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-18%

-7%

-15%

Law enforcement andjustice

-17%

15%

11%

-23%

6%

2%

-26%

3%

-1%

Defense

-24%

33%

11%

-30%

22%

2%

-32%

19%

-1%

Science

-21%

26%

51%

-27%

16%

39%

-30%

12%

35%

Services to the nationaleconomy

-57%

6%

-2%

-60%

-2%

-9%

-61%

-5%

-12%

Socialexpenditures

4%

-1%

-8%

-4%

-8%

-15%

60%

52%

41%

Government debtservice

-8%

-23%

5%

-11%

-25%

2%

-12%

-26%

1%

Financial aid to Russianregions

-34%

2%

-16%

-44%

-13%

-28%

-26%

15%

-5%

Otherexpenditure

-44%

-31%

-32%

-48%

-37%

-38%

-7%

13%

11%

TOTALEXPENDITURE

-22%

-2%

-1%

-28%

-10%

-8%

-18%

3%

4%

Sources: RF Ministry of Finance, estimatesby the book’sauthors.

Despite attempts to increase the federalbudget's real expenditure to 16.3 per cent of GDP, in actual fact real budgetexpenditure would be 11.3 per cent of GDP over the year. Some increase of realexpenditure financed through seigniorage would be observed only immediatelyafter the rise of the rate of money issue. An estimate of the federalbudget’s realexpenditure for a longer term (1999-2000)2

277 shows that in December 1999, it willalready be lower than under the first two scenarios (see Fig. 1.12). ByDecember 2000, real budget expenditure would fall below 4 per cent ofGDP.

Fig. 1.12

It should also be noted that while in 1999,the second scenario shows a higher level of real expenditure (includingthe additional expenditure on support for the regions and transfers to thePension Fund) than the first, by the end of 2000 these figures becomepractically the same. Obviously, if such policy continues, in 2001 realexpenditure would already reach a higher level. This means that a rise of realbudge expenditure not backed by regular revenues through monetary financing isfeasible only in the short term. With time, the inevitable rise of the rate ofinflation would invalidate all such attempts.

The forecast inflation rate for 1999-2000is determined by a range of values close to the trajectories of the first andsecond scenarios (see Fig. 1.13) and would in fact depend on the scale ofindexation attempts. The harder the government would try to deal withsocioeconomic problems through monetary financing and not budgetary reformsaimed at raising the efficiency of government expenditure and sensible taxreforms, the more rapid the fall of real budget expenditure and the deeper thesocial problems would become, and the inflation rate would tend toward figuresconsistent with the monetary-financing option of fiscal policy.

Fig. 1.13

1.4. The Primakovgovernment’sperformance: early results

In early 1999, after six months in office,the government was still trying to formulate its economic and political course.Its desire to implement a tight budget conflicts with the chosen tax reformorientation and is not supported by measures aimed at raising the efficiency ofgovernment expenditure, while declarations about keeping inflation at 30 percent in 1999 go hand in hand with a soft monetary policy.

The chief economic implications of thiscourse are as follows:

  • lower realrevenues for the enlarged government budget due to an incompetent tax reform.Significant reductions in the enlarged government’s real expenditure and, inconsequence, a new level of budget equilibrium with tax exemptions of about27-28 per cent of GDP (in 1997, 32.6 per cent of GDP) and governmentexpenditure standing at 32-33 per cent of GDP (from approximately 43 per centin 19972
  • 288);
  • acceleratedinflation in 1999 and the danger of extremely high inflationrates;
  • a furtherdeterioration of the standard of living of employees in the budget-supportedsector and of pensioners, a higher share of those with incomes below thesubsistence minimum, a wider income gap;
  • demonetization ofGDP as a factor behind continued production decline.

