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. Last Updated: 07/27/2016

The Best and Worst of Times for Economy




Russia's prospects have seldom appeared brighter. Economic growth has resumed. Inflation has declined. The exchange rate is stable. Foreign exchange reserves are increasing. A new government has come to power peacefully f and is advancing initiatives that are generally well received both within and outside of Russia.


Then the government prosecutor drops the Vladimir Gusinsky bombshell. Why is this a concern? Because the arrest of the media company chief appears discriminatory. We don't know if Gusinsky is guilty or innocent. But we know all too well that myriad other crimes f notably in the financial-services arena f are not being prosecuted. It begs the question of whether Moscow has its priorities straight.


This is a critical moment. Russia is enjoying good economic news today. But this is clearly the result, first, of high world energy prices and second, a substantially devalued ruble. Economic growth will not be sustained over the long term unless the government begins now to implement a credible program of reform in energy, industry and banking.


Russia is far behind most of the world in reform of the energy sector. Two large monopolies, Unified Energy Systems and Gazprom, control the production, transmission and distribution of electricity, heat, hot water, and natural gas. They, in turn, are largely controlled by the state.


Tariffs charged to users of electricity, heat, hot water and gas are subject to chaotic and uneven regulationby regional governments. Tariffs are too low to cover costs. Although major improvements have been made, collection of tariffs is still inadequate.


This all adds up to extreme waste of energy. Enterprises have had little incentive to make investments in energy-saving equipment. Many uncompetitive, high-cost, energy-intensive enterprises continue operating because tariffs have been too low or not collected.


There is a worldwide public policy consensus on the main elements of successful programs of energy reform, much of it embodied in European Union directives. They include the following:


?Independent regulation of tariffs;


?The breakup of integrated utility monopolies;


?Separate tariff regimes for production, transmission and distribution;


?Competition among producers of energy;


?Tariffs for transmission and distribution set by the regulatory authorities, not only to cover costs but also to encourage cost efficiency.


These basic principles are at the core of the restructuring proposal of the management of UES. It is very much in accordance with accepted international principles for the restructuring of the power sector. Yet the proposal has met fierce opposition from the private shareholders of UES and the new chairman of the Russian Securities and Exchange Commission. Why?


After having read and reread the proposal and complaints about it, I conclude that much of the criticism arises not from what is in the proposal, but from what is not in it. One investor has said: "Our objection is not to the attempt to introduce market mechanisms into the power sector, which we think is a positive and necessary development, but is over the timing and methodology of its implementation."


The proposal contains very little about timing and implementation. It does not have enough information about the number and nature of the constituent parts into which UES would be split.


Much of the criticism is also driven by fear that the UES management will repeat the mistakes of the past f sale or transfer of generating assets to new owners on a closed, nontransparent basis. The sale of constituent parts of UES should take place in a fair, open and transparent manner. Distribution companies should be sold only to qualified strategic investors with the skills, experience and ability to install modern systems of energy billing, metering and collection of tariffs.


Much of the investor criticism is valid, but some of it is driven by the desire to maintain the UES monopoly for years to come. It is not appropriate to maximize shareholder value through monopoly exploitation. The UES monopoly must be broken soon, without waiting for the perfect regulatory regime or 100 percent tariff collection.


UES does not have the power or right to reform energy regulation f that is the role of government. But we have yet to hear from the government of the Russian Federation whether it is committed to energy regulatory reform, or when they expect it to happen.


Enterprise restructuring. If you asked me what has been the single greatest failure in Russia's transition so far, my answer would be, without hesitation: the restructuring of enterprises. Most key deficiencies in Russia's economic performance over the last decade can be attributed to the modest achievements in this area.


Under communism, government-owned industrial enterprises did not purchase their inputs or sell their outputs in competitive markets. They looked to government ministries or other government-owned enterprises. As a result, many of these enterprises expanded through vertical integration, producing everything they needed for themselves, from capital goods, spare parts and service inputs to final products. Small and medium enterprises to supply large enterprises and distribute their products never developed.


Many of these large enterprises, still grossly inefficient and slow in innovating, continue to survive, despite being forced to compete in world markets. They survive by receiving directed credits from state-owned banks, and by building tax arrears and arrears in payments for energy.


Enterprise restructuring will only take place if all enterprises are forced to adopt international accounting standards, pay their taxes, pay for energy in cash, and get their credits from hard-nosed, private-sector bankers who face the threat of bankruptcy if they make bad loan decisions.


Banking. It has been nearly two years since the August 1998 collapse of the private-sector banking system. Little progress has been made in rebuilding it. Lax accounting requirements allow insolvent banks to continue to operate. Assets have been stripped from insolvent banks and placed in new operating banks owned by management or privileged shareholders. Creditors of insolvent banks often hold nothing more than claims on empty shells. The thieves who stole the assets remain unpunished f while Mr. Gusinsky goes to jail.


Russia will only grow rapidly if the banking system is reformed in two crucial ways.


First, there is a need for more competition, so that savers who make the deposits, as well as entrepreneurs who invest in the real economy, have a variety of choices for deposits and loans. This will only occur if there is a universal system of deposit insurance, in which all banks, public and private, share equitably the costs and the benefits. Limitations on foreign bank entry into the market should also be eliminated, not just to benefit foreign investors but also to benefit Russian depositors and investors.


I am fully aware of the crucial role played by largely state-owned Sberbank in shoring up confidence after the August crisis. Sberbank is and will remain a key partner for the EBRD, particularly in implementing EBRD's highly successful program of loans for small businesses and in trade finance. But competition requires that Sberbank's monopoly on the market be broken. What chance do other banks, particularly small regional banks owned by Russians, have of prospering in the shadow of such a giant?


Second, there is a need to build more confidence in the banking system in Russia. Greater confidence will lead to greater use of banks by the public, providing more and less-costly funding for the growth of industry and commerce.


A credible system of universal deposit insurance is part, but far from all, the answer to the problem of lack of confidence in the system. Better and more consistent regulation of banks f including imposition of international accounting standards f is also necessary.


The world has waited for a long time, and is still waiting, to see if Russia has the political will to develop a modern, efficient banking system, worthy of an economy of global stature and competitive in the global marketplace.


Charles Frank is acting president of the European Bank for Reconstruction and Development. These remarks were adapted from a speech he delivered Wednesday at the St. Petersburg Economic Forum.