The IMF and the ruble zone.

When the Soviet Union broke up, ten of the fifteen successor states were hit by hyperinflation. Before 1993, only eighteen incidents of hyperinflation had been recorded in world history. (1)

Hyperinflation is a very serious social condition, and it can be blamed for the initial failure

These problems were closely connected with the persistence of the common currency area in the CIS till 1993. The three Baltic countries that wisely broke out in 1992 escaped actual hyperinflation, and so did Kyrgyzstan, which was the first CIS member to establish a national currency in May 1993. Thus, of the eleven remaining members all but Russia experienced hyperinflation, and Russia was not far off.

The ruble zone also hampered deregulation. In its shade, bilateral state trade persisted till 1994, helping to sustain price controls, export quotas and export licensing. As a result, a large part of the trade of all the CIS countries remained heavily regulated for the first three years of transition. Mutual trade collapsed accordingly (Michalopoulos and Tarr 1997; Olcott et al. 1999).

The big dividing line in post-communist transition can be drawn between the CIS countries and East-Central Europe. There are many corroborating factors--the degree of economic distortions, the years of communism, and geography, but membership in the ruble zone and the accompanying state trade stand out as the possibly the most important factors, although co-variation makes it difficult to make firm distinctions (Aslund 2002; Berg et al. 1999).

Arguably, the preservation of the ruble zone was the worst single mistake in the post-communist transition in terms of its costs, and the question is what role the IMF played in this mistake. In their paper "The IMF and the Ruble Area, 1991-93," John Odling-Smee and Gonzalo Pastor (2002) try to defend the position of the IMF in this drama. I welcome their interest in sorting this old issue out. While I have few disagreements on facts, I am surprised by how different our perspectives were, given that both John Odling-Smee and I were deeply engaged in this drama and met repeatedly during its course.

My comments concern four issues. The first one is possible alternative monetary regimes. The second issue is the politics of the ruble zone. Third, the bankers' meeting in Tashkent in May 1992 is worth a discussion, and finally when the IMF publicly came out against the ruble zone. (2)

Alternative Currency Regimes

The key issue is what policy options really existed. Odling-Smee and Pastor (2002) argue that there "were three main options for the currency regime: a cooperative ruble area arrangement in which all participating central banks would have a say in credit and monetary policy for the ruble area; national currencies; and a Russia-dominated ruble area in which the CBR would be solely responsible for monetary and exchange rate issues." (p. 12)

The last option with a Russian monopoly on monetary emission was politically impossible, and that was widely understood, as Odling-Smee and Pastor conclude. By 1991, all fifteen Soviet republics had already set up central banks which were issuing ruble credits, that is money, independently of one another and of the remaining Soviet Gosbank. In particular, the Central Bank of Russia and Gosbank were issuing money in competition with one another (Johnson 2000).

Today, all these countries have independent national currencies, and every financial stabilization was preceded by the introduction of a national currency. The Baltic countries that launched their national currencies first also stabilized first. In hindsight, it is difficult to fault that option.

The whole strife was over the possibility of a cooperative ruble area. Its fundamental problem was that it was hyperinflationary. Fifteen republican banks were already issuing credits in competition with one another. The more credits any republic issued, the larger the share of total GDP it received. This was not only a free rider problem but rather a prisoner's dilemma, because if one republic issued less money than other republics, it obtained a smaller share of the common GDP (Bornefalk 1994).

The Balts, most of the Russian reformers and all their foreign advisors understood this and insisted on the early introduction of national currencies throughout the former Soviet Union. The underlying understanding was that it was impossible to control monetary emission by several central banks in one currency zone through a cooperative agreement. Instead, a technical monopoly must control the issue of money in each monetary area, which only the introduction of national currencies would deliver. The incentives to cheat were enormous. The reporting system was deplorable, and one republic might only hear about credits issued by another republic after months. Electronic payments were not even legal, leaving everything to a slow post system that was falling apart. The legal system was in tatters and could hardly be used. Finally, the former Soviet republics did not trust each other in the least, and mutual cheating was perceived as the only sensible approach. To anybody who understood anything about monetary systems and post-Soviet reality, it was obvious that a cooperative monetary system in one ruble zone could not work. (3)

The obvious historical precedent was the dissolution of the Hapsburg Empire after World War I. Only one of its successor states escaped hyperinflation, namely Czechoslovakia, which broke out of the Austro-Hungarian currency zone at the earliest opportunity and thus secured monetary stability. Its currency was made fully convertible from the outset, and the country pursued conservative fiscal and monetary policies, which allowed its economy to flourish in the otherwise so arduous interwar period.

