FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking-Member LaFalce, I am grateful for this opportunity to discuss recent economic and financial developments in Russia, which I know are of considerable interest to this Committee as well as to other members of Congress.

There is no question that the United States has enormous economic and national security interests in what happens in Russia. Economic instability in Russia raises important concerns for our broader national security, given Russia's pivotal and continuing role with respect to nuclear security, the battle against terrorism, the stability of Eurasia, and conflict resolution in global hot spots like the Balkans.

I would like to structure my testimony today around seven points. First, Russia can point to some reform accomplishments (both political and economic) during the past eight years and they remain in place. Second, events since August suggest that there is a greater consensus in Russia on economic objectives than we might reasonably have anticipated. Third, although all the news over the past eight years and last 10 months about economic reform in Russia has not been uniformly negative, the plain fact is that Russia continues to suffer from an inability to implement a consistent, comprehensive and sustained economic reform agenda. Fourth, criticisms of the West's efforts to help Russia based on the results achieved and corruption that remains tend to confuse the medicine with the disease. Fifth, looking ahead, the approach that best serves U.S. and Russia's interests is to continue to support credible extension of market-oriented economic reform. Sixth, a resolution of Russia's debt situation is intimately bound up with the issue of Russia's cooperation with the international financial institutions on an agreed program of economic reform. Seventh, in light of past shortfalls relative to expectations, Russia and the international community should try to develop new, innovative ways to promote Russia's transformation to a fully functioning market economy, including through support of broad based, structural and institutional reforms.

Turning to my first point, although many observers with reason are disappointed in progress that has been made in Russia's economic transformation, we should not lose sight of what has been accomplished over the past eight years, accomplishments that generally remain in place. Russia has a free press, voters select their political representatives via the ballot box, Russians trade freely in both goods and information with the rest of the world, and private property and free enterprise are generally accepted elements of the economic landscape. Well over half of economic activity is in private hands; by 1997 military spending had fallen in real terms to one-seventh of its peak Soviet level in 1988, and to two-fifths of its 1992 level; and the central bank has demonstrated that it has the technical capacity to bring inflation under control.

Second, it is easy to be discouraged about Russian economic reform and performance because there is a lot to be discouraged about. However, developments since last August suggest more of a consensus in Russia on the fundamental economic objectives than might have been anticipated or feared. Even during a period in which many of the leaders of the government were identified with the failed policies and structures of the Soviet past, there has not been a reversion to central planning, directed lending, industrial subsidies, or reliance on the printing press. Given this experience, it is a reasonable judgement that the probability of such retrogression in the immediate future has been reduced. Moreover, going forward, the continued presence in the new government of reformist elements is reassuring, and the commitment by the current and previous governments to reforms agreed with the IMF and World Bank appears to demonstrate that support for core economic and financial reforms is more firmly entrenched in Russia than some may have thought was the case.

Nevertheless, and this is my third point, the root problem in Russian economic reform since the dissolution of the Soviet Union has been the inability to translate promising intentions with respect to reform into reasonable reality. This problem unfortunately remains today, and it has been stressed in previous testimony by Administration officials. A bloated bureaucracy, an unwieldy and distorted tax system, and a failure to implement fundamental fiscal reforms led to a buildup of debt which overwhelmed the authorities in August of last year. The Russian banking sector never developed into an effective mechanism for allocating savings to productive private investment. It follows from these shortcomings that the Russian government's capacity to implement fundamental fiscal and structural reforms will be a core consideration in assessing both the likely trajectory of Russian policies going forward and the appropriate level of support for those policies by the international community.

With respect to IMF economic and financial policies toward Russia in the aftermath of the August crisis, critics of Russia's reform process have focused their critiques on two aspects. First, they have argued that Russia's default and devaluation last August demonstrate that the macroeconomic prescriptions of the IMF, prescriptions supported by the United States and other G-7 governments, were flawed. Second, they have argued that Russia is simply "too corrupt" to reform.

The first criticism is the equivalent of concluding that the medicine is ineffective when the patient has not taken it or has only intermittently taken half the recommended dosage. My sense is that there was and is quite a broad consensus, both in Russia and in the West, regarding the benefits of macroeconomic stabilization in terms of building confidence, facilitating long-term planning and investment, and providing the basis for economic growth. Having said this, it is also broadly understood that a robust fiscal framework was never put in place in support of the stabilization that was achieved in Russia in 1995. Without a sustainable financial structure for the public sector backed by a credible budget process, it was only a matter of time until the effects on government debt of the compounding of high interest rates would cause the macroeconomic stabilization that had been achieved to crater. However, it was not possible to predict when the failure to fully reform Russia's budget and tax systems would be manifested in the markup. Moreover, the severe setback to stabilization that ultimately resulted in no way detracts from the fundamental desirability of the course that was persistently advocated but not consistently pursued from 1995 on. There was always a reasonable chance that the race between the forces of fiscal reform and the arithmetic of fiscal excess would be won by the former.

The second criticism of policy toward Russia -- the issue of corruption -- assumes, incorrectly in my view, that the causal arrow between corruption and reform points in only one direction. In fact, one of the core goals of a balanced program of reform is the elimination of opportunities for corruption which proliferate in a system that is ruled by arbitrary administrative controls administered by underpaid bureaucrats. From this perspective, the disturbing persistence of widespread corruption is indicative of just how far Russia has to go and of the inadequacy of progress over the past eight years. Corruption in Russia is a very serious issue not only for Russia but also for the international community that is trying to be supportive of Russian reform.

