FROM THE OFFICE OF PUBLIC AFFAIRS

Good morning. I'm glad to have this opportunityto return to the US Russia Business Council, once again, at acrucial juncture along the path of Russian reform. This is a goodtime to look at the Russian economic reform effort following thePresident's historic meeting with President Yeltsin in Helsinki.I want to take this opportunity to report to you how we see theRussian economy, what Russia has to do and what we in the UnitedStates and the international community must do to support Russianeconomic reform.

This is as important a moment as any in the lastfive years. Russia has gone through much of the painful work ofeconomic stabilization. It has a re-energized Presidency and adream economic team. Now is a moment of opportunity but also amoment of danger.

Last year, economic policy narrowed to meetingIMF budget targets, as privatization, sectoral reform, and otherefforts stalled. This is understandable as Russia focused onelections and the president's health. But by year-end, Russia wason an unsustainable course.

The contrasting case is Poland which shows howmuch can be achieved with steady reform progress. Poland launchedits reforms at the beginning of 1990, fully opening its economy,liberalizing prices, slashing subsidies and putting an end tohyperinflation. By early 1992, GDP had fallen by 20 percent, andunemployment was at 14 percent and rising. The tax base collapsedas state enterprises hit hard times. And there was preciouslittle FDI. The public mood was sour and reforms were nearlyabandoned.

Fortunately, the government chose to strengthen,rather than slow, its reform effort with fiscal reforms and theadoption of a value-added tax in 1993. By 1994, Poland wasgrowing at 6 percent and Poles began to see potential rewardsfrom reform.

While Russia is not Poland, Poland's exampleshows that while reform may not be rewarded quickly, it isrewarded. Some argue that reform and recovery may be technicallypossible but are not politically possible in Russia. This view isalso mistaken. In referendums and elections, the Russian populacehas consistently surprised pundits by voting for the future overthe past. In fact, regional voting results show a positiverelation between unemployment levels and the Yeltsin vote. Peopleare learning that failure to reform may mean holding on to a jobbut in a failing firm with no paycheck.

Russia's problems aren't intractable. We cometogether at a moment when a newly invigorated president backed bya new economic team have a unique opportunity to solve them. Thetask before them is no less than building a new state -- onewhich can fulfill the essential functions of government andcreate the environment needed to support a healthy, prosperingeconomy. I would like to begin by discussing the steps thatRussia can take to advance to the next stage of reform.

• First, Russia must fix its tax system.

• Second, it must fight crime and corruption.

• Third, it must attract investors

• Fourth, it must strengthen its capital markets.

• Finally, it must maintain economic stability.

Fixing the Tax System

Establishing an efficient, equitable tax systemis priority number one. The current system can not reliablysupport essential state functions. Russia’s macroeconomicsituation will remain perennially at risk until a predictable,adequate revenue stream is established. To be sure, Russia’sproblems in this area are not unique. All the transitioncountries have faced a similar challenge: to generate enough newprivate firms to compensate for the tax losses from decliningstate enterprises and a tax system which brings these firms intothe tax base.

But the issue is not just revenue. Russia’scurrent tax system is perhaps the most visible blight on theinvestment environment. It discourages new capital formation inthe formal sector, and it distorts existing economic activity.Russia’s economic team and the Duma have to work together toreduce VAT exemptions and establish a corporate profits tax thatdefines profits according to internationally recognized practice.

Tax administration presents equally fundamentalchallenges. The institutions for tax collection have to bestrengthened, and the incentive structure transformed so thatpaying taxes becomes widely perceived as rational behavior. Now,Russian firms often reckon that the expected costs of compliancewith the tax code exceed the expected costs of noncompliance.This is not just a simple question of tax evasion. With high taxrates, unpredictable application of tax rules, and extreme taxpenalties, the act of paying your taxes puts you in jeopardy offacing large additional obligations.

I discussed these issues at length with PrimeMinister Chernomyrdin and First Deputy Prime Minister Chubaisduring my visit to Moscow last month. I was very much encouragedthat both are clearly engaged and highly committed to tax reform.I was also able to highlight the very substantial efforts thatthe United States and the IMF are already making and willcontinue to make to provide technical assistance on tax reform. Idon’t think this effort is widely known. We have 20 advisorsliving in Russia and additional 50 advisors which visit regularlyto provide advice and assistance. Since 1993, there have beenmore than 100 tax reform missions to Russia organized by the IMF,Treasury, and AID. A central objective of my March visit was tomake the most senior levels of Russia’s government fullyaware of this effort and to improve cooperation between USadvisors and their Russian counterparts.

Fighting Crime and Corruption

The enormously difficult job of fightingcorruption is just as critical. The problem remains pervasive andfundamentally corrosive. Commercially motivated murders may havefallen but that may only indicate that corruption and criminalactivity have become more organized. Three-quarters of Moscowshops pay private security firms for protection. Russianbusinesses routinely pay bribes to obtain export and importlicenses, to lease commercial space, and to register theirenterprises with local officials. Bribery, payments to overcomeregulatory obstacles, and protection payments may total as muchas 15% of wage costs, according to a small survey of privatesector firms. Investment just will not happen with that kind ofuncertainty or that kind of fear.

