The Virtual Economy and Economic Recovery in Russia
by Clifford G. Gaddy and Barry W. Ickes

Russia is in the midst of an economic recovery. GDP is growing for the first time since transition began. Signs of improvement appear widespread. Immediately after the financial collapse of August 1998, the future of the economy was spoken of in apocalyptic terms. More recently, optimism has returned. One recent evaluation asserts that the "current performance of Russia’s macroeconomy could not be more impressive." Since the crisis, it is argued, there has been "a positive reversal in all the indicators of the so-called ‘virtual’ economy." The question then arises whether the virtual economy model remains applicable to Russia.

We argue that the answer is "yes." The virtual economy hypothesis remains the best way to understand current economic developments. The recent performance of the Russian economy does not pose a puzzle for the virtual economy hypothesis but is fully consistent with it. The real puzzle is why the recovery is so weak relative to the massive change in Russia’s external competitiveness. As we show, the recovery occurred because of the windfall brought about by the exchange rate shock and the rise in world market prices for oil and other resources that Russia exports, not because of any essential change in the behavior of enterprises in Russia. This suggests that although postcrisis developments have given Russia a window of opportunity, this window is likely to close before any serious structural reforms take root.

Understanding the current state of Russia’s economy has to begin with an examination of the real devaluation of the ruble that occurred in the wake of the crisis. Thanks to a nominal depreciation that exceeded the ensuing inflation rate, the real value of the ruble at the end of 1998 was only about 36 percent of its immediate precrisis value.

In view of this dramatic real depreciation, it should hardly be surprising that Russia has shown signs of recovery. This exchange rate shock has hugely increased the ruble value of exports. Hence even without any behavioral changes, the balance sheets of exporters improve significantly.

One important mitigating factor slowing recovery is that the increase in competitiveness has coincided with a dramatic fall in household incomes. This was especially true in 1999, when incomes were roughly 75 percent of the 1995 level. This decrease in real incomes depressed domestic consumption. The increased competitiveness of domestic manufacturing has caused expenditure switching in favor of domestically produced goods, but the extent of this import substitution has been constrained by the decline in real incomes.

Perhaps the more important reason for the limited response to the real depreciation is that the incentives to undertake costly restructuring activities remain weak. Hence enterprises continue to operate as before. Poor quality means that producers are unable to reap the benefits from the huge improvement in their external competitiveness: despite the improvement in the terms of trade, Russian producers are exporting less than they did before the financial crisis.

How can we account for the fact that while Russian unit labor costs (measured in dollars) are still much lower than before the crisis (figure 1), machinery exports (measured in dollars) are below the levels achieved in 1998? One reason is that the real depreciation increased the cost of imported inputs, and the possibilities for import substitution in components for machinery manufactures may be slim—much smaller than in, say, food processing. Machinery producers may thus see their cost advantage dissipate.

There is an ironic paradox here. Consider the plight of enterprises that had invested to improve their competitiveness before the crisis. They may have purchased foreign-made machinery or retooled to be able to use high-quality imported components and materials, incurring dollar-denominated debt to purchase them. Although their efficiency improved, they now face an increased burden to import components and service debt. Were it possible to switch to domestic producers, they would be in a better position. The data on machinery exports suggest differently.

There has been a significant decline in barter as a share of industrial sales in Russia since the August 1998 crisis. There has also been an increase in tax payments paid in cash. These trends are widely interpreted as a sign of a healthy behavioral change on the part of manufacturers, even as an indication of the demise of the virtual economy.

To understand why these signs may have been misinterpreted, it is important to dispel a common misunderstanding. Barter is not the essence of the virtual economy. The essence of the virtual economy is the transfer of value from value-producing sectors—primarily, but not exclusively, energy and raw materials—to value-destroying sectors. Before the August meltdown, barter was a means of implementing this transfer.

One needs only to think about the effect of the real ruble depreciation on barter to understand what has been happening. The extent to which enterprises use money or barter is an economic decision. Because barter is costly, enterprises used cash for some transactions even when use of barter was at its peak. Enterprises traded off the transactions cost of barter against the cost of using money. (In the current Russian environment, that cost is primarily increased visibility, which implies greater tax liability.) When cash is more plentiful, the margin between using barter and using money shifts. Real depreciation thus shifts behavior toward greater use of money. This is a behavioral change, but it does not represent restructuring.