For this reason, the issues of crime and corruption have received increased attention in recent years, much of it linked in one way or another to our efforts. To set the record straight, we have been working with the Russians for several years now to combat organized and other types of crime. U.S. government programs have focused on development of the rule of law, law enforcement training, building working relationships between U.S. and Russian law enforcement counterparts to enhance cooperation on specific criminal cases, and negotiation of core law enforcement agreements to enhance overall coordination of anti-crime efforts on the basis of internationally accepted standards. We have also supported anti-corruption efforts, by helping to promote good governance and transparency. At the Department of Treasury's Financial Crimes Enforcement Network (FINCEN), we are working with Russian authorities to assist in the development of money-laundering legislation and the creation of a financial intelligence unit for the surveillance of large-scale financial transactions.

There are some early indications that all this work is beginning to bear fruit. Notably, the Office of the Prosecutor General has initiated and is prosecuting numerous cases against Russian officials, including high-level officials, who have allegedly abused their government positions. Russia is also beginning to pass much-needed legislation, including civil and criminal codes, which will form the basis of a "rule of law" society. Perhaps most importantly, there are signs of greater recognition at the political level of the negative consequences which unchecked crime and corruption can have on the development of democracy and sustainable economic growth. However, I do not want to understate either the seriousness of the corruption issue in Russia or the difficulty of dealing with such phenomena once they are entrenched. We will continue to support programs that help Russia combat corruption.

Looking forward, and moving on to my fifth point, we believe that the approach that best serves Russia's interests, as well as those of the United States, involves principally a renewed commitment by Russia to the market-oriented process of reform. The scope of U.S. and international assistance should be predicated on the quality of the efforts of the Russian authorities and the support they receive from the general population. The strategic importance of Russia dictates continued engagement, but a process of engagement that is predicated on performance, not just promises. We intend to continue to stand ready to engage Russia across a broad spectrum of pursuits and to remain alert to new opportunities to reinforce economic and financial reforms. We also intend to continue our long-standing support for the International Financial Institutions' objectives in Russia, with program objectives appropriately gauged to current conditions as well as conditioned on Russia's adherence to its program of reform.

Because of past policy failures, Russia now faces serious external financial challenges. The issue of Russia's external debt problem is, in turn, intimately bound up with the issue cooperation with the Fund for three key reasons:

First, avoiding additional borrowing or printing money to finance budget deficits requires the type of fiscal and monetary discipline and the close technical attention to detail and consistency that a Fund program can engender;

Second, Russia will need external financing to help cover a substantial financing gap over the program period; and

Third, Paris Club creditors will not proceed to negotiate about Russia's debt situation without an IMF-approved economic program in place; such a program helps provide confidence that Russia is implementing the policy steps needed establish a sustainable external financial position.

The program that the Russian authorities have agreed with the IMF focuses on areas such as fiscal reform and strengthening the banking system that we believe are key to restoring stability to the economy, and the Paris Club (assuming Russia has put its new IMF-supported program in place) can help provide needed "breathing space" regarding Russia's external payment obligations. We hope to avoid a counterproductive outcome where an impossibly large external debt burden reduces incentives for Russia to remain engaged and to continue the process of economic reforms. At the same time, we must be realistic about what Russian policy can achieve under current political circumstances. We must also be cautious about adding further to Russia's debt burden, and we must ensure that any funds advanced by the IMF are dedicated to the repayment of obligations to it. Similarly, any funds advanced by the World Bank or EBRD should be targeted to the achievement of well-specified reform objectives.

On my final point, we must recognize that Russia continues to face very difficult economic challenges and it is handicapped by its limited accomplishments to date. Against this background, Russia and the international financial community should try to develop new, innovative ways to promote on a broader basis the transformation of Russia to a fully functioning market democracy using mechanisms that reflect the lessons of recent years. Once a new economic program supported by the IMF is in place and pressure on Russia's external financial position has abated, the focus should be on helping Russia craft a comprehensive reform strategy that will be politically salable to a broad spectrum of Russian citizens.

Emphasis should be on:

• lower tax rates with more uniform application (including increased pressure on tax- delinquent enterprises);

• comprehensive bank restructuring;

• increasing the flow of financing to small- and medium-sized enterprises;

• improving the investment climate by enhancing the rule of law, reducing the regulatory burden and strengthening the rights of minority shareholders;

• redirection of expenditure priorities towards health and education;

  reductions in redundant bureaucracy and in arrears to teachers and health service workers; and

• increased attention to Russia's regions, with extra support directed to those regions that display a willingness to embrace more aggressive reforms.

Greater emphasis should also be placed on our dialogue with Russia on issues of political legitimacy and on the development and implementation of a robust social contract.

Finally, more attention should be paid in the coming months to an intensification of the dialogue between the Fund and the Bank on structural reforms so that progress on structural issues advances in tandem with achievements with respect to fiscal and other macroeconomic stabilization goals.

This agenda is challenging. There is no assurance that it can be implemented, but in our view it is the way forward. However, it is up to Russia to choose this course.

Mr. Chairman, I hope these points have been helpful, and I stand ready to try to answer any questions from you and this distinguished committee.