This case was well analyzed at the time (Pasvolsky 1928), and it had been brought to recent attention by Tom Sargent (1986) and Rudiger Dornbusch (1992), who argued strongly for the breaking up of the ruble zone at an important seminar in Moscow in September 1991. (4)

Given that a Russia-controlled monetary system was not politically feasible, the only economically acceptable alternative was the swift breaking up of the ruble zone, and the establishment of one national currency in each of the Soviet successor states. It was inconceivable that any "cooperative" model would work, and any attempt was likely to lead to hyperinflation. This prediction was made by Jeffrey Sachs and shared by most market reformers, tacitly even by the research department of the IME However, the IMF also argued that the cooperative solution was conceivable.

Thereby the IMF lent the cooperative solution economic legitimacy. It rendered the choice between the maintained ruble zone and its break-up into national currencies a political question, bringing political forces rather than economic arguments to the fore.

The Politics of the Ruble Zone

Several groups favored the preservation of the ruble zone, but all of them did so for rather bad reasons.

The most important group consisted of rent seekers. The ruble zone with its competing credit issue by mutually independent central banks led to a horrendous credit emission. In 1992 and 1993, many countries increased their credit by 30-60 percent of GDP. As nominal interest rates stayed low till the end of 1993, these credits were sheer gifts to the powerful and well connected. The accompanying state trade with its price regulation offered wonderful arbitrage opportunities to rent seekers. Therefore, the old elite in all former Soviet republics tended to favor the ruble zone. They included state enterprise managers, especially in old big industry, the agrarian lobby and the banking community.

A second group comprised old Russian imperialists, who wanted to maintain the ruble zone in the hope that it would lead to the rebirth of the Soviet Union. Economically, this position was defended with the dangers and costs of disruption of old economic links, while the very purpose of the market transformation was to encourage more rational economic links. This group also included some people who are usually characterized as reformers. The most striking example is Grigory Yavlinsky. Many did not know what to do, preferring the least change, although they lacked the ability to evaluate whether the current state of affairs was tenable.

Curiously, a third group was formed out of nationalists in some non-Russian countries, notably Ukraine, who ultimately favored a national currency, but they wanted to benefit from cheap Russian credits and raw materials as long as possible.

None of these groups had any respectable argument. An additional strange argument, that was raised by outsiders, was that most of the CIS countries had such poor possibilities to attract sufficient international financing that their best option was to try to get all financing they could get from Russia. That was exactly what happened.

Europe added another argument. As the European Union had just agreed on the formation of the European Monetary Union, the EU was in principle in favor of a currency union and did not want to see one break apart in its neighborhood. The EU Ambassador in Moscow, Michael Emerson (1992) even entered the public debate in favor of currency union arguing in the Russian press: "Economists argue whether a common market really requires a common currency also. I believe that it does. A single monetary unit more fully uncovers the advantages of economic integration, according to my view." Alas, the reporting, trust and legal preconditions in the EU were completely different from those in the CIS.

On the opposite side stood the Baltic reformers, most of the Russian reformers and a lot of economists. While all these wanted to establish national currencies as soon as possible, they differed over speed and technicalities, as reflected by the successive breaking out by the Baltic states. Their dominant concern was logistics, how to print and distribute the currency. For this, they needed the technical support of the IMF. For instance, the leading Russian reformer Yegor Gaidar (1993, p. 84) wanted to "nationalize the Russian ruble" as the catch phrase went, but before assuming office in November 1991, he reckoned that the technical preparations for monetary reform would take at least nine months. This could be done faster, as Estonia proved, but the IMF did nothing to assist the reformers to undertake early monetary reform.

With its open mind about either maintaining a ruble zone or its dissolution, the IMF was naturally influenced by the political preferences among its potential clients and shareholders. Most CIS states favored the ruble zone because of fear of the unknown or rent-seeking inclinations, and the EU countries on the IMF board liked the idea of a currency union.

The Tashkent Meeting, May 21-22, 1992

Everything came to a head at the CIS meeting of heads of central banks in Tashkent, May 21-22. The basis for this meeting was the so-called Minsk Agreement of March 30, 1992, on the formation of an Inter-Bank Coordination Council with the purpose of working out coordinated solutions in key areas of monetary and credit policy. However, the Minsk Agreement was only signed by the heads of seven central banks (Armenia, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Russia and Uzbekistan), leaving eight members of the ruble zone out. Admittedly, three of these were the Baltic states which were adamant about their early adoption of national currencies, though they were by no means encouraged by the IMF, and even Estonia broke out only in June 1992.

