After The Vote: The Economy, Stupid!

When the struggle for Russia's presidency plays its course in the coming month, the victor will find that his problems are just beginning.

Whether the polls produce a win for the incumbent or his communist opponent, the new president will have to deal with a tricky situation with a rising budget deficit, a banking system in crisis, the ruble under pressure and a weeping social security system.

Should Communist Party leader Gennady Zyuganov prove triumphant, he will face the added threat of knee-jerk capital flight as both domestic and foreign investors make moves that could jeopardize the ruble's stability.

The situation is by no means hopeless: Inflation has been dragged down to under 30 percent a year, the ruble is stable within a fixed corridor, and most would say that if the next government gets it right, local and foreign investment could start booming.

"The key point for whoever wins the election is that Russia really is on the edge of a sustained period of economic growth," said James Lister-Cheese, Russia analyst for the London firm Independent Strategy.

But the short-term outlook is worrying, especially for investors and economists looking at the government's fiscal situation.

Basically, for the past six months, the government has been spending more than it can raise in taxes and the only solution has been to borrow big. Eventually, the bubble could burst and Russia could be hit by renewed inflation and instability.

Revenues this year have fallen to only 60 percent of what was planned in the budget, according to government officials. The basic reason: In the last six months particularly, government officials have been reluctant to force taxes from the industrial bosses and regions whose support is needed prior to the polls.

In fact, the government has been busy granting tax exemptions as a means of winning votes. One economic think tank put tax exemptions from January through April at 21 trillion rubles ($4.2 billion), a reduction in income of about 30 percent.

"Before the presidential elections, it is very difficult to extract a lot of the taxes ... because the bargaining power of the state is so low," said Yaroslav Lisovolick, an economist with the Russian-European Center for Economic Policy.

Yet, even though revenues are down, it has been politically impossible to cut expenditures correspondingly. It appears that the budget deficit kept below 4.3 percent last year is now bouncing up to 7 percent. The reason is that President Boris Yeltsin has continued to fund such causes as increased pensions and student stipends, raises for teachers and health workers, cheap loans to regional governments and -- yes -- a car for the lady in Vorkuta.

Although Yeltsin's spending promises are easy to criticize, many of the issues being targeted are worthy, economists say, noting the abysmal state of public health and the need to sustain what has been considered one of the world's finer systems of public education.

The reality of finding resources to meet these needs, however, is another issue entirely.

The only way out of this budgetary crisis for the government has been to borrow either from the domestic market for government bonds, known as Treasury Bills, or from the Central Bank. Both have their problems and both will mean the next government faces a major threat to low inflation and a stable ruble.

On one hand, borrowing on the T-bill market has become punishingly expensive: Annualized yields at last week's primary auction were driven to 215 percent. Although most analysts attribute the tremendous expense of borrowing to political fears, some economists have called the financing regime a house of cards waiting to fall should yields fail to drop following presidential elections.

Some say the government could increase its borrowing on the T-bill market just by lowering barriers to foreign participation. Foreign investors say if they are let into the market, they could provide more capital and lower interest rates.

But in the meantime, the T-bill market is practically at boiling point, and the government has been forced to looked increasingly to Option No. 2 -- the Central Bank.

In theory, this is a no-no. The government has promised not to borrow from the Central Bank, a practice that amounts to printing money and is guaranteed to raise inflation. The bank is being constantly monitored on its grants to the government by the International Monetary Fund as part of the conditions for a $10.2 billion loan signed earlier this year.

But in fact, the Central Bank has been the biggest source of funding for the government in 1996. The bank is supposed to follow an independent policy but it, and the IMF, have until recently been more or less willing to cooperate to help the government through.

In the past three months, while the Russian government has managed to raise only 33 trillion rubles ($6 billion) in revenue, the Central Bank allocated it another 25 trillion rubles. It transferred this money direct to the budget from foreign loans, quietly handed out guarantees to some foreign investors in treasury bills and lent the government money by direct purchases from the secondary T-bill market.

But to do this, the bank has been forced to dip into its hard-currency reserves -- cash better saved as insurance to support the ruble.

"In April and May, the total volume of currency sales by the Bank of Russia reached $3 billion," bank officials said in a statement. "That's the price the bank has paid to keep the current monetary policy intact."

The Central Bank's cozy cooperation helping the government out of its hole may now be about to end as the government becomes more desperate. In a worrying precedent, the government recently passed a law forcing the Central Bank to transfer another 5 trillion rubles to government coffers.

The move provoked an angry response from Central Bank head Sergei Dubinin who says he will appeal the move in the Constitutional Court. Dubinin also made public the extent to which he has been bailing out the government, giving markets some worrying food for thought.

And Central Bank also bared its political teeth, hiking reserve requirements on commercial banks. This is partly a move designed to squeeze the money supply to counteract the effect of printing 5 trillion rubles, but it also lets any new government know that the Central Bank has the power to hit the banking system where it hurts.

Whatever happens, all of this spending by the Central Bank could undermine the government's progress on cutting inflation. Moreover, Russia's new president will have to take steps to reassure markets, eager for stability, that he is committed to continued independence of the Central Bank.

"If the Central Bank loses its independence, then the main source of economic stabilization that we've had so far will crumble," Lisovolick said.

