However, in Russia, because of the immaturity of financial markets and the continuing instability of the macroeconomy, exchange rate speculation had a significant negative effect on the private sector. After the introduction of the target exchange rate band, this trend declined and financial institutions redirected investment to short-term ruble- denominated bonds. This had the effect of raising the demand for rubles, and contributed to the stabilization of the exchange rate and non-dollarization of the economy.
Assessments of the Exchange Rate Level Opinions are divided on the level at which the target exchange rate band was set. The level has been criticized as too high particularly by the export industries. Certainly, one of the problems of a nominal anchor policy is that the attempt to maintain the nominal exchange rate in the face of rising inflation tends to result in the deterioration of the external balance of trade by undermining export price competitiveness. However, at the present time, there is little reason for concern because Russia's trade surplus continues to expand and, because it is a resource rich country, foreign currency can be acquired by exporting resources.
Rather it is more likely that setting the exchange rate artificially low would tend to protect domestic producers from the pressures of international competition and ultimately prevent the restructuring of export industries. Moreover, a policy scheme of maintaining the real exchange rate, which reduces the nominal exchange rate in the wake of accelerating inflation, is likely to be conducive to inflation.
On the other hand, in some quarters, the current ruble exchange rate is considered to be too low in terms of purchasing power parity. At present, Russia's purchasing power parity taking into consideration changes in the price structure is moving at a level of around twice that of the actual exchange rate Figure 9. The gap between purchasing power parity and the actual exchange rate was 9 times in but just recently it has dropped below 2 times and prices are becoming aligned to world prices.
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This trend is particularly marked in the case of energy prices. World Bank , Government of the Russian Federation As seen in 1 above, if we look at the major economic indicators as they relate to macroeconomic policy, the Russian economy appears to be moving towards stabilization. However, if we look at the supply side, we find various problems. For example, even though privatization has proceeded, restructuring still fails to make progress and investment continues to show large declines.
We will now explore the problems on the supply side of the Russian economy. For details, see OECD Continuing Insider Control and Inefficiency Nevertheless, because many of the privatized enterprises are now owned by employee shareholders 3 , problems of corporate governance have emerged and it is not possible to say that corporate activities are carried out in conformity with the market economy.
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In the developed countries, putting aside some national variations in systems Anglo-American, Japanese, etc. However, in Russia's privatized companies where the employees hold the majority of the shares and there are no externally imposed incentives to regulate the activities of the company, often the same managers continue to use the management practices they were accustomed to under the socialist system.
As a result, there are problems such as continuing inefficiency and lack of progress in restructuring which are manifested in over-employment, non-repayment of loans, the stagnation of capital investment and so on. For example, though hidden unemployment in Russian companies has fallen from a peak of 5. Further, relative to the slump in GDP after the introduction of the reforms, the slump in employment was small suggesting that companies were taking some sort of labor hoarding measures Figure This could probably be regarded as a hang-over from the socialist period when a larger number of employees was an advantage in terms of political leverage when it came to obtaining subsidies from the federal government.
In addition, the problem of outstanding corporate debt which amounts to as much as 1. According to a survey by the Russian Federal Anti-Monopoly Commission, only 1 in 5 of the privatized companies are engaged in activities which are consistent with a market economy in the sense that they are supplying products which meet market needs, cutting costs including wages, concentrating on capital investment and so on Tselichtchev, The great majority of companies are lax in their efforts towards restructuring, still seek government subsidies and special treatment for trade and engage in rent-seeking activities.
The issue remains as to what extent the activities of these companies can be converted to those of a market economy in the future. Thus, although as indicated above, the Russian economy can be judged as in the process of stabilization in terms of the major macroeconomic indicators, corporate activities still do not follow the rules of the market economy, and investment which ought to be the engine of economic growth continues to decline.
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In other words, problems which have to be resolved continue to mount so that it is impossible to predict whether the Russian economy will be able to achieve sustained growth or not. The Meaning and Limitations of the Stabilization of Macroeconomic Indicators Economic stabilization usually refers to the stability of the economic indicators used in the formulation of economic policy, that is, macroeconomic indicators such as the rate of price increases and the exchange rate. This is not only because they are objective indicators which are readily understood and internationally accepted, but also because they represent a necessary precondition if the various economic agents both households and corporations , are to be able to engage freely in economic activities including production, consumption and investment.
Russia is no exception. Under the direction of international organizations such as the IMF and the developed countries, particularly the G7, the government has pursued contractionary economic policies with the primary objective of stabilizing the macroeconomy. By , this objective had largely been achieved and if the trend continues, could be expected to have a favorable effect on the economic activities of the respective economic agents. However, the stability of the macroeconomic indicators does not necessarily bring robust economic activity and economic growth.
