FROM THE OFFICE OF PUBLIC AFFAIRS

Introduction

Thank you, Graham for that kind introduction. It is a pleasure to be here tonight among a group that is doing so much for Russia's future. I share with the organizers of this conference the view that the development of Russia's capital markets will be critical to Russia's re-dedication to the process of reform. This evening I would talk about two things. First, I would like to strike a note of warning: Russia must restore momentum to its process of reform. Second, I would like to discuss the potential of Russia's capital markets and chart out the concrete steps that Russia must take to achieve this potential.

I. The Stakes for Russia

I do not have to tell this group about the tremendous distance that Russia has covered in its journey towards a market economy. Since embarking on a process of reform, Russia has... fundamentally changed the character of its society to a market economy, shifted 70 percent of its enterprises to a private form of ownership; and laid to rest the risk of hyperinflation.

Last year, Russian inflation dropped to 22 percent -- below Mexico's 27 percent, and near the 19 percent recorded by Hungary and Poland.

Yet in applauding what Russia has achieved, we must also recognize that 1996 was a year consumed less by policy than by politics and cardiology. Let me be frank: The Russian government drew and defended a line on macroeconomic policy in 1996, but the rest of the economic reform process stalled.

Privatization of large firms proceeded at a snail's pace amidst serious questions about the fairness of the process. Key structural measures dropped off the reform agenda. Other reforms slowed as well including efforts to audit and tax major state enterprises, adjust pension fund benefits, and make "strategic customers" pay for energy purchases.

The Russian tax system was essentially missing in action in 1996, at least for domestic firms, threatening macroeconomic stability and even the minimal core functions of the government.

To compare Russia's process of reform to a football game, the team has had a pretty good first half. But halftime has gone on too long, for most of 1996 in fact, and the crowd has begun to squirm in their seats. It is now time for Russia's economic reform team to come back on the field, or else risk losing the contest by default.

Let me be clear about the risks Russia faces if it fails to follow through on reform. Successful transition does not end with the creation of markets. Far too many market economies, where poor policies have discouraged investment, have struggled from economic crisis to crisis without managing to raise living standards. In contrast, countries that succeed in creating a favorable investment climate, can see living standards double in only a decade.

The record of development shows that the longer you delay, the harder progress becomes. Latin America, for example, paid a steep price for gradual reform in the 1970s.

Whether Russia ends up trapped in a cycle of instability and despair, or graduates to become a strong economy, has tremendous implications not only for Russia but for the world as a whole.

Compare the following two scenarios, the first in which Russia stands still and the second in which it renews its commitment to reform.

In Russia today: At current exchange rates, per capita GNP is about $3400 or only one sixth of the EU average. Only 25 companies' shares trade actively in Russia, and the top 200 firms (excluding Gazprom) are capitalized at under $40 billion -- roughly equal to the capitalization of Gillette or Motorola. Turning to Russia's major export sector, a barrel of oil reserves in Russia is capitalized at under 5 cents, versus about $2.50 anywhere else. Russian international trade reflects the primitive state of many of its industries. Russians import half their food and pay for it with oil, timber and aluminum. Russians buy more consumer goods in Istanbul than they do in St. Petersburg.

While I do not claim to have 20/20 vision in looking into Russia's future, I have found it instructive to speculate on what Russia could look like in the year 2020 if it accomplishes goals already met by other emerging countries--using some simple arithmetic. Were Russia able to attain the same depth of capital markets as other emerging economies, the capitalization of the Russian stock market would be 35 times what it is today, or over $1 trillion -- a combination of increased capital issuance and share appreciation. If Russian economic growth were to average six percent a year to the year 2020, per capita income in dollars would be four times what it is now--or $14,000 (in real terms)--on a par with that of Spain. Sustained growth in Russia would lead to huge demand for consumer durables--automobiles, appliances, and electronic equipment--as it has already in Eastern Europe. If Russian domestic demand reached current Spanish levels, this would mean...

55 million passenger cars on the roads versus 13 million today; and 60 million telephone lines versus 25 million today;

I want to emphasize that these are possibilities not predictions. But while ambitious, they lie within Russia's power to achieve. Growth at this pace will not happen automatically, however. And it most assuredly will not happen unless Russia re-invigorates its process of reform.