There are also some serious politicalproblems. There is a threat of state power significantly weakening despite thePrime Minister's repeated statements regarding his commitment to the ideologyof etatism and consolidation of the State as a priority of his work as Cabinethead. The main factors behind the weakening of the state, which are likely togrow stronger, are as follows:

  • limited opportunity to influencedevelopments in this country and deal with economic, political, and defenseissues due to reduced federal budget revenues;
  • loss of control over governmentexpenditure both at federal and regional levels. Due to a rapid rise oflobbying inside the Cabinet, the latter's failure to function as an integralpolitical team, it becomes impossible to pursue a consistentpolicy;
  • as central authority weakens, thegovernors' position will consolidate. The rise of inflation would inevitablyweaken the regional authorities' dependence upon the Center. The regions willbegin inventing their own ways of combating inflation, which would mostprobably be incompatible with the provisions of the relevant federal laws. Aspecial danger would be presented by price-regulation attempts because theshortages that would begin as a result would supply the regions with a weightymotive for restricting the flows of goods, which would undermine the integrityof the country's economic space.

The most general conclusion prompted byanalysis of the earliest results of the Primakov government's work shows thatthe country is steadily and inexorably approaching another stage in its socialand economic crisis. This stage is likely to be far more damaging than that ofmid-1998. Its features will include high inflation, a steady fall of the ruble,and overall macroeconomic and social confusion. What is more, for a number ofsocio-psychological and political reasons, this crisis may prove much morepainful than at the outset of market reforms.

The government and the Prime Ministerpersonally seem to be aware of these dangers. After a period of indecision andopen determination to avoid drastic steps, Primakov showed an awareness of thefact that the heart of the crisis lies in the monetary and fiscal, that is,macroeconomic field. The draft budget demonstrates a desire to coordinatemonetary and fiscal policy not by weakening the former but by tightening thelatter, that is, a refusal to succumb to ‘economic populism’.

However, there are at least three problemshere. First, a number of serious mistakes have already been made, especially asregards taxation, which cannot but have an adverse effect on the budgetsituation. Second, the proposed budget parameters, which are not backed bystructural reforms, would be difficult to observe. Third, a certain danger liesin the Prime Minister's predilection for political compromise, which, althoughdesirable, is not always possible without fundamental losses for economicpolicy. Naturally enough, Primakov does not want to lose the government'saccumulated political capital - relative popularity in society and the StateDuma's support. But the problem is that failure to take resolute steps maycause a gradual deterioration of the economic and then the social environmentso that the effects may prove far more serious.

The Prime Minister's diplomatic talents arewell-known and may be useful. But economic policy requires an ability to makethe right choice. Unlike modern foreign policy based on compromise and abalance of interests, economic policy has no room for compromise between lowerbudget revenues and higher expenditure, between the printing press and ahealthy national currency. The economic policy course will have to be clearlydefined.

Circumstances are bound to confront thegovernment with an increasingly pressing need to choose between a toughstabilization course and a populist economic policy. It is a choice that cannotbe avoided. Reluctance to make it would only lead to a decision imposed by thelogic of economic circumstances. It would be a choice of both policy and thesocial forces that would have to bear the costs of itsimplementation.

1.5. Subfederal and municipalborrowing

The structure of localauthorities’borrowing

In 1997-1998, the performance of theregional debt market was largely shaped by the financial market situation andthe instability of investors' expectations regarding the magnitude ofRussia’s countrycredit risks. Failure to contract long-term financing made the system ofsubfederal borrowing akin to that of the GKO market. Bank loans and loan bondswere backed, in real terms, not so much by the regions’ budget revenues and still less bythe property of the oblast administrations as by a capacity to obtain new loansto refinance the accumulated arrears.

Investors' optimistic expectations enabledthe regions to increase their borrowing by financing the growing primary fiscaldeficit, which in 1997 reached 1.25 per cent of GDP. And it was not until theRF Finance Ministry tightened its policy on granting demand loans to theregions in early 1998 that the consolidated fiscal deficits of the RFconstituent members finally went down to 0.81 per cent of GDP (as atend-August).

While in 1997, loans from the Centercovered more than 53 per cent of the local budgets' deficit, at the moment ofthe August financial crisis only 6 per cent was financed by the FinanceMinistry loans. But, despite the steady rise of interest rates on the financialmarkets in the first half of 1998, the local budgets' deficit was financed fromprivate sources at approximately the same level as in 1997, reaching 0.67 percent of GDP by August 1998 (Table 1.21).

Table 1.21

Consolidated budget deficit financing in RFconstituent members, per cent of GDP

Year

1995

1996

1997

August 1998*

1998

Deficit financing

0,38

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