Experts have agreed that establishing a viable financial sector is a vital requirement for Russia to have a successful market economy. In the first five years of the post-Soviet era, the development of Russia's financial sector as an efficient distributor of money and credit to other parts of the economic structure has mirrored the ups and downs of the rest of the economy. In 1996 some elements of the central planning system remained obstacles to further progress.

The Soviet Financial System

The financial system of the Soviet period was a rudimentary mechanism for state control of the economy. The government owned and managed the banking system. The State Bank (Go-sudarstvennyy bank--Gosbank) was the central bank and the only commercial bank. In its capacity as a central bank, Gosbank handled all significant banking transactions, including the issuance and control of currency and credit, the management of gold reserves, and the oversight of transactions among enterprises. Enterprises were issued money and credits in accordance with the government's planned allocation of wages and its management strategy for other expenses.

Wages were paid only in cash, and households used cash exclusively for making payments. Checkbooks, credit cards, and other alternative forms of payment were not available in the Soviet Union. Wage earners could keep savings deposits in the Savings Bank (Sberbank), where they earned low interest, and these funds were available to the government as a source of revenue. Two other banks also existed prior to 1987. The Construction Bank (Stroybank) provided investment credits to enterprises, and the Foreign Trade Bank (Vneshtorgbank) handled financial transactions pertaining to trade.

In 1987 and 1988, the Gorbachev regime separated commercial banking operations from Gosbank and replaced the two specialized banks with three banks to provide credit to designated sectors of the economy: the Agro-Industrial Bank (Agroprombank), the Industry and Construction Bank (Promstroy-bank), and the Social Investment Bank (Zhilsotsbank), which managed credits for the social welfare sector. The Soviet economy also had state-controlled insurance firms, but other forms of finance such as stocks and bonds did not exist.

The Financial Sector in the 1990s

In the 1990s, Russia's financial sector, particularly its banking system, has been one of the fastest changing elements of the economy. Although changes have moved clearly in the direction of market principles, in the mid-1990s much additional reform was necessary to achieve stability.

Reform of the Banking System

The Russian banking system has developed from the centralized system of the Soviet period into a two-tier system, including a central bank and commercial banks, that is the standard structure in market-based economies. The Russian Central Bank (RCB) assumed the functions of Gosbank in November 1991, and Gosbank was eliminated when the Soviet Union dissolved one month later. In its first years of existence, the RCB functioned under the guidelines of the 1977 Soviet constitution and Russian laws passed in 1990, which made the bank essentially an arm of the Russian parliament, whose members manipulated bank policy to help favored enterprises.

Russia's 1993 constitution gave the RCB more autonomy. However, the president has substantial influence on bank policies through his power to appoint the bank chairman, who in turn wields extensive authority over bank operations and policy. (The nomination is subject to the approval of the State Duma.)

Viktor Gerashchenko, a former Gosbank chairman, was the first chairman of the RCB. In late 1994, he resigned under pressure from President Yeltsin after the so-called Black Tuesday plunge of the ruble's value on exchange markets (see Monetary and Fiscal Policies, this ch.). Yeltsin named Tat'yana Paramonova to replace Gerashchenko, but she remained acting chairman throughout her tenure because the State Duma refused to approve her appointment. Powerful Duma members opposed Paramonova's policy of restricting credits to favored industrial sectors. In November 1995, the Duma approved Yeltsin's nomination of Sergey Dubinin to replace State Paramonova; Dubinin remained in that position through the end of Yeltsin's first term as president in mid-1996.

The Law on the Central Bank, enacted in April 1995, provides the statutory authority for the RCB. Under the law, the RCB is responsible for controlling the country's money supply, monitoring transactions among banks, implementing the federal budget and servicing Russia's foreign debt, monitoring the foreign-exchange rate of the ruble, implementing Russian exchange-rate policies, maintaining foreign currency reserves and gold reserves, licensing commercial banks, and regulating and supervising commercial banks.

The RCB has had the greatest impact on Russia's economy through its role in monetary policy. The RCB controls the money supply by lending funds to commercial banks and by establishing their reserve requirements. For several years after its establishment, the RCB issued direct credits to enterprises and to the agricultural sector at subsidized rates. Such credits were directed via commercial banks to politically influential sectors: agriculture, the industrial and energy enterprises of the northern regions, the energy sector in general, and other large, state-run enterprises.

