FROM THE OFFICE OF PUBLIC AFFAIRS

Mr Chairman, I am grateful for this opportunity to discuss recent developments in Russia, which I know to have been of considerable interest to this committee and other members of Congress.

United States policy toward Russian economic reform has been and will continue to be a subject of vigorous debate in Congress and elsewhere. But there can be little debate about its importance. Russia's transition to a market democracy is one of the defining economic challenges of the end of the twentieth century. The outcome will help define the shape of the 21st century global economy and the progress of democratization around the world.

From a more immediate standpoint, we have seen in recent weeks that -- despite the relatively small size of Russia's economy and financial markets -- developments in Russia can have a disproportionate impact on confidence in other emerging markets and around the world. They can also profoundly affect how investors view the prospects for underlying stability.

A prolonged financial crisis in Russia would likely strengthen opponents of further political and economic reform and likely mean a regression toward a more inward-looking, protective, and ultimately ineffective economic strategy. It is also clear that Russia will continue to play a pivotal role with respect to nuclear security, the battle against terrorism, the stability of Eurasia, and conflict resolution in global hot spots like the Balkans.

Let me start by putting the present crisis in the context of Russia's longer-term transformation effort. I will then discuss what the U.S. government and the international community have done to promote Russia's transition since 1991 and respond to a number of criticisms of our approach. I will end with a few words about prospects or the future.

I. Recent Developments in Context

Mr Chairman, for nearly seven years the Russian government has struggled to lay the foundations for a stable and prosperous market economy amid the wreckage that the collapsed Soviet system left behind. The government faced unique obstacles in doing so -- not least the fact that communism had been in place in Russia far longer than in Eastern Europe. Those political and economic obstacles to reform led to numerous setbacks and disappointments. Nonetheless, reformist policy makers did succeed in laying many of the building blocks of a market economy. Extensive privatization took the economy out of the government's hands -- 70 percent or more of all economic activity is now generated by the private sector. Prices were liberalized and government spending was cut by more than 40 percent.

That said, other critical reforms lagged behind. Principal among these was the failure to control the budget deficit and government borrowing. Russia's budget problems are a manifestation of the political struggle over the country's economic direction. That is because the budget has been the battleground for disputes about the proper role of government and about resource allocation. So, as these disputes went unresolved, budget difficulties continued and borrowing continued unabated. That borrowing starved the incipient Russian private sector of capital. Also critical was a failure to build and institutionalize a favorable investment climate and the rule of law. This kept much of the economy off-the-books, under-monetized, vulnerable to crime and corruption, and dependent on barter. Those failings sowed the seeds for the current crisis.

After a bout of hyperinflation in the early 1990s, the government for 3 years achieved rough control of inflation through the maintenance of a exchange rate band, backed by tight monetary policy. Yet macroeconomic stability remained fragile as long as the budget deficit and government borrowing remained high. Successive Russian cabinets -- supported by the International Monetary Fund and other international financial institutions -- committed themselves to tackling the borrowing problem through reform of the tax code and other long overdue structural reforms aimed at providing permanent budgetary improvement. However, despite sporadic successes, poor tax collection, weak budgetary control, chronic wage and pension arrears, and a dysfunctional tax and social payments system kept Russian government borrowing at unsustainably high levels.

Russia's problems intensified during the past ten months as a number of factors combined to put pressure on the exchange rate: continued Russian policy failures; periodic, debilitating political uncertainty; contagion from Asia leading to worsening investor sentiment; and slumping oil and gas prices. First among these was the political paralysis that prevented the Kiriyenko government from forging a political consensus in favor of fiscal restraint and reform that could have led to improved investor sentiment and in time improved budgetary prospects. Also important was the slump in energy prices. The value of Russia's energy exports has fallen 18 percent this year, resulting in a sharp increase in the current account deficit from less than $1 billion in 1997 to a likely deficit of $10 billion this year. In the end, opposition to the Kiriyenko reform agenda and the deterioration in market conditions helped fuel great market scepticism. A breakdown in confidence followed.

Russia's authorities then decided on the enormously risky course of simultaneously devaluing the ruble, imposing a debt moratorium and restructuring government bonds. This was the Russian government's decision and not one which we supported. It should not be viewed in any sense as a precedent or guide for future policy responses by other emerging markets under pressure. Those regrettable actions have played out in a manner which has deepened the crisis of confidence, unleashed spending, lending, and inflationary pressures, and prompted a change in government. Russia's crisis has become one of grave political and economic dimensions.