A second effect of the depreciation on barter—one that involves no behavioral change at all—is probably much more important. The depreciation of the ruble increases the size of the export-oriented part of Russia’s economy (which is predominantly value adding and cash based) in ruble terms relative to the dinosaur part of the economy (which is largely value subtracting and noncash based). Hence the nonmonetary transactions that are needed to subsidize production at value-destroying enterprises shrink in ruble terms. This does not reduce the cost to the economy of this value transfer, however: the opportunity cost of the transfer rises with the increased profitability of exports.

Real depreciation will necessarily reduce the dollar value of the value-destroying sector. Think of it this way: a large enough ruble depreciation would shrink the dollar value of the virtual economy to zero. But that would still not end value-destruction as long as the industries responsible continue to operate. If there is no behavioral change, resources are still being destroyed.

The fact that a large real depreciation can make economic performance look strong without any change in behavior is a rather simple point, yet it seems to be lost amid the glowing statistics. A simple accounting example can illustrate just how this phenomenon works.

Imagine an economy (which we call a "pre-August" economy) that appears in terms of the recorded value of output or sales to be half barter and half monetized. Assume, too, that the monetized sector is itself composed of two equal parts: one part sells to export markets (for dollars), the other sells domestically (for rubles). The barter sector is exclusively domestic. Say that total output in the economy is 100 rubles at official prices. This means that the breakdown between the sectors is as shown in table 1.

Let us now subject this economy to an "August 17-like" event. That is, we devalue the ruble against the dollar by a factor of four and let domestic prices double. This means that the cash export sector’s output is now worth 100 rubles instead of 25, the domestic cash sector’s sales are priced at 50 rubles instead of 25, and the barter sector’s recorded sales are 100 rubles instead of 50. Table 2 shows the new ruble values and the percentage of the total economy that each sector now represents.

Finally, let us deflate these values to account for inflation, using a deflator of 2.0. That is, the barter sector’s inflation-adjusted output is 50 rubles, the domestic cash sector’s is 25, and the export cash sector’s is 50 (table 3).

Table 3 presents the postdevaluation outcome in predeval-uation (table 1) rubles. Comparing table 3 with table 1, we see two positive effects. First, total output in the economy grew from 100 to 125—a real (inflation-adjusted) increase in output of 25 percent. Second, the share of barter in the economy dropped from 50 percent to 40 percent. Both of these effects come solely from the increased real value of exports due to the devaluation: neither growth nor "remonetization" involved a change in enterprise behavior. All the enterprises in all of the sectors continue to produce exactly what they did before, in the same amounts (absolutely and relatively), selling to the same customers as before. They use (and perhaps waste) the same physical amounts of inputs (gas, electricity, steel, labor, and so on) as before. In fact, it is easy to see that the positive effect of the increased value of exports could even offset (and conceal) negative developments elsewhere. For instance, the barter sector could grow in size (in terms of physical volume of goods produced and traded) or the domestic cash sector could actually shrink. But if the growth of the export sector—thanks exclusively to the devaluation—were large enough, the overall figures could still show net growth and net remonetization.

The point of this exercise is to underscore that barter is not the essence of the virtual economy. Barter is not the main problem in the Russian economy; it is a symptom of the problem. The essence of the virtual economy is enterprise behavior that exploits what we have called relational capital to protect and maintain value-destroying activity—soft goods production. Barter is important because it facilitates that behavior. The real question for the Russian economy is what happened to enterprise behavior as a result of the positive cash shock and the shift in relative prices between hard and soft goods production? This stylized example tells us that simply looking at figures on the percentage of barter in the economy tells us nothing about behavior.

There is another important lesson here. It is that aggregate statistics can often distort reality. While the virtual economy permeates the Russian economy, it does not do so in a uniform way. Often we can gain real insight into its operation only by looking at specific regions or industries.

A case study of one (admittedly extreme but not unique) case, the Republic of Sakha (Yakutiya), shows just how misleading statistics can be. During the first half of 1999, the economy in Sakha appeared to be performing impressively:

These statistics would suggest that Sakha’s economy is growing, monetizing, and modernizing. Yet other indicators raise some questions. The percentage of loss-making companies rose from 57 percent to 63 percent, and only 14 percent of enterprises were technically solvent. Nonpayment problems were also getting worse.