Before this meeting, the IMF had circulated several notes on "The Coordination of Monetary Policy in the Ruble Area" (April 29, 1992) and "Guidelines for the Conduct of Monetary Policy in the Ruble Area" (April 29, 1992). These two documents are slightly different from the memorandum that Odling-Smee and Pastor (2001) attach to their working paper. (5) The essence of the documents is that "each republican central bank would agree to set a limit on the expansion of its net domestic assets." (Attachment I, p. 30) "The Central Bank of Russia will negotiate with the other central banks in the ruble area ceilings on the amounts of net credit to be extended by the CBR to other central banks." Yet, these "ceilings would generally not be binding when other central banks are adhering to their respective ceilings on net domestic assets." (Attachment I, p. 33)

The principle was wrong, and the IMF memoranda only vaguely indicated that the CBR could impose penalty interest rates or suspend the right to obtain ruble currency, if any central bank misbehaved. With the poor reporting, this could only happen after a serious destabilization, and such a decision would be difficult politically in the face of strong lobbies. Financial and economic policies are omitted altogether in the IMF memoranda.

For unknown reasons, a section on the role of the IMF has been omitted in the memorandum that Odling-Smee and Pastor submit. In that section, the IMF stated: "If Russia followed an appropriate monetary policy and the other countries adhered to the `Guidelines,' monetary stability could be achieved. If they did not, the CBR would still be in a position to exercise overall control over monetary conditions in the ruble area." The tone is strikingly leisurely, and nowhere in these documents does it become apparent that these countries were on the verge of hyperinflation.

I base my version of what happened in Tashkent on what Sergei Ignatiev, the then Deputy Chairman of the CBR told me soon afterwards. Ignatiev came back from Tashkent very upset with Odling-Smee, the senior IMF representative present. Odling-Smee tried to convince him to sign an agreement on the cooperative ruble zone arrangement designed by the IMF. He refused to do so on behalf of Russia because he considered it unworkable, lacking unified control over emission and allowing each state to act as a free rider. Ignafiev saw the incident as a surprise coup by the IMF.

Georgy Matiukhin, the Chairman of the CBR, does not seem to have had strong view regarding the ruble zone, which was a reason why he delegated these activities to Ignatiev, who was the Gaidar man at the CBR. In his memoirs published in 1993, Matiukhin (1993) does not even mention the ruble zone controversy.

Ignatiev's version does not differ in substance from Odling-Smee and Pastor's, but it does in nuances. The main point is that the IMF had drafted a cooperative ruble arrangement for which it pushed actively in Tashkent.. It did so with the support of ignorant, uncertain or inert heads of central banks against the Russian reformers, well represented by Ignatiev. The question is only the fervor with which the IMF pushed its draft agreement.

IMF's Public Position

Odling-Smee and Pastor are trying to present the IMF as an open society with all kinds of views. More commonly, the IMF is likened to an army. When one principle is being changed, because something has happened somewhere in the world, that alterative is instantly enforced throughout the world from Timbuktu to Vladivostok, wherever the IMF has a position. Usually, the regional departments overrule the research department and other specialized departments.

In recent years, the IMF has become a much more open organization with an excellent website, where reviews of economic policies and IMF agreements with various countries are published swiftly. Yet, this is a very recent phenomenon. A decade ago, the IMF rarely made detailed public policy pronouncements, and its policy on the ruble zone is a case in point.

Possibly, the IMF changed its policy on the ruble zone in the fall of 1992, as Odling-Smee and Pastor suggest, but it made no public statement to that effect. At the time, the Financial Times had an excellent bureau chief, John Lloyd, in Moscow. He was probably the best informed journalist about Russian economic policy. Only on May 22, 1993, did he report that the IMF "had changed its position of encouraging the former Soviet states to remain in the rouble zone." That was after Kyrgyzstan had introduced its own currency with the explicit support of the IMF (and the Russian Minister of Finance) in May 1993 (Lloyd 1993).

Conclusions

In the end, the case is pretty clear. First, Odling-Smee and Pastor admit that the IMF considered a cooperative ruble area arrangement as a real possibility. The IMF let economics down.

Second, when they had accepted a cooperative ruble area as an economic possibility, it became the natural choice because of the configuration of political forces. Quite possibly, the politics of the ruble zone would have looked different, if the IMF had stated firmly that a cooperative ruble zone could not work, as later proved to be the case.

Third, at the CIS central bank meeting in Tashkent, May 21-22, the IMF pushed actively for an agreement on a cooperative ruble area against the Russian reform government.