The problem is not intractable. President Yeltsinhas taken the first step by signaling that corruption must not betolerated. The lesson of other countries shows that only when acountry's leadership shows that there will be no impunity, evenamong the rich and powerful can progress be made.

Attracting Investors

Attracting investment also includes an array oflegal, regulatory, and investment policy reforms which togetherbasically create a system where: property rights are clear andenforced, productive risk-taking is rewarded, and neitherdomestic or foreign firms are subject to regulation purely forits own sake. In Russia’s case, this means:

• Passage of a land code and other laws to support needed collateral-based finance.

• Passage of the Bilateral Investment Treaty with the United States along with elimination of important barriers to the right of establishment for foreign investors in strategic areas and of barriers to capital earnings repatriation.

• Passage of supporting legislation to establish production sharing arrangements. Russia has an estimated $50 billion in potential foreign energy investment waiting for an environment where investors can be confident of a return on their capital as well as of their capital. Under the current enormously inefficient system, it takes an average of 50 months to get from tender announcement for oil projects to contracting signing. In China, it take 18 months; in the U.S., it takes 10.

• Reducing unnecessary regulation.

The fact is that Russia’s current investmentstatistics tell a very disturbing story. Per capita foreigndirect investment was $47 for the period 1990-96. Compare that to$326 for Poland, $585 for Chile, $130 for China. The problem isnot only a lack of foreign interest. Russian domestic investmentis now only 13 percent of GDP.

Capital Market Development

As you all are aware, in the last 6 months Russiahad two highly successful Eurobond issues. The first, a $1billion dollar offering, sold at 345 basis points above 5-yearTreasuries, a spread comparable to that of Mexico or Argentina.This, and the most recent DM 2 billion issue are an indication ofhow far Russia has come and how far it has to go.

But, despite their success in tappinginternational markets, Russians still invest far more abroad thanthey bring in at home, with capital flight estimated at $10billion per year. The challenge for Russia is to develop itsdomestic capital markets. This involves building theinfrastructure of capital markets, such as share registries anddepositories, protections for minority shareholders, andtransparent and informative systems of accounting.

To assist Russia in developing its capitalmarkets, Secretary Rubin and SEC Chairman Levitt cochair theU.S.-Russia Capital Markets Forum with Chairman Vasiliev of theRussian Federal Commission on Securities Markets. The Forum hasenlisted the participation of the best experts the US can offer,who, along with their Russian counterparts, will provide concreteand detailed recommendations for fostering healthy and vibrantRussian capital markets.

Consistent Stabilization

I haven’t mentioned economic stabilization,chiefly because Russia has already had some major success in thisarea. Inflation has been sharply reduced and the ruble is stable.But it is almost axiomatic that stability serves little purposeif it is not sustained.

The truth is that Russia will have to undertakethe broad reform program I have outlined in the context of thebroader imperative of maintaining stability. This, of course,adds to the complexity and difficulty of the task. It is hard todo tax reform in the midst of severe shortfalls in revenue.Russia will certainly continue to face very difficult budgetdecisions this year and will continue to have to impose verytight limits on spending.

Steps for the West

To support and assist Russia in achievingeconomic takeoff, there are five things the internationalcommunity and the United States must do:

• First, we must work to deepen Russia's relationship with the IMF

• Second, we must expand the role of the World Bank in Russia.

• Third, the US must expand investment in Russia.

• Fourth, we must work to integrate Russia into the world market.

• Finally, we must bring Russia into other international economic organizations.

Deepen Russia’s Relationship with the IMF

Russia’s relationship with the IMF iscritical; it is the springboard both for better economicperformance and for growing engagement with the privateinternational financial community. The Russian partnership withthe IMF has already produced enormous gains. Russia has broughtinflation from 131 percent in 1995 to 22 percent in 1996. Theeffect on market confidence is demonstrated by the decline ininterest rates on T-bills from a peak of 300 percent in May, 1996to about 30-35 percent on an annual basis.

But it would be a mistake to conclude that theimportance of this relationship has peaked. As Russia moves intoa new stage of reform, intensive cooperation on stabilizationmust be continued and augmented by a focus on structural reformswhere the Fund has particular expertise, such as restructuringthe tax and fiscal system. The IMF should use the opportunity ofa new economic team and a new Fund program to make a fresh startin defining a program strategy for Russia. Managing DirectorCamdessus’ visit to Russia this week represents an importantsignal that the Fund intends to seize this opportunity.

Expand the Role of the World Bank in Russia

As Russia wrestled with stabilizing its economy,the IMF justifiably played the central role. But the agenda thatI have described demands the World Bank’s expertise onstrengthening the public sector, promoting development of theprivate sector, and tackling sectoral problems. World Bankconditionality, operating through numerous projects and programloans, is also more focused and surgical than what the IMF can dowith a single program.