How can these conflicting trends be reconciled? The answer is one word: diamonds. The region’s largest enterprise is ALROSA, which accounts for 69 percent of all industrial output. Although the region’s industrial output, measured in rubles, rose 80 percent, the physical volume of output barely increased at all. The reason is that ALROSA, which exports nearly all of its diamonds for dollars, earned four times as many rubles on the same volume of exports as before. Aggregate net profits in the republic in the first half of 1999 were Rub 5.4 billion, and ALROSA’s net profits were Rub 5.6 billion. This means that taken together, the region’s other 19,300 corporate entities had a net loss of Rub 0.2 billion. Thus the increased ruble value of ALROSA’s diamond exports alone—its positive cash shock—explains the region’s higher profits, increased industrial output, and improved fiscal performance. There is little to indicate that anything else changed in the region.

The most important positive sign during 2000 has been the recovery in consumption and investment. We have seen that increased monetization is not necessarily indicative of real change, but a rebound in consumption and investment may signal that recovery is sustainable. Of course, as we have shown with our simple accounting example, real depreciation causes an increase in real income. This increase ought to manifest itself in higher consumption and investment. The real question is whether this recovery is more than just that.

The recovery in consumption is an important positive sign. During 1999 recovery was fueled almost exclusively by the depreciation of the ruble. The high cost of imports led to increased consumption of domestic goods, but this effect was seriously limited by the decline in household income in the wake of the August crisis. The fact that consumption is increasing means that there are some domestic sources of demand. Though still not at the 1995 level, consumption does appear to be on a steady increase.

The recovery in consumption is a welcome sign for Russia. But it is important to recognize that consumption has yet to achieve the levels reached in 1997 and early 1998. At this point there is no evidence to suggest that this is more than a cyclical recovery from the depths of the crisis—a "catching up" from the earlier decline. There is no evidence that Russian consumers are more optimistic about the future and have altered their consumption behavior, generating a new source of aggregate demand. Whether or not consumption growth is sustainable will depend on what happens to income, which in turn depends on whether the recovery itself is more sustainable. The recovery in consumption is not an independent variable in this recovery.

The steady growth in investment appears to be an even more positive sign. Investment grew robustly in the past year, rising 17 percent over the same period the previous year between January and August 2000. But the increase is from an extremely low level. Real expenditures on new construction and equipment are about 12 percent higher than in the summer of 1999, but they are still below the level of 1995 and 1996, and the average age of the capital stock rose from 8.4 years in 1970 to 16 years in 1998. It is hard to believe that the recent upsurge in investment can make a serious dent in this trend. Moreover, direct foreign investment was actually 22 percent lower in the first half of 2000 than in the same period in 1999.

The real question, however, is not the volume of investment but what this investment is used for. It could be that enterprises are using their export windfall to make necessary changes that will increase competitiveness. But it is also possible that enterprises are using this windfall as breathing room to avoid having to make such changes. Enterprises may be continuing to invest in good relations with officials and workers rather than in better productive processes. The critical question is whether this investment is an indicator of restructuring. An illuminating discussion of how the export windfall has translated into investment comes from a recent discussion of reform in the region.

Some view [the devaluation] as the latest removal of a hard budget constraint and an opportunity to recreate the firm [sic] which existed before the collapse in production. They are reinvesting in social assets to create a better environment for their workforce, and see their major task as increasing production to pretransition levels with little thought to efficiency or profitability. The General Director of Uralsyazinform, one of Russia’s most successful and potentially promising regional telecoms, in the same breath mentioned that he was planning to sell 8 percent of his company in the form of ADRs to increase liquidity (perfectly laudable) and that his number one aim for investment was to improve the quality of his firm’s social assets, which included hospitals and kindergartens.

The General Director of Uralsyazinform is investing—but not necessarily in reducing the competitive disadvantages of his enterprise. Investing in relationships may be advantageous to the director—and even to the enterprise in its negotiations with officials—but it does nothing to improve the economy as a whole. Investment may thus rise in response to the improvement in the financial condition of enterprises; whether that investment will be directed toward restructuring will depend on how durable agents expect the recovery to be.

The real depreciation of the ruble ended in January 1999. Since then the ruble has appreciated gradually in real terms, as a result of inflation, which averaged more than 19 percent during 2000 while the ruble held fairly steady. The rise in inflation has been due to rapid money growth, a consequence of unsterilized capital inflows, the counterpart to Russia’s large current account balance.

This raises the question of whether the windfall is disappearing—an especially troublesome question given the lack of restructuring that seems to have taken place during this window of opportunity. Some evidence can be inferred from recent profit data. In the first four months of 2000, real profits in large and medium-size enterprises in Russia were up about 50 percent over January-April 1999. However, most of this growth came from the resource industries. Excluding oil and oil products, real profit growth was only about 10 percent. Excluding metals (ferrous and nonferrous), profits were 13 percent lower in January-April 2000 than in the same period in 1999.