The long-term solution is, of course, to start collecting taxes. In addition to eliminating tax breaks, the government must find a way to penetrate the regions through a transparent process of giving and receiving tax funds, Lisovolick said. Reforming the system is key, as the current system of abuses has been dubbed both the greatest obstacle to investment and the cause of a domestic economy functioning primarily underground.

The fiscal crisis is not the only problem facing the next government. For instance, a clear result on the elections will probably calm markets, leading to a fall in interest rates. This will help the government with its fiscal problems but it could be a double-edged sword because it could spell death for many of Russia's 2,000-plus banks.

In theory, this would be no bad thing. One analyst said more than 1,500 of Russia's shaky banks should close their doors.

The question is whether the Central Bank will be able to winnow the sector gently or whether a full-fledged collapse could bring massive banking failures.

They have been largely sustained over the past year by high T-bill yields. Already hundreds of smaller banks have folded since a liquidity crisis hit the sector last August.

Moving forward on bank reform should be another priority -- one obviously put on hold prior to the election, with only a few dozen licenses revoked so far this year compared with 314 in all of 1996, Lisovolick said.

Another tricky problem will be what to do with the ruble. Should Yeltsin win re-election, demand for rubles could surge amid increased foreign investments, returning flight capital and a de-dollarization of the economy, according to Vladimir Mau, deputy director of Gaidar's Institute for the Economy in Transition.

While the flood of investments would undoubtedly be welcome, a strong ruble will continue to undercut manufacturers competing against imports and hurt exporters who say they are already being priced out of world markets.

The government's policy has been to devalue the currency in line with inflation, but if investment in rubles surges it may find that it must print huge numbers of rubles to meet the demand.

"The Central Bank can either issue a little money and it will increase inflation a little and the real exchange rate will be much lower ... or it will not do it and the level of exchange will climb," said Mau.

The reverse -- an outflow of money from Russia -- is an even worse scenario, and would likely occur should Zyuganov win the presidency, analysts said. The result could be devastating for the country's young currency and capital markets.

"If Zyuganov were to get in, I think that would be a tremendous shock, particularly to the international investor, and you could see a considerable move to repatriate money and considerable pressure on the ruble," said Anthony Thomas, an economist with Kleinwort Benson in London.

How Zyuganov might respond to such an exodus would be critical. In his official program, Zyuganov has said he will allow the currency to fall below its current ruble corridor but most economists agree that too little is known about the former Communist Party ideologist to hazard a guess.

Tackling the mafia is another key area for a future government and it will be high on the agenda after the importance of law and order issues in the election campaign. "The major problem is that it affects small business through local mafia and has a limiting effect on the financial sector, with the use of physical threats rather than legal redress," according to Richard Layard of the London School of Economics.

Another issue that won't go away after the elections is inter-enterprise debt -- the money owed between Russian enterprises, many of which took on barter techniques as liquidity dried up and the value of the ruble plummeted. Recently, First Deputy Prime Minister Oleg Soskovets placed at 719 trillion rubles the debt owed between enterprises and between these businesses and various regional governments.

However, the LSE's Layard argued that the importance of debt between enterprises is exaggerated, and used instead by industrial bosses in search of further tax breaks.

"One argument for not paying taxes is that they're owed all kinds of money," he said. "It's important not to give in to that."

Payment of wage arrears, an issue which has driven many of Yeltsin's election promises, will also continue to be a divisive issue.

Despite the government's steps to pay its workers, 23.5 trillion rubles in arrears remain, mostly in the private sector, the Economics Ministry has reported.

But some economists warn against enterprises which try to pin their wage problems on the government.

"There are some companies which are not paying wages even though they could," Layard said. "It's irresponsible to offer to pay people like that."

The government will also face pressures to get production back on track. Earlier this month, Economics Minister Yevgeny Yasin announced that gross domestic product would probably fall 2 to 3 percent this year, rather than stabilize or even grow as many economists had predicted.

A communist government is likely to respond to these problems by pumping money into the economy, abandoning the governments attempts at financial stabilization and trying to boost production and end wage arrears and inter-enterprise debts.

But the risk is that a sharp change in policy will undermine the good signs that are already out there. In fact, there are some.

Consumption is up 4 percent over a year ago by some estimates, an increase which may prove more important than investment in leading the Russian economy into the future.

"As people find better and more productive jobs, they will get higher incomes and they will spend more," said Layard.

This consumption will provide a beacon for investment, which has fallen 65 percent since 1991 according to official figures, he said.

Foreign trade turnover has increased 35 percent over the past two years, suggesting trade could bring considerable new growth.

And despite the government's raiding of the Central Bank till, it stil has comfortable hard currency and gold reserves -- placed variably at $16 billion by bank head Sergei Dubinin and $12.5 billion by one of his deputies.

Although in sheer numbers the minuses may appear to outweigh the pluses, many analysts believe otherwise. The countervailing factors -- low inflation, high foreign trade balance, faith in the ruble, a professional Central Bank -- are significant.

"I wouldn't draw the picture as catastrophic or anything," said Lisovolick. "The healthy fundamentals are there, and the authorities are there to keep most of the main macroeconomic aggregates under control."