Fourth, even the well-informed Financial Times became aware that the IMF encouraged a former Soviet state to leave the ruble zone only in May 1993.

The broader point is that the IMF did little to establish conditions that would impede hyperinflation in the former Soviet Union, although hyperinflation was widely expected from the end of 1990, and it mostly erupted in 1993 rather than 1992. Ample time was at hand to finish the ruble zone earlier. The IMF played an active role in possibly the biggest mistake of post-communist economic transformation.

Notes

(1.) We define hyperinflation using the ordinary standard of one month of inflation of more than 50 percent. In this calculation we do not include the initial price hikes caused by price liberalization.

(2.) I have previously discussed this topic at length in Aslund (1995), pp. 102-136.

(3.) Lots of reformers presented similar views. The key work is Sachs and Lipton (1993). Other noticeable pieces are Hansson (1993) and Granville (1995a and 1995b).

(4.) I attended that seminar.

(5.) I received these documents in the spring of 1992 from Russian officials in Moscow. The reason for the difference might simply be that I use a slightly earlier version of these documents, as IMF documents tend to be revised piecemeal repeatedly.

References

Aslund, Anders, How Russia Became a Market Economy, Washington, DC: Brookings, 1995

Aslund, Anders, Building Capitalism: The Transformation of the Former Soviet Bloc, New York: Cambridge University Press, 2002

Berg, Andrew, Eduardo Borensztein, Ratna Sahay, and Jeronim Zettelmeyer, "The Evolution of Output in Transition Economies: Explaining the Differences", Working Paper No. 73, International Monetary Fund, 1999.

Bornefalk, Anders, "The Ruble Zone: A Case of Irrationality?" Working Paper No. 90, Stockholm Institute of East European Economics, 1994.

Dornbusch, Rudiger, "Problems of Post-Communism: Lessons from the End of the Austro-Hungarian Empire", Weltwirtschaftliches Archiv, 128, (3), 1992, pp. 391-424.

Emerson, Michael, "The CIS on the Maastricht Road?" Ekonomicheskaya gazeta No. 51, December, 1992.

Gaidar, Yegor T "Inflationary Pressures and Economic Reform in the Soviet Union", in P. H. Admiraal, ed., Economic Transition in Eastern Europe, Oxford: Blackwell, 1993.

Granville, Brigitte, "So Farewell Then Rouble Zone", in Anders Aslund, ed., Russian Economic Reform at Risk, New York: St. Martin's Press, 1995a, pp. 65-88.

Granville, Brigitte, The Success of Russian Economic Reforms, London: Royal Institute of International Affairs, 1995b.

Hansson, Ardo H., "The Trouble with the Ruble: Monetary Reform in the Former Soviet Union", in Anders Aslund and Richard Layard, eds., Changing the Economic System in Russia, New York: St. Martin's Press, 1993, pp. 163-182.

Johnson, Juliet, A Fistful of Rubles: The Rise and Fall of the Russian Banking System, Ithaca, N.Y.: Cornell University Press, 2000.

Lloyd, John, "Most CIS States to Get Own Currencies", Financial Times, May 22-23, 1993.

Matyukhin, Georgy G., Ya byl glavnym bankirom Rossii (I Was the Chief Banker of Russia), Moscow: Vysshaya shkola, 1993.

Michalopoulos, Constantine, and David G. Tart, "The Economics of Customs Union in the Commonwealth of Independent States", Post-Soviet Geography and Economics, 38, (3), 1997, pp. 125-143.

Odling-Smee, John, and Gonzalo Pastor, "The IMF and the Ruble Area, 1991-93", Working Paper No. 101, International Monetary Fund, 2001.

Odling-Smee, John, and Gonzalo Pastor, "The IMF and the Ruble Area, 1991-93", Comparative Economic Studies, 44, No.4, 2002, pp. 3-29.

Olcott, Martha Brill, Anders Aslund, and Sherman Garnett, Getting It Wrong, Washington, DC: Carnegie Endowment for International Peace, 1999.

Pasvolsky, Leo, Economic Nationalism of the Danubian States, London: George Allen & Unwin, 1928.

Sachs, Jeffrey D., and David A. Lipton, "Remaining Steps to a Market-based Monetary System," in Anders Aslund and Richard Layard, eds., Changing the Economic System in Russia, New York: St. Martin's Press, 1993, pp. 127-162.

Sargent, Thomas J., "The Ends of Four Big Inflations," in Thomas J. Sargent, ed., Rational Expectations and Inflation, New York: Harper and Row, 1986.

Anders Aslund
Carnegie Endowment for International Peace
Washington, D.C.