This is particularly the case in the transition economies. If the market does not function fully and the economic agents do not conduct economic activities in accordance with the principles of a market economy, there is the danger that there will not be a shift to a growth path based on the market mechanism. Instead stagnant economic activity will produce a certain equilibrium and the economy will fall into the stagnation trap. The Importance of Growth through the Market Mechanism It is generally recognized that the high economic growth at the beginning of the socialist period was achieved by utilizing large amounts of productive factors, that is, large amounts of labor and capital Krugman, In contrast, rather than increasing the amount of productive resources, it is improved productivity through competition and the efficient allocation of resources via the market mechanism which plays a major role in achieving high economic growth in a market economy.
For example, if we analyze the factors behind post-war economic growth in Japan, we find that it cannot be explained in terms of the amount of labor and capital but rather in terms of rising productivity and the technological improvement. In other words, the biggest difference between a command and a market economy, is whether or not growth is achieved through the market mechanism. In the former socialist countries, even if they achieve macroeconomic stability, it is difficult to achieve sustained growth if the market mechanism does not function.
Having achieved the first stage of reform - macroeconomic stability, the major remaining issue for the Russian economy is whether it can establish a growth foundation which will enable it to go on to fully develop the market mechanism and reach a sustained growth path. As seen in the previous section, Russia has largely achieved the objectives of the first stage of the transition to a market economy - that is, macroeconomic stability. In this section, we will look at the medium to long term policy objectives which are required for the next stage and the basic approach to the construction of the necessary policy framework.
In order to debate the policies for this second stage of the transition, we first need to review the characteristics and policy objectives of the first stage. Then, after discussing the definition and meaning of the second stage of the transition, we will demonstrate that the policy objectives should be the transition to a sustained growth path by means of the market mechanism and integration into the world economy. In order to achieve these two policy objectives, the encouragement of investment and structural change in industry and regional economies will be necessary.
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This, in turn, will require that a growth foundation be established to stimulate autonomous economic activity by households and corporations which is consistent with the market economy Figure Russia's transition to a market economy brought about 1 hyperinflation caused by monetary overhang; 2 a drop in production due to the collapse of the centrally-planned economy; and 3 internationally, a breakdown of former trade relations due to the collapse of COMECON. These outcomes were also evident to a greater or lesser extent in the transitional economies of Central and Eastern Europe and elsewhere so they can be regarded as characteristics of the first stage of the transition to a market economy.
At the first stage of the transition, the principal policy objectives were macroeconomic stabilization and establishment of the structures required for a market economy. Specifically, this involved macroeconomic stabilization including the control of hyperinflation by means of contractionary budgetary and financial policies , and the creation of structures such as the establishment of a currency system, privatization of government enterprises, the introduction of the right of private ownership, and the introduction of a civil code including laws of contract and bankruptcy , which is indispensable to the smooth operation of a market economy.
Despite some differences between countries, the above policies were generally successful in the countries of central and eastern Europe. With the disappearance of the negative aspects of the first stage of the transition, most of these countries began to show positive growth in GDP from about onwards. As seen in the Part 1, the phenomena associated with the first stage of the transition are also coming to an end in Russia and signs of macroeconomic stability indicate that Russia is entering the second stage of the transition.
Many systems have been changed in the past few years and although there has been some degree of disorder, it seems that the systemic change necessary for the creation of a market economy is in the process of consolidation.
However, the development of some systems, such as the law of contract, are still incomplete, while others, such as the law of bankruptcy, have been introduced but are not functioning adequately. In other words, at this stage, the construction of new systems is far from complete.
Stage two of the transition period is that in which the economy is stabilized at the macroeconomic level as seen in the disappearance of the hyperinflation characteristic of stage one and the bottoming-out of the decline in production , the basis of the market economy begins to be established and the economy enters a period of sustained expansion. On the other hand, it is also a turning point which, depending on the appropriateness of the policy mix, will see either the transition to a growth path or a decline into the stagnation trap.
The Russian economy is now at this critical turning point Figure 15 4. NOTE 4 : In his Annual Address in February, , President Yeltsin identified the stimulation of production and investment, the raising of economic efficiency, and structural change in the economy as the issues for the third stage : the first stage being deregulation of the economy and the second stage financial stabilization. However, if financial stabilization refers to decline in inflation and stabilization of the exchange rate, then our stage one is largely equivalent to Yeltin's stages one and two.
As seen below, the issues for what we call stage two in this report correspond closely to the issues which Yeltsin associates with stage three in his address. The Danger of the Stagnation Trap So far, macroeconomic stabilization and the deregulation of the economy in Russia have failed to automatically bring about autonomous and robust economic activity by households and corporations which is consistent with a market economy. Each of these economic agents, rather than pursuing efficient economic activity based on a medium to long term perspective, is pursing immediate profit or is seeking current profits by choosing conservative options while ultimately relying on the government to provide support.