II. United States Support for Russian Economic Reforms

Mr Chairman. Since 1991 the United States has taken a leading role in multilateral financial support for Russian market reforms because we believe that a successful market transformation in Russia to be critical to American interests -- and because we believe that, when policy makers themselves are committed to reform, IMF and World Bank programs can materially increase the prospect of such a transformation being achieved. This has been the experience in other regions. In Latin America and in Central Europe, the IMF and the World Bank have led countries to sustained growth and stability. Russia has proven an uniquely complicated and difficult case. Much more of the market economy has had to be constructed from scratch than in other places. And the struggle to build a political consensus in support of reform has progressed poorly.

Since 1992, Russia's cooperation with the international financial institutions produced an important economic transformation and a fragile stability. That stability has now evaporated. But this painful setback should not obscure what has been accomplished during those years. Russia is now a different country and a different economy. Let me describe a little of what has changed.

First, economic activity has been put in private hands after 70 years. Private property and profit are no longer regarded as evils.

Second, there has been a dramatic demilitarization of the Russian economy. Last year, Russia's military spending was only one-seventh its peak Soviet level in 1988 and two-fifths its 1992 level.

Third, an economy which had been cut off from the world for most of this century, has been opened up to trade, investment, technology. Between 1992 and 1995, in cooperation with the IMF, Russia dramatically reduced import duties to an average of 15 percent with a 30 percent ceiling. In addition, the World Bank has helped Russia cast off quantitative restrictions on international trade and refrain from implementing any export controls disguised as mandatory monitoring of quantity, quality, or price of exports.

Fourth, prices generally reflect market forces. In 1992, oil and gas prices were a tiny fraction of world prices, leading to energy use far in excess of levels in Western industrialized countries. Now prices have moved toward world prices. And the incredibly wasteful resource allocation which flowed from unrealistic communist pricing has been curbed dramatically.

Fifth, Russia has private banks and private capital markets. The IMF played a large role in reforms to monetary and exchange policy which conquered hyperinflation and supported the development of the financial sector. The central bank stopped providing directed credit to the government or enterprises -- the major cause of high inflation before 1995, and adopted modern tools for controlling liquidity and exchange rates. At the same time, the ruble was made fully convertible for current account transactions. Unfortunately, monetary reforms were not matched with fiscal reforms, ultimately undercutting both ruble convertibility and stability.

While the fiscal policy failure was central, it should be properly viewed in a broader context of other important policy weaknesses. Russia's banking sector never developed into a strong intermediator for channeling savings into productive private investment. The terms of privatization frequently were not competitive, and private ownership often failed to improve company management. Corruption remains pervasive and fundamentally undermines peoples' faith in the legitimacy of the political and economic system. Russia still does not have a properly functioning land market, and use of land as collateral has been stifled. Social payments are not adequately targeted and, as a result, the truly needy often receive little or no support. In all of these areas, reform has lagged, especially in comparison to Central Europe.

In this context, the Kiriyenko government began taking the right steps. That government's strategy, as supported by the IMF, was to cut spending, especially unproductive subsidies, while building a new tax system capable of raising revenues adequate to finance reduced federal spending. The IMF also secured commitments from the government to cut federal government non-interest expenditures by 20% this year. Federal government expenditures were to fall to 16.4 % of GDP; non-interest expenditures to 11.1% of GDP. Further expenditure cuts, to 15.7% of GDP, were planned for next year.

The rationale for the $22.6 billion additional multilateral financing package mobilized in July was to provide measured, conditional assistance to support these reform efforts and, by helping Russia withstand intense financial pressures, give it time to continue reform . The first element of this support was a $4.8 billion tranche from the IMF on July 20.

We supported this financing because we believed there was a reasonably good chance, not a certainty, but a reasonably good chance, that reform would move forward in the period ahead. This judgement was based on the fact that President Yeltsin and Prime Minister Kiriyenko had just taken some important steps, largely in the form of decrees, to cut Russia's federal deficit.

There was every indication that the government planned to continue a course of essential reforms on which there is a broad international consensus. Deficit cutting was not the extent of the Kiriyenko government's reform horizon. Additional IMF and World Bank financing was to be made available to support important structural reforms. On the fiscal side reforms were aimed at strengthening the budgetary control process, extending the Treasury system to cover all ministries, improvements in tax administration, and the elimination of "offsets" (swapping government spending obligations to firms for the firms' tax obligations). More broadly, Russia was urged to make the privatization process more transparent and open; cut substantially the number of "strategic firms" exempted from privatization; accelerate reform of the banking and energy sectors; eliminate non-cash payments for utilities and infrastructure; increase capital market transparency; strengthen measures to enforce minority shareholder rights; and improve bankruptcy legislation and enforcement.

This Administration has also strongly encouraged the World Bank to intensify its engagement with Russia as a means of broadening and deepening structural reform. With our support, the World Bank is working to promote reforms in the public sector, banking, the pension system, programs for social assistance and unemployment, and the coal sector. As part of the $22.6 billion additional financing package, World Bank financing of $6 billion this year and next could be made available to support further reforms in these areas as well agricultural reform and regional fiscal reform.