One barrier to a robust recovery in Russia is the still frail nature of its infrastructure. The sorry state of Russian infrastructure was highlighted, to some extent, by the events of last summer: the Kursk tragedy and the fire at the Ostankino TV tower. Generally, though, Moscow is somewhat of an outlier with regard to infrastructure. The situation elsewhere is much worse.

Perhaps the most important sign of the state of the Russian economy is capital flight, an important indicator of how agents view the stability of the economy. Capital flight from Russia remains high. The net outflow as of mid-2000 was about $18.4 billion—double the 1999 rate and about 18 percent of GDP. This increase coincides with a massive improvement in the current account balance. To some extent this is a blessing for Russia. If capital flight were not so high, inflation would be worse, because the Central Bank of Russia cannot effectively sterilize inflows. Given the lack of behavioral change, it is likely that a substantial share of domestic investment is going into production capacity typical of the virtual economy (that is, soft goods production). Given that likely alternative, capital flight at least preserves some of Russia’s wealth until it can be used more productively.

One thing that is clear is that banks do not seem to have identified profitable investment opportunities. They are still flush with cash: bank credit (loans and interbank credit) accounted for less than 38 percent of total banking assets during the first half of 2000 (in the West the figure is 80–90 percent). The banks hold about 45 percent of their assets in foreign exchange and another 14–15 percent in noninterest-bearing accounts at the Central Bank of Russia.

The August 1998 devaluation represented a pure windfall for Russia’s raw materials exporters, whose earnings rose by a factor of four as a result. The devaluation represented a massive, positive cash shock for these enterprises and for local economies based on them. As a result of the devaluation, tax revenue also increased, and wage, pension, and tax arrears fell. The devaluation also had modest benefits for a small sector of the economy that gained a price advantage relative to foreign imports. But these benefits carried a heavy cost. Incomes fell drastically, and they remain down. The poverty rate rose by nearly 50 percent.

The squeeze on households has been important. If there has been pressure to change anywhere in the economy, it has been not on enterprises but on households. The rise in profits has come largely at the expense of a decrease in real wages. The consequent pressure on households has not led to a push toward the market. The virtual economy is a protective mechanism. When it prevails, further pressure merely tightens the cocoon of protection against the market. The greater the hardship, the less likely people are to leave the cocoon.

The real depreciation of the ruble, followed by the rise in commodity prices on the world market, gave Russia a window of opportunity to alter the course of its transition. The depreciation could have provided the cushion needed to begin extricating Russia from the grips of the virtual economy. To date, however, there are few signs that such an effort is underway. This window opened at great cost to the Russian population, and it is now starting to close.

Even if this opportunity is not seized, there will no doubt be another in the future. But lessons from this current experience must be drawn. The key question is why behavior has not responded to the real depreciation, why the opportunity provided by the devaluation is being dissipated. The most basic answer is that structural factors that generate the incentives facing enterprise directors have not appreciably changed. The underlying structure of the virtual economy remains intact—value producers are still subsidizing value destroyers. Costly restructuring that could make an enterprise more competitive is still inhibited by fear of tax consequences and an end to subsidies. The economy is still stuck in the virtual economy trap.

The power of that trap is clearly huge. One would think that a 70 percent real depreciation would be a large enough shock to change the expectations of all players in the virtual economy. And yet if such a shock is viewed as temporary and if departing from the behavioral strategies of the virtual economy has long-term consequences, it should not be a surprise that agents are wary. To induce behavioral change it is necessary to convince them that the policy regime has changed.

What, then, can we say about policy, both in the postcrisis period and in the future? Since the financial crisis, the primary imperative of Russian leaders, including Yegeniy Primakov and Vladimir Putin, has been national security and domestic stability, not radical economic reform. This is not surprising. Radical reform would require wrenching economic change at a time when real income is already declining due to the real depreciation. As a result, the windfall in tax revenue that these governments enjoyed was used to pay arrears rather than to close plants that need to be shut down. Given the absence of government leadership, enterprise directors most likely concluded that the window of opportunity was not likely to remain open. For the overwhelming majority, the response has been to pocket the windfall rather than make painful adjustments.

Table 1. The Pre-August Economy

Table 2. The Post-August Economy 
(Nominal Values)

Table 3. The Post-August Economy
(Inflation-Adjusted Values)