This, in broad outline, is the stagnation trap 5 , the danger which is latent in the present Russian economy. To put it another way, it is the failure of the system in which the negative effects of the various contributing factors are mutually reinforcing. These factors include the deficiencies of the new structures, the continuation of customary practices from the old system, the fact that the activities of the economic agents continue to rely on these practices, the reaction of the government and so on.
Sustained Growth and Integration into the World Economy Standing at this cross-roads, the principal objective for the second stage of the transition is to prevent the economy from falling into the stagnation trap and ensure that it achieves sustained expansion. This must be a 'transition to a sustained economic growth path via the market mechanism'. In other words, it must not be economic growth on the socialist model with full mobilization of the labor force and allocation of capital by the government, but market-driven economic growth generated by the autonomous activities of corporations and households.
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This means making it possible for the new structures and organizations which were created during the first stage of the transition to fulfill the functions expected in a market economy. However, a market economy does not spontaneously come into existence as a result of economic deregulation or stability.
A considerable policy effort is also required. Secondly, in order to achieve growth, the Russian economy must be integrated into the world economy. As the world economy is being swept by a wave of globalization and each country's economic activities are carried out within a network of interdependent trade and investment relations with other countries, it is unrealistic to suppose that Russia alone can remain a closed economy.
Moreover, international trade and investment will provide the maximum possible increase in economic welfare. In recent years, participation in global trade and investment activities has contributed to the economic growth experienced by Asian countries and the transition economies such as the Czech Republic and Hungary which have joined the OECD. In the context of increasing globalization, integration into the world economy is an indispensable policy objective for the transition to sustained economic growth.
To achieve the two policy objectives of the second stage of the transition period, it is necessary to increase the efficiency of the economy as a whole by expanding investment and by bringing about structural change in industry and regional economies. Moreover, a multiplier effect can be expected by pursuing these objectives simultaneously. In order to achieve the necessary promotion of investment and structural change in industry and regional economies, as mentioned in Part 1. The Three Foundations of Growth In view of the present state of the Russian economy, the foundations of growth which are particularly important are 1 macroeconomic stabilization, 2 corporate activity consistent with the market economy; and 3 development of the adjustment function of the markets for the factors of production labor market, capital market.
In order to promote investment, it is necessary for corporations as agents of the market economy to pursue economically rational activities, that is, management must eliminate excess manpower to reduce costs so that excess capital can be redirected to needed investment. Moreover, unless the capital market functions properly and capital is supplied to investments with the highest expected returns, investment will not grow. In order to encourage structural change industry, regional , the capital and labor markets must function to transfer the factors of production from declining industries to growth industries.
In the medium to long term, given the twin objectives of sustained growth and integration into the world economy, the creation of a growth foundation will provide the environment for investment and structural change thereby avoiding the stagnation trap and moving the Russian economy from stability to growth.
Issues for the Future - Growth Strategies In integrating into the world economy, the issues likely to concern the policy-makers in the future are those relating to the pattern of development that the Russian economy will follow, and the policies which should be adopted in relation to trade and investment. Given the spectacular growth of the Asian countries, there is plenty of support for an export-led growth strategy such as that employed by the Asian NIEs or China.
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On the other hand, there is also the view that Russia should utilize its natural advantage as a resource-rich country and pursue the merits of an import replacement growth strategy such as was adopted by Central and South America and Australia. Of course, because of differences in the stage of economic growth, the endowment of resources, and the international environment, none of these approaches should be applied to the Russian economy in a simplistic manner 6. In the future, with the cooperation of economists from around the world including Japan , hopefully there will be widespread debate and discussion about the direction which Russia's economic development should take.
NOTE 6 : The Asian NIEs achieved high rates of growth in the process of the industrialization starting from a low base built on agriculture but Russia has already industrialized. Indeed, it is probably over-industrialized particularly with respect to the heavy and chemical industries. The existing industrial structure centered on the heavy and chemical industries must be reorganized as part of the conversion to a market economy.
Compared to the process of economic growth in China for example, this will be a much more difficult task. Further, unlike the Asian NIEs which have scarce resources and abundant labor, though Russia is rich in natural resources, labor is relatively scarce and is regionally maldistributed. Therefore, assuming perfect competition, in terms of Heckscher-Ohlin type static international trade theory, the structure of comparative advantage in Russia and the Asian NIEs is completely different.
If, for example, the emphasis is placed on export of resources in which Russia can be regarded as having a comparative advantage in static terms, Russia will suffer the so-called Dutch disease, much of manufacturing industry will be neglected, structural adjustment will not occur, and the possibility that economic performance will decline in the medium to long term cannot be denied.