In the early years, the RCB also financed state budget deficits by issuing credits to cover Government expenditures. The availability of such credits played a central role in the high inflation that the Russian economy endured between 1991 and 1994. In 1995 new legislation and regulations reduced this type of credit by prohibiting the use of credit to finance state budget deficits, and recent RCB chairmen have raised discount rates for RCB borrowing by commercial banks. Such restrictions have been heavily influenced by requirements of the IMF to maintain strict fiscal and monetary standards to be eligible for international financial assistance (see Foreign Debt, this ch.).

Initially, the RCB's regulation of commercial banks also was lax because the banking sector grew rapidly as the centralized economy collapsed and because Russia had no experience in establishing a market-based system. In the early and mid-1990s, the failure of regulation led to a plethora of new commercial banks, most of which were of dubious quality.

In the mid-1990s, the World Bank (see Glossary) assisted the Russian government in establishing a core of large banks, called international standard banks, that met the standards of the Bank for International Settlements (BIS--see Glossary). The new banks must conform to strict standards for the size and interest rates of loans; the size of a bank's capital base; the volume of loan reserves that banks must maintain; and the scrutiny under which banking activities will be monitored. The International Standard Bank program anticipates that the core of banks that meet its requirements will grow until the entire banking system conforms to the BIS criteria.

Meanwhile, plans called for the RCB to remain the foundation of the Russian banking system. Its success will depend greatly on its retaining as much independence as possible from both the executive and the legislative branches of government and on bank officials' ability to maintain credible monetary policies.

Commercial Banks

By the end of 1995, Russia had nearly 3,000 commercial banks. However, most of these banks were small and had little capitalization. A large portion of them are financially linked to companies and act exclusively as conduits of subsidized credits to these enterprises. The financial health of such institutions is highly questionable, and experts forecast that many of them will merge into larger, more viable institutions or go bankrupt as the RCB continues to tighten its requirements and as the role of cheap credits diminishes.

The commercial banking system has a core of large, viable banks that have attained financial credibility and that experts expect to remain in operation under any foreseeable economic conditions. The former state-controlled specialized banks of the Soviet system form the foundation of the current commercial banking system, including the six largest commercial banks in Russia. In 1991 three of the banks--the Agroprombank (subsequently renamed Rossel'bank), the Promstroybank, and the Zhilsotsbank (reorganized into Mosbusinessbank)--were reorganized into joint-stock companies and became independent commercial operations, forming the foundation of the commercial banking system.

The Soviet-era Savings Bank (Sberbank) was reorganized as the Sberbank of Russia, with the RCB holding controlling shares. In 1996 the Sberbank held between 60 and 70 percent of Russians' total household savings; that figure decreased from 90 percent in 1991 as other commercial banks began to provide competition. The Foreign Trade Bank (Rosvneshtorgbank) also remains state-controlled, and it continues to handle most foreign transactions, although by the mid-1990s it received competition from newer, privately owned banks. The Moscow International Bank handles business between the large Russian banks and Western banks. Sberbank and Rossel'bank have systems of nationwide branches.

The types and quality of services that the Russian banking system offers to the public are still rudimentary according to the standards of Western industrialized countries. They are unable to offer diverse and efficient customer services because the Soviet Union had no retail banking tradition and because Russia lacks the sophisticated infrastructure, especially high-speed telecommunications and trained staffs, on which modern Western financial institutions depend.

Most of the commercial banks offer their customers savings deposit accounts, and the more established banks provide foreign-exchange services, investment services, and corporate services. Bank checks are still rarely used in Russia because check clearance is a long process. Some banks offer debit cards that allow customers to have payments for goods and services deducted directly from their bank balances. Some banks also offer credit cards to customers with impeccable credit ratings. The continued predominance of cash transactions has slowed the rate of Russia's commerce.

Although foreign banks have played a larger role in the Russian economy in the mid-1990s, that role has met substantial resistance from nationalist factions. In early 1996, the State Duma passed a statute prohibiting the RCB from licensing foreign banks that did not have operations in Russia before November 1993. However, opponents of such a policy have pointed out that efforts to protect the fledgling domestic banking sector from foreign competition also deny access to Western financial techniques that eventually would improve the competitiveness of Russian banks.

Other Financial Institutions

A Russian securities market has evolved with the rest of the economy. When the first Russian stock market was established in 1991, few private companies existed to offer shares, so trading activity was quite low. The securities market got a large boost from the Russian government's privatization campaign. Shares in privatized firms were issued, and then a secondary market emerged for the privatization vouchers that the government issued to each citizen (see Privatization, this ch.). As the first phase of the privatization program ended and companies' capital requirements rose, an efficient securities market became increasingly important.