II. What Russia Needs to Do

The list of reforms Russia needs to rediscover to join the highly successful market economies is extensive and detailed. But they share one thing in common: if enacted, they will improve Russia's hospitality to capital.

Russia must enact reforms to attract capital but it must also put an end to policies and practices that repel it. Two things in particular keep capital at arms-length -- the tax system and crime and corruption.

Tax Reform

The most potent factor repelling investment in Russia is the Russian tax system, as many in this group can probably attest. Despite some of the highest tax rates in the world, Russia has one of the lowest rates of overall tax collections. The high rates, complexity, and arbitrariness of the tax system lead far too many investors -- actual as well as potential -- to throw up their hands in despair -- as you are all no doubt aware. In fact nowhere on earth is the case for supply-side economics as strong as it is in Russia and several other countries of the NIS.

In contrast to the current system tax rates should be low, and applied to as wide a base as possible. In addition, taxes should be paid by all. According to some estimates, only about 17 percent of firms pay taxes regularly and in full, while at least a third publish no accounts and make no tax payments at all. With a federal tax system that now collects only 9 percent of GDP in taxes, Russia has room to boost its revenues and still remain one of the world's lowest tax environments.

Crime and Corruption

The second factor repelling capital is crime and corruption. No society is completely free of crime or corruption, but the pervasiveness, and certainly the perception of widespread crime and corruption has increased sharply during Russia's transition and, equally debilitating, there is a growing sense among businesses that they have no recourse when problems occur.

By some estimates, 80 percent of businesses make payments to criminal organizations to provide a "roof" or kryshe [KRIH-SHA] over their heads. The Russian Interior Ministry sent a truck loaded with vodka on a 700 km trip in 1995. Police stopped the truck 24 times, and demanded bribes in all but 2 cases.

I have spoken often before on the issue of crime and corruption, arguing that liberalization eliminates opportunitites for bribery, urging reforms of the criminal code and judicial procedure, and offering U.S. assistance in strengthening law enforcement.

But we must also recognize that a successful campaign against crime and corruption must begin with a commitment at the very top. The leadership of the government must say flatly that there is no longer impunity in Russia. And that statement must be followed by action--prosecutions and imprisonment--demonstrating that the rule of law will be applied evenly and universally and that even prominent and powerful people will be called to account.

Capital Market Development

I have talked about the things that keep capital away. Now let me talk about how Russia can attract capital for productive investment.

I don't need to convince this audience of the importance of capital market development for investment and long term growth. Capital market development is necessary in order to... channel funds from savers to investors discipline management to ensure good performance meet individual needs such as housing and retirement finance; and provide citizens with a financial stake in the success of Russian capitalism.

Almost all of the former Communist countries have set up securities markets, but capital markets are much more than a stock exchange and a group of listings. In fact the equity markets in Russia, the rest of the NIS, and all of Eastern Europe raised less than $1 billion in new capital from 1991 to 1995. This is about equal to net inflows into US mutual funds per day last year. Infrastructure

What is lacking is the basic infrastructure for participation in the capital markets, principally mechanisms that confirm, facilitate and legitimize securities ownership and transactions. With equity shares in Russia largely paperless, ownership is recorded in the ledgers of share registries. Hundreds of registries exist in Russia, most of them outside of Moscow and most representing a single company. If you buy shares in a Siberian company, your broker has to travel there to transfer the shares and verify that the registry entry is accurately made in your name. For example, the register of Komineft was until recently kept in the city of Ukhla in the Komi Republic -- a city not known for the frequency of its international flight connections.

If the fact that companies often own the registrars of their shares makes you suspicious, it should. There have been cases where registry entries have been "erased" and shares assigned to someone else. In one notable case two years ago, UK-based Transworld bought a 20% stake in Krasnoyarsk Aluminum Smelter, only to find that the enterprise had unilaterally decertified its holdings.

In addition, concepts of minority shareholders' rights have not yet taken hold, and both managements and controlling shareholders regularly abuse the smaller holder. In October, the Surgut Holding Company purchased an entire new share issue in Surgutneftegaz at a price far below market. After actions by the Federal Commission on Securities Markets, Surgut was forced to increase its purchase price by 40 percent. In April 1995, Primorsky Shipping sold a secret share issue worth $20M to a subsidiary for $90,000, diluting the holdings of foreign investors.