Of course, it would have been vastly preferable if the Kiriyenko government had been able to forge a broad political consensus in favor of the full program of fiscal restraint and reform. But the reality is there was, and is, strong opposition in the Duma and elsewhere from powerful special interests and from those who seek a return to communism. In this sense, the origins of this financial crisis are fundamentally a political struggle over the economy's direction.

In the end, the opposition helped fuel great market skepticism, and a breakdown in confidence ultimately followed. But if the IMF had not acted quickly to support key elements in the government's anti-crisis program, it and we would have been rightly criticized for timidity and for a failure to seize a critical opportunity to support reform and stabilize Russia's economy.

III. The Logic of the United States' and the IMF's Approach

The periodic setbacks in Russia's progress lead inevitably to the question of what the multilateral community should have done, or should do, to help Russia improve its economic performance. Historians will debate whether too much or too little Western assistance has been provided since the collapse of the Soviet Union. Some observers now charge that while large amounts of financing were promised to Russia in this decade, little was actually disbursed. In fact, most of this financing was disbursed, although the IFI lending components were delayed because reforms lagged. There has clearly been no absence of willingness on the part of Western governments to provide support for credible Russian reform.

Too much, for too little?

Some argue that IMF and World Bank support has been too forgiving of Russian policy failures. The truth is that IMF support has been delayed or cut when the Russian government has not made good on its commitments. Moreover, since 1992, Russia's persistent failures to achieve solid reform in some areas have led to ever tighter conditionality. For example, Russia was the first country to have monthly tranching as part of its IMF program.

With regard to the most recent IMF loan announced in July, $9.5 billion of the total $15 billion commitment was to be provided at normal IMF interests rates of about 4 «%, while $5.6 billion from the new Supplemental Reserve Facility would carry a higher rate of about 7 1/2% which would be increased if the loan were extended beyond 1 year.

The $4.8B first tranche of this program went to bolster the foreign exchange reserves of the Russian central bank, which is where all IMF funding to Russia has gone. Support for Russian reserves combined with policy progress helped achieve a sustained period of exchange rate stability from 1995 to August 1998. But in recent months, as confidence in prospects for reform waned, additions to reserves ultimately proved unsuccessful in defending the ruble. We acknowledge that, under these circumstances, the use of reserves to maintain exchange rate stability benefitted those who wished to convert their ruble holdings into dollars. But, this does not mean that the goal of exchange rate stability was not the right goal. Large-scale capital flight can only be addressed by a strong stable policy environment as well as measures to combat crime, corruption, and money laundering. Russia, unfortunately, did not make sufficient progress in these areas.

It is important to stress that disbursement of funds in July was based on completion of a long list of prior actions -- largely tax reforms and expenditure cuts. These prior actions included new tax administration procedures and a budget code; more uniform application of the VAT, including application to barter transactions; a simplified small business tax; and reductions in federal subsidies.

The IMF insisted that it needed more than legislative proposals as a basis for disbursing this money. It required laws passed or actions that had the force of law. The important decrees issued by the Russian government were therefore directly related to IMF conditionality. Because two actions were not taken -- a rebalancing of personal income tax revenue sharing and closure of the pension fund deficit -- the IMF Board cut the disbursement from $5.6 billion to $4.8 billion. Our firm position going forward is that IMF and World Bank financing must remain strictly tied to fulfillment of policy conditions.

We very much share the concern in Congress about corruption in Russia and so do the international financial institutions. It is a fundamental threat to Russia's stability, democratization, and prospects for a broadly-shared rise in living standards. And there is a real risk that corruption will be mistakenly blamed on reform.

Much corruption in Russia is related to government economic and regulatory policy. Below-market-value sales of government assets to favored oligarchs, protection payments extorted from firms in the "informal" sector, the prevalence of barter rather than cash payments to avoid the punitive tax system, violations of minority shareholder rights, crony bank lending to clients with ownership ties, and bribes extorted by government officials are all related to policy/regulatory failures. (These problems are, of course, compounded by weak law enforcement agencies and organized crime infiltration of government and financial institutions.) These are precisely the failures that the IMF has been trying to correct -- through its support for competition, tax reform, improved corporate governance, more firm and government transparency and disclosure, stronger bank supervision, and restraints on the discretion and scope of government regulation.

On a bilateral level, legal reform and the battle against corruption have long been a central focus of Vice President Gore's work with the Russian Prime Minister and President Clinton's dialogue with President Yeltsin. To cite just one Treasury-related example, we are working with Russia to curb money laundering through promoting passage of legislation which criminalizes money laundering and consulting on the creation of a financial intelligence unit.