Russian laws and regulations of the stock market and other elements of the securities market have not kept pace with the growth in the industry, fostering irregularities in the market. Among the most infamous was the operation of the MMM investment company, which developed into a pyramid scheme guaranteeing investors very high returns on their investments. A number of Russian small investors, whose savings had been eroded severely by inflation, were attracted to the scheme and eventually lost large sums of money. The head of MMM, Sergey Mavrodi, was arrested and jailed on tax fraud, but the MMM case underlined the lack of Western-style commercial laws in the Russian legal system. The Russian securities market also lacks a modern communications infrastructure, so registration and reporting of financial transactions are very slow.

In 1993 the Government added a new element to the securities market by issuing treasury bonds to help finance its budget deficits. In addition, Russian citizens are able to buy and sell rubles for foreign currency at selected banks. The exchange rate is established through weekly auctions on the Moscow International Currency Exchange (MICEX).

Insurance remains a small part of the Russian financial market. In 1996 approximately 200 insurance companies were operating in Russia, including the privatized versions of former Soviet state insurance companies. According to experts, Russia's relatively new financial institutions are likely to face a long period of adjustment as weaker banks close or merge with stronger banks, and a regulatory framework must be developed to ensure public confidence in the banking system and enable banks to offer reliable support in the development of private enterprise--a role that has expanded rapidly in the first five post-Soviet years. Other aspects of the financial system, such as securities markets, also lack the degree of standardized regulation required for large-scale domestic participation. However, as the private sector's role in the national economy grows and as Russia develops needed regulations and infrastructure, the securities markets and other nonbank financial institutions are expected to follow the banks as important elements of the economy.

Taxation

Throughout the first half of the 1990s, international financial institutions warned Russia that major adjustments were needed in the structure and the administration of the country's tax-collection system. However, in 1996 few meaningful changes had emerged. Tax reforms until that time had emphasized revenue from income, consumption, and trade, with the value-added tax (VAT--see Glossary), corporate profits taxes, and personal income taxes accounting for 60 to 70 percent of total revenue (see table 16, Appendix). Beginning in 1993, experts have pointed to changes in the bases and rates of the profit tax and the VAT as a major cause of declining revenues. Between 1993 and 1994, the ratio of taxes collected to GDP declined from 41 percent to 36 percent, although the percentage of GDP paid in taxes already was lower in Russia than in any of the Western market economies. In the first quarter of 1996, only 56 percent of planned tax revenue was realized.

The system in place in 1996 taxed the profits of enterprises heavily, especially in comparison with the tax burden of personal income. In 1993 business profit taxes were three to seven times higher than in Western economies, and personal income taxes were two to four times lower. That emphasis was not conducive to expanding investment, and many non-wage sources of income were not captured by personal income tax standards. According to a 1996 estimate, Russians kept US$30 billion to US$60 billion in foreign banks to avoid taxation.

The VAT, which is levied on imported and domestic goods, is set at 21.5 percent for most purchases and 10 percent for a specified list of foods. Administration of that tax is complicated by uneven compliance and accounting rules that do not define clearly the amounts to be classified as value added. Taxation on the extraction and sale of natural resources is a major revenue source, but the current system yields disproportionately little revenue from the energy sector, especially the natural gas industry. Excise taxes are levied on merchandise of both domestic and foreign origin. The tax on imported luxury items ranges from 10 to 400 percent, and the rate on imports has been kept higher than for domestic products in order to protect domestic industries.

Taxes on trade are a major revenue source. In the mid-1990s, export taxes became a more important source of revenue as other types of trade control were eliminated. Frequent changes in the tariff schedule for imported goods have led to confusion among importers. The average tariff rate in mid-1995 was 17 percent, but a reduction of maximum rates was announced for the medium term.

Russia's taxation agency is the State Taxation Service (STS), which was established to administer the new market-based tax system installed in 1991 and 1992. Although in the mid-1990s its staff of 162,000 employees was much larger than tax agencies in Western countries, the STS has been hampered by poor organization, inadequate automation, and an untrained staff. Training and reorganization programs were announced in 1995, and some streamlining has resulted in separating the roles of various levels of government, identification of tax-eligible individuals and corporations, and application of penalties for tax evasion and tax arrears.

Experts have identified the most serious defect of the tax administration system as the ad hoc granting of tax exemptions, which distorts the overall revenue system and undermines the authority of administrators. The most problematic examples of this practice are exemptions granted to agricultural producers and the oil and natural gas industries.

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Source: U.S. Library of Congress