.

From their inception, commercial banks served as government check-cashing windows, similar to those used by U.S. welfare recipients. Banks were inherently insolvent because their loans were not supposed to be recoverable. The commercial banking system of Russia began its existence with inherently bad assets. When these assets were dissipated by inflation, a new stock of bad assets accumulated because of government-directed credit. As a result, banks required either a continuous flow of central bank refinancing at subsidized interest rates or, when this means was eliminated, other forms of government refinancing and recapitalization.


Analyzing the transition economies of Central and Eastern Europe and Asia has created a new area of scholarly inquiry, producing a spate of books and journals exploring a variety of transition issues as these countries try to make the adjustment from their former socialist systems to market economies. It is not clear that the word transition is suitable for Russia. A more appropriate concept might take the form of asking what is required to destroy the old economic and financial systems and then, on a clean slate, how to build new systems.

In 1991, there was no broad consensus on the correct transition strategy. Between March 1985 and October 1990, varying teams of economists proposed twelve different economic reform plans to then Soviet leader Mikhail Gorbachev. All twelve were subsequently dismissed or abandoned.

The first genuine reform measure was the first privatization law in 1991, which established the right to private property in productive assets. In 1992, the government liberalized prices and began a small-scale privatization program, followed by a voucher privatization program. A new system of ownership structure was created, but that structure was not private property in a normal sense. The reason, as explained below, is that private property was not accompanied by private budgets.


It is important to dispel the notion that privatization created real private property in Russia. In reality, spontaneous privatization in the former Soviet Union began in 1988 when the Law on Enterprise allowed enterprises to withhold the remittance of profits to the government and convert them into wages and managerial bonuses. Private ownership of previously government-owned enterprises was initially acquired by insiders but not in a form that could be sold or traded. In financial terms, ownership did not take the form of securities in joint-stock corporations, which would entitle holders to a share of the enterprise and a portion of its profits.

The government proceeded with a program of voucher privatization, which segregated the country's assets into two unequal parts. All highly profitable enterprises, especially in natural resources, remained government owned, with a proportion of transferable shares distributed to workers and managers of these firms. All other enterprises were converted into joint-stock corporations, or securitized, and their shares were exchangeable for broadly distributed vouchers (every Russian citizen received a voucher).

Between October 1992 and June 1995, a process of spontaneous privatization and voucher distribution and use resulted in the sale of more than fifteen thousand large state-owned enterprises (more than 118,000 for the whole economy). By mid-1995, 75.5 percent of all industrial firms were nominally private, producing 87.7 percent of industrial output and employing 77.7 percent of industrial workers (more than 18 million people).

Most Russian citizens placed their vouchers in largely unregulated voucher investment funds and became shareholders of those mutual funds. The investment privatization funds, IPFs as they became known in many transition economies, exchanged the vouchers they collected from individuals for shares of enterprises slated for voucher privatization. Most of the funds then vanished. Individual Russians were hard-pressed to identify what they owned and rarely received any dividends. In 1996, the government considered closing and banning the remaining voucher investment funds because of widespread fraud and the impossibility of monitoring and supervising them. Still, some funds remain. Where and with whom the actual stock of voucher-privatized enterprises ended up remains a mystery because there is no property registry. Scores of holding companies own other holding companies, which own enterprise shares. Invisible and illegitimate ownership created further incentives to run down assets rather than foster new investment.

In 1995, the government began to sell through various, largely rigged cash auctions the truly valuable assets that were spared the voucher episode of privatization. The first wave of these sales was best known as "loans for shares." To justify the subsidized transfer of highly profitable assets in natural resource firms to a small group of selected banks, the government gave the banks shares in "temporary trust" for state-owned resource firms in exchange for their loans to the budget. Banks financed those loans from government deposits they held (a bizarre circular process). When the government failed to repay the loans (as expected), the elite banks became owners of a large chunk of Russian natural resources. (See chapter 3 for details and unforeseen consequences.)

Revenues from privatization fell from 0.28 percent of GDP in 1995 to 0.11 percent in 1996. Activity picked up in January 1997 with the sale of an 8.5 percent stake in United Energy Systems. In the third quarter, the government sold a 25 percent stake plus one share in Svyazinvest, the telecommunications holding company, which raised almost half as much revenue as all previous privatizations combined. The government also sold major stakes in Tyumen Oil Company and Norilsk Nickel; each of those sales was managed and won respectively by the insider banks that had advanced the loans for those shares (financed by government deposits at these banks) in the first place.

Today, almost all production is nominally in private hands, and few industrial workers remain state employees. But this does not mean that the Russian economy is built on a foundation of private property or that private enterprises are really private. On the contrary. What appear to be private firms are not really private because they share a common budget with the public sector. So-called private firms and private banks in Russia have served largely as appendages to a differently constructed system of state control and financing than was the case in the former socialist system. The lines between the public and the nominally private sectors are so blurred that government financing of economic activity has been far in excess of the ostensible 30 percent ratio that defines government expenditures as a share of GDP, rendering this measure almost meaningless.

The evidence for the proposition that the size of the government exceeds 30 percent of GDP is the large share of the negative value added in production previously mentioned. In a privately financed economy, firms cannot produce negative value added (output whose market value is less than that of its material resource inputs) for long. Such firms and industries soon go broke. Russia is different. One-third of the value of natural resources and one-half of the final value added of industrial output amounts to value subtraction, a process that survives on the basis of subsidies from the natural resource sector and the few profitable firms in other sectors. Neither income nor expenses derived from production are truly private. All flows of funds are linked to a regime of subsidies and cross-subsidies, which creates a common budget for all the ostensibly separate entities. The common budget is facilitated through the interplay of the government and the banking system. Within this system, the appearance of domestic free market prices is deceptive. All prices embody subsidies and taxes in one form or another. Prices serve a fiscal, not a market role, as is always the case under socialism.

The normal meaning of private property rights is exclusive ownership of assets and their returns. So-called private assets that do not generate real private returns are private in name only. When these so-called private assets generate income, largely on the basis of access to government subsidies, they are of little long-term value to their new owners, who face incentives (given the insecurity of their property rights in these assets) to strip them of their real economic value. The value that remains, after real assets have been stripped, is the claims that the owners make on the real resources of other enterprises and actors (by accumulating debts to other enterprises, banks, and the tax authorities they cannot pay or do not expect to pay). Such a system perversely transforms liabilities into assets.

Russian-style privatization, which has thus far amounted to continuous access to government subsidies, is the antithesis of real privatization. A famous theorem in economics, named after Nobel laureate Ronald H. Coase, states that, regardless of initial ownership, real tradeable private assets will ultimately end up in the hands of the most efficient owners, who will bid them away from their initial owners in the expectation of securing higher returns.


Excerpted from Fixing Russia's Banks by Michael S. Bernstam, Alvin Rabushka. Copyright © 1998 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents


1. Russian Economic Conditions,
2. The Nonmonetary System and the Ersatz Banking System in Russia: 1991–1995,
3. The Emergence of a Resource-Based Monetary System, Hamstrung by the Persistence of Ersatz Banks: 1996–1997,
4. Will Russia Maintain Its Emerging Monetary System and Develop Real Banks? 1998 and Beyond,
About the Authors,

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