It’s time to pass the baton across 19thStreet. I call on the World Bank to now take the lead, andgreatly increase its role in Russian reforms. The Bank is clearlyready. Through intense efforts, it has nearly doubled its projectexecution and disbursement rate in Russia. The Bank should nowgreatly expand the scope of its activities, in areas of fiscalmanagement and social protection, and in sectoral programs inareas such as agriculture and power, to provide $2 billion inadditional loans this year.

Three weeks ago I visited the Energia facilitynear Moscow, the site of the original Sputnik production. I wasreminded there that Russia has tremendous intellectual resources,including some of the world’s finest scientists, andstudents whose average test scores in math and science wouldplace them second only to Japan when compared to the G-7countries. These talents are being put to good use in the SeaLaunch Project, in which Energia participates, which will providean ocean platform for launching satellites into geostationaryorbit from the most efficient point on earth, the equator. Thisproject is supported by an innovative World Bank loan guaranteethat extends coverage to risks of government interference inproduction and export of launch vehicles and related systems.

To promote Russia's transition to growth, theWorld Bank will also have to play an active role in catalyzingprivate investment.

US Investment Support

The third step is the expansion of US support forforeign investment in Russia, which is at the center of USassistance strategy for Russia. At Helsinki the President pledgedto make available up to $4 billion in loans and guaranteesthrough OPIC and ExIm Bank.

Both institutions are working to increase theirability to provide support. Last November ExIm opened for thefirst time on a limited basis to the private sector in Russia,and is actively seeking Russian commercial banks through which itcan work. ExIm and OPIC each anticipate doing $2 billion inbusiness with Russia this year, which together is as much supportas they provided in the previous four years.

Integrate Russia into the World Market

The fourth step that the international communitycan take is to more fully integrate Russia into the internationalmarketplace. At Helsinki, Presidents Clinton and Yeltsin pledgedto take steps to increase access to each others’ markets.

Russia’s membership in the World TradeOrganization is a major step in this process; the presidents saidthat they would undertake every effort to bring Russia into theWTO in 1998.

At Helsinki, the Presidents were clear thatRussia must enter the WTO on normal commercial terms. This isimportant for us and for Russia, because trade liberalization isfundamental to achieving sustained growth in Russia, and becausethe international commitments that Russia takes will spare itmuch of the effort needed to fight rear-guard actions against theprotectionist pressures that will inevitably arise.

Russia has already accomplished significant tradeliberalization, reducing its average tariff rate to about 14%.But this still is well above the industrial country average, andRussia should also agree to bind its tariffs at or below currentlevels. In addition, trade policy is far more than tariffs.Russia should begin to liberalize trade in a variety of services,commit to national treatment for foreign investors, agree tolimit subsidies in agriculture, and provide more effectiveprotection of intellectual property to fully participate in theinternational market.

Bring Russia into other International EconomicInstitutions

The final step is to bring Russia into thoseinternational economic institutions--the Paris Club, the OECD andthe G-7 summit that involve major responsibility.

The significance of Russia’s impending entryinto the Paris Club is not fully recognized. Russia is a majorglobal creditor. Its inherited claims from the old Soviet Unionhave a nominal value of perhaps $120 billion, when valued at theold Soviet ruble exchange rate.To be sure, Russia will have torecognize that by no means all of its Cold War debts will, orshould be, be repaid. And once it becomes a Paris Club member, itwill have to commit to Paris Club terms for debt rescheduling,terms which balance the interests of creditors in repayment witha realistic assessment of developing countries’ ability torepay.

With respect to the OECD, the obligations andmutual examination that exists in the OECD will be extremelyvaluable to Russia, and to the West. OECD members agree tobinding obligations covering freedom of capital movements andinvestment, cross-border provision of services and rights ofestablishment for banks and securities firms, obligations oninternational tax treatment and tax cooperation, and obligationson chemical products and shipments of hazardous waste. Althoughthe Presidents did not set a date for joining the OECD, theyexpect Russia to make considerable progress towards accessionover the next few years.

As you know, President Clinton has also invitedPresident Yeltsin to come to the Denver Summit. We stronglysupport full Russian participation in the Summit of the Eight.While some economic and financial issues will continue to behandled by the G-7, making the Summit itself a group of eightsends the important signal that we are committed not only toRussian integration into the global system but to a globalleadership role for Russia.

Conclusion

This is how we see the Russian economy, thechallenges facing the Russian government and our own role inproviding support. The stakes are high. The success of many ofthe businesses represented in this room depends on what we do,the security of the world's oil market over the next severaldecades depends on investments made today and even our ability tofully harness science and technology depends on Russia's capacityto nurture its intellectual resources. But even morefundamentally, the lesson is that confident, secure nationscontribute much more to global stability than those that areinsecure and whose people are dissatisfied. If Russia can seizethis moment, I believe it can create an economic environment forthe 21st century that will benefit not only Russians but the restof the world.