Russia's rugged road to capitalism

Kiplinger's Personal Finance Magazine, Feb, 1998 by Steven T. Goldberg

Walking among the dreary vacant buildings of Melodiya (Melody) Records -- the largest producer of Russian phonograph records less than a decade ago -- Irina Lobushkova, the firm's number-three official, recalls its collapse. When Communism fell, imported compact discs flooded Russia, and the market for vinyl records evaporated. Yet the company, suddenly uncoupled from state ownership, had no money to buy machines for manufacturing CDs. Melodiya soon found itself unable to pay its bills. Customers, in similar straits, stopped buying from Melodiya. But What really brought the record company to its knees was taxes. Russian law doesn't allow corporations to deduct many of the normal costs of doing business, so many firms owe more in taxes than they make in profits. "We have no profits, but we owe taxes," Lobushkova exclaims. "It's a Russian miracle."

Melodiya's bizarre tax problems are typical of the absurdities and contradictions hindering Russia's transition to a market economy. * Because so many companies lack cash to pay their taxes, the government hasn't been able to collect needed revenues. Tax collections for the third quarter of 1997 were only 46% of the budget target, prompting the International Monetary Fund in November to suspend at least one $700-million installment of a $10-billion loan to Russia until the government imposes more fiscal discipline. * St. Petersburg is accepting tax payments from local businesses in towels, paint or whatever the companies produce because they lack cash. Meanwhile, many of the nation's manufacturers are partially paying employees in goods, and one major firm, lzhorskiye, is paying shareholders dividends in sugar, preserves and other foods. "The biggest problem in Russia right now is that most of the domestic sales are barter," says Igor Ignagov, a Moscow-based analyst with Credit Suisse First Boston. * Construction is seen everywhere in Moscow. But because almost all land is still owned by the government, most of the work involves renovating existing buildings. You can't own the land under a building, so it's often impractical to knock down an old building and put up a new one -- or even to build on vacant land. * If you open a business in Russia, whether it's a huge hotel or a tiny kiosk, you usually end up with Russian mafia members as your "partners." Unless you pay protection money to one of these gangs, you're liable to be beaten up or shot. * The average Russian man dies at age 60, and life expectancy has declined since Communism fell. Alcoholism, long rampant in Russia, has increased -- vodka consumption has doubled since 1990. Meanwhile, the health care system continues to deteriorate and pollution worsen. One morning Muscovites awoke to find the air green.

All of which raises the question: Is Russia a place where you should risk even a single dollar of your money? Many say no. "I think it's trouble and that responsible investors have no business being there," says David Herro, manager of Oakmark International fund. "Accounting statements can't be trusted, and there's no real regulation."

Indeed, the Russian stock market plunged 44% from its peak October 6 to December 1. The decline was sparked by troubles in Asia, which forced up interest rates, and exacerbated by momentum investors who bailed out the moment stocks began falling. But the sell-off followed a two-year stretch when the market was the hottest on earth, rising more than sixfold. In 1997 alone, the market was up 180% at its peak and, even after the recent decline, it was ahead 80% for the year to December 1.

Mark Mobius, manager of closed-end Templeton Russia fund, expects "tremendous growth" in Russian stock prices over the next five years. Mobius sees a burgeoning economy feeding the stock market. "The trend is clear," he says. "Inflation has come down dramatically, the economy is beginning to move, and privatization of state-run industries is picking up steam."

THE TAXING QUESTIONS

While Russia is still taking baby steps toward capitalism, the political situation suggests that bolder reforms are coming, assuming President Boris Yeltsin is healthy enough to govern. Yeltsin, who has a heart condition and was hospitalized in December, has given full backing to economic reforms.

Yeltsin desperately needs to get at least piecemeal tax reform through the Duma (one-half of Russia's two-house parliament) in 1998. Currently, corporations are badly overtaxed, but individuals are hardly taxed at all. Even partial reform should make it easier for the government to collect taxes and would likely spur the IMF to reinstate its $10-billion loan.

Under Russia's constitution, Yeltsin has far more power than the Communist-controlled Duma, and so far he has been able to stare down the Communists on most important issues. While citizens are unhappy with Yeltsin, according to opinion polls, they dislike even more the right-wing ultranationalists and the Communists. "Russians are great at putting up with hardship," says Ken Payne, political analyst with Regent Securities in Moscow. "After all, the socialist experiment lasted 70 years."