Counterproductive policies

In the Russian context and in certain other countries hit by crisis, some have accused the IMF of being part of the cause of financial crisis rather than part of the solution. Critics blame sharp interest rate hikes under IMF programs for bringing down banking sectors. Yet in the Russian case, the blame for high interest rates lies fairly and squarely on an unsustainably high fiscal deficit. Especially because the Russian economy is under-monetized, the budget deficit absorbs much of the scarce financial savings of the Russian people. By raising dependence on volatile capital inflows, it also makes Russia vulnerable to external shocks and financial market upheaval. This burdensome borrowing requirement not only keeps interest rates high even during non-crisis periods, it destroys prospects for growth. That is why cutting Russia's budget deficit to a sustainable level has been such a fundamental IMF and U.S. objective since transformation began.

During the global financial turmoil which intensified beginning last October, Russia's monetary authorities raised interest rates sharply to support the ruble which had come under strong pressure. They made the judgement, we think rightly, that ruble stability had to be their policy priority to protect crucial Russian progress on price stability. In the end, the deficit, large borrowing requirements, and an increasingly difficult global financial environment brought down the ruble even with high interest rates. But it is a mistake to blame interest rates or monetary policy for Russia's crisis. Russia's macroeconomic problem is fundamentally fiscal; interest rates are more properly viewed as a symptom of that problem, not a cause.

By way of comparison, the countries that withstood the Asia contagion did so initially with an interest rate defense, followed by policy adjustment, especially fiscal cuts where that was relevant. Russia also used the interest rate defense, but, despite consistent and urgent IMF advice, delayed too long on the policy adjustment.

IV. Prospects for the Future

Today Russia's future lies shrouded in uncertainty. Neither the composition nor the aims of the new government can be known with any confidence and I would certainly hesitate to predict them here. What is clear is the grave risk if Russia fails to set the economy back on the reform course. Many of this century's worst crises have had their roots in economic failures -- in the loss of control over prices and a failure to lay the legal and institutional basis for the rule of law. A similar failure today in Russia could carry very serious implications for our broader national security and for the stability of the global economy at this critical time.

The United States thus has a strong stake in Russia successfully overcoming today's crisis and laying the grounds for a more stable future -- by carrying out the kind of macroeconomic and structural reforms included in the IMF program. We will strongly support a Russian government that is determined to carry out these changes and continue the process of democratization. This is not about imposing "American" economic models or any other kind. Russia has its own unique history and traditions and it will plot its own path in the economic arena as it will in every other respect. It will have to make its own decisions about specific institutions and market arrangements. Yet, as President Clinton said in Moscow last week, if the past year has taught anything it is that no country can escape the imperatives of the global marketplace.

All countries must have: fair tax laws and enforcement, private ownership and free land markets, independent courts that enforce laws and contracts, strong banks that safeguard peoples' savings and channel those savings to productive private investment, securities markets that deter fraud and protect legitimate investor rights, social spending targeted to those really in need, and prevention of hidden, anti-competitive ties between government and business interests. These policies and institutions will work for Russia just as they have for countries in all regions of the globe.

The reform agenda now confronting Russia is formidable it combines the urgent need to restabilize and the imperative of laying the foundation for growth. By devaluing and restructuring debt, Russia has taken drastic measures to cope with failed policies. Russia's authorities urgently need to clarify those steps and begin a dialogue with creditors. At the same time, Russia must resist pressures to spend and lend which will doom the economy to another bout of high, perhaps hyper- inflation. The effort to restabilize must combine a rational strategy for coping with the failure of the banking system with sound monetary and fiscal policies. Russia needs to make a decision on a new exchange rate regime. Beyond restabilization, it must chart a long term growth strategy based on reform, creating an environment in which business and investment can flourish. This will require not only price stability but also vigorous legal reform, attacking corruption, creating the institutions of a market economy, finishing privatization including land, and completely revamping the social payments system. The present crisis and politics may make the chance that Russia will pursue this course remote, but it is the only route which will lead Russia's people to the prosperity they deserve.

Mr Chairman. Russia faces a choice, to restart, accelerate and deepen reform, or to drift in dangerous policy directions. The pressures at the moment are all for spending, subsidies, intervention etc. to provide relief from the perceived hardships of reform. Many view reform and reformers as discredited. It will be hard for many in Russia to understand that the failing was too little rather than too much reform. As President Clinton said, "There is no shortcut to developing a system that will have the confidence of investors around the world. These are not American rules or anybody else's rules. These are [the rules] in a global economy." We all have an interest in Russian economic success and the President made clear that the administration is ready to offer further assistance if Russia stays with the path of reform.

Thank you. I would now welcome any questions.