The Russian Federal Commission on Securities Markets has taken action to develop and regulate independent share registries for registries that have over 500 shareholders. But enforcement of new regulations remains a problem; it is one thing to delicense a poorly performing registry; it is another thing to get it to cease operations. Even some very simple steps have yet to be taken to improve the security of Russian share registries. One of the major selling points of the National Registry Co., for example, has been that unlike many competitors, they back up their data. Other infrastructure elements must also be developed. Share depositories and improvements in payments systems would greatly facilitate trading in shares.

One of the sharpest paradoxes of Russian stock trading is that, with over 50 stock exchanges and over 2,000 banks, virtually all stock trading is nonetheless done over-the-counter and settled offshore. Recognized custodial services, along with centralized depositories, would allow purchase of Russian shares by U.S. mutual funds, greatly increasing demand.

Taxation

The Russian tax system is also an obstacle to development of smoothly functioning securities markets. Broker/dealers pay taxes of 43 percent on their share-trading profits. Moreover, their capital losses cannot be used to offset capital gains, and there is no allowance for inflation.

The tax system also discriminates against certain kinds of securities, and certain kinds of institutions: Broker/dealers, but not banks, are subject to a 3 percent road use tax on their profits from share trading. As a result of the difficulties in settlement and the tax system, 9 out of 10 Russian securities transactions are settled offshore.

Transparency and Corporate Governance

Yet another obstacle to fair and efficient markets is the absence of appropriate mechanisms for corporate governance. Russian privatization resulted in a concentration of ownership in the hands of company insiders. In well over half of privatized firms, insiders hold a majority stake.

The absence of protections for minority shareholders has retarded access to equity capital and the development of equity markets. To illustrate the problem, the Gazprom Board of Directors has the right to approve or disallow each trade in Gazprom shares in Russia. Not surprisingly, trades are few.

Let me particularly emphasize the importance of accurate information -- through accounting standards of value to investors, auditing, and rules on disclosure--to healthy markets. A strong body of research suggests that access to information drives the development of markets. One need only look to the passage of the Companies Act of 1900 in the United Kingdom, which opened up the growth of equity markets there.

Mutual Funds

One area of great potential is the development of mutual funds to tap the estimated $20-30 billion in mattress savings. In the longer run, the development of private pension funds, which now have assets of under $500 million, could provide a powerful impetus to the growth of this market. The creation and effective regulation of mutual funds is a priority of the Federal Commission on Securities Markets, which licensed its first funds in November. Nine funds are now operating in Russia. However public confidence is still fragile after the experience with the MMM pyramid scheme and the abuses that characterized many of the voucher funds. Careful shepherding of the funds industry will be crucial to its development; Russia cannot afford another small investor debacle.

Capital Markets Forum

Assisting Russia in the development of its capital markets is a top priority of the Treasury Department. Secretary Rubin and SEC Chairman Levitt have agreed to co-chair the U.S.-Russia Capital Markets Forum, designed to marshal the expertise of the U.S. private sector to help support and guide the development of Russia's capital markets. Four working groups, drawing on some of the best talent that the United States has to offer, on capital markets infrastructure, investor protection, mutual funds, and accounting and tax issues.

The Forum will produce detailed, operational recommendations endorsed by high level officials from Russia and the United States. While foreign direct investment will play a vital role in supplying technology, and managerial expertise, and in supplementing Russian capital, we should recognize that Russia will largely finance its investment needs from its own resources. By quickly implementing the recommendations of the Capital Markets Forum, Russia can begin to tap the considerable savings of the Russian population, as well as those of overseas investors who have remained on the sidelines.

III. Conclusion

Let me conclude where I began. Russia has made the transition to a market economy, but the transition has decidedly lost momentum. The reforms necessary to place Russia in the ranks of the highly successful economies are both technically and politically difficult. But the rewards are enormous.

To do nothing, or to continue to show the lethargy that characterized 1996, will almost surely consign Russia to the ranks of struggling nations and leave Russians little better off in a decade's time than they are today.

But if Russia renews its commitment to reform and the kind of market-friendly environment that attracts capital, rather than repells it, then, I believe, Russia can assume its place as a free, great, and prosperous market economy.