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Public finance for the new order succeeding the USSR.

For two years, a group of American public finance experts has been engaged in an advisory role related to the establishment of a new public finance system as part of the evolution of the new structures and new governments succeeding the USSR. These activities have been organized through a nonprofit, United States corporation known as EcoLink.

Obviously, there has been a problem in maintaining a clear definition over this period of time with respect to the governments that would employ the new structures. For the sake of convenience, the author uses the term, Soviet Union, in this article to mean both the central government and the geographic area that existed in the USSR prior to the most recent separation by several republics.

Of course, the dominant economic and governmental area for many centuries, including the period of Soviet rule, has been Russia itself. While it is possible that the new public finance structure will be employed by the future central government that may exist as a confederation or similar form of government, loosely tying several republics together, the projects on which the new public finance system will be based and for which EcoLink has been involved consists of project financings to be employed for public projects within the Republic of Russia, and with a possible extension to peripheral republics. Therefore, the program that will be discussed herafter should be seen in the context of the Republic of Russia, for clarification purposes.

Representatives of EcoLink have made approximately 15 trips to the Soviet Union in support of demonstration projects on which the future public finance system will be based. Initially, the central government provided the impetus and counterparties to the American group. Gradually, local and republic representatives there have become more directly involved.

Bond Issuance in the Soviet Union

Prior to the 1917 revolution, the use of bonds within Russia was quite extensive with various types of commercial activities, such as railroads, raising capital both domestically and on the international marakets. In addition, the Russian government had sold a significant amount of bonds, the so-called Czarist Bonds, prior to 1917. Of course, after the Bolsheviks gained power, the responsibility to make payment on these obligations was abrogated.

The Soviet government used bonds for various purposes during the 70 years of its existence. For example, in 1922, government bonds were issued to farmers as a form of payment for the requisition of agricultural goods; farmers were required to exchange food stuffs for a bond which entitled them to a payment for goods within 10 years.

The Soviet government in the 1920s and 1930s issued bonds to help redistribute funds among state-owned enterprises by taking funds from enterprises that had excess rubles to subsidize those activities that were in a deficit ruble position. During Stalin's tenure in the 1930s, the government issued large quantities of 20-year bonds that yielded no interest and were developed as a way of fighting inflation, as a result of severe shortage of goods. During World War II, 20-year war bonds were issued as a way of paying for the war, and individuals were required to purchase their proportionate share of the bonds. At maturity date, after Stalin's death, Khrushchev then delayed the payment of the bonds for another 20 years, but at the subsequent maturity date, President Breshnev paid the principal to all bondholders. Since interest payments were not made, the value of the bond repayment was, at best, minimal.

Later, other forms of bonds surfaced, such as a "lottery bond" and a "commodity bond." These programs were not popular, lacked the confidence of investors and citizens, and eventually were eliminated.

Recently, with Soviet budget deficits exceeding 10 percent of GNP, the Soviet government decided to sell more than 75 billion rubles worth of long-term bonds to institutional and individual investors. The new bonds paid 5 percent interest, had coupons attached, a call feature and a maturity of 16 years. The bonds were backed by the central government and by the State Bank of the USSR and were distributed by savings bank branches. The bonds sold miserably because the low interest rate was well below the inflation rate of 10 percent or more. As a result, the government raised the interest on the certificates for individuals to 10 percent, which allowed the bonds to be sold more effectively.

The experience of the Soviet system in honoring its debt obligations has again been brought into question as a proposal has been made, and apparently agreed upon, for the external Soviet debt to be restructured by the international holders so that financial and budgetary pressures for the central government can be alleviated. The decision for the government to restructure existing debt has been a highly controversial proposal, both domestically and internationally, since the amount of debt is relatively modest, substantially less than $100 billion, and indicates to the world financial community an evaporating commitment of the government to honor obligations that had very recently been made to the international financial community.

Notwithstanding the internal and external controversy surrounding the decision to restructure the current, external Soviet debt, it should be emphasized that by any standard, the financial stability of the central government has deteriorated dramatically. For example, the Soviets measure the flexibility and fundamental strength of their financial system by comparing "money stock" against their commodity reserve. A loose analog of such an index at the municipal level in the United States is the relationship between general fund expenditures and the government's fund equity position. Soviet money stock consists principally of bank deposits and presumed cash on hand. This amount is measured against a commodity reserve which consists of the government's inventory of saleable commodities. Recently, there has been a precipitous and absolute decline in the relationship between money stock and commodity reserve. The 1991 figure is less than one-half that in 1985 and is less than one-quarter of the figure that existed in 1970. This fact is obviously significant when judging the rationale for restructuring external Soviet debt.

Economic Reform

One of the most surprising aspects of EcoLink's participation has been the attention paid to public finance by the central government, the Republic of Russia and local government officials. Virtually every major official involved with economic reform policy has given individual attention to the development of the new public finance system, as proposed by EcoLink, and many have been instrumental in creating the environment for governmental and economic reform for the Soviet Union.

The primary reason for the interest has been twofold. First, the physical facilities previously have been funded principally by the central government from current operating outlays. With dwindling resources and competing demands for the remaining budgetary outlays, the ability to spread out these payments for physical facilities over a longer period of time through the use of long-term bonds is especially attractive. Second, inflation can undermine the prospects for economic reform. if investment can be made by individuals and enterprises in an amount that decreases the substantial overlay of nonproductive ruble inventory, then the dangers of hyper-inflation and more social instability has been mitigated. Because of the key ingredients that these two factors represent for the success of economic reform, public finance continues to be an attractive option for government officials.

Many American public finance experts have argued that the international financial community will be the most effective source of funding for capital expenditures in the areas that formerly consisted of the Soviet Union. They state that the internal sources of capital are limited and less inclined for investment than sources at the international level. It is very difficult, if not impossible, to argue against this position. Nevertheless, from an economic reform perspective, external funding of public finance projects does not directly attack the problems that have been identified. For example, external funding may reduce the amount of current expenditures that will be applied to capital projects, but it does nothing to eliminate the ruble reservoir that can contribute to hyper-inflation.

It also should be noted that public finance, as an alternative, is of increasing importance to government officials at the republic and local levels as well. Republic and local officials have begun to recognize that the use of an internal bond market for the financing of large-scale capital expenditures can reduce the budgetary pressures that will exist for independent governments.

Projects to be Financed

At the beginning of the endeavor, three projects were selected to demonstrate the important role that a new public finance system could provide to the economic reform movement being established and implemented by the central government in late 1989 and through much of 1990. These projects consisted of an AIDS hospital, and industrial complex that produced goods and services for which limited "hard currency" had previously been used to buy such goods and services on the international market, and the financing of a series of stock exchanges. Subsequently, the latter project became inappropriate, as the stock and commodity exchanges became so popular and lucrative that the facilities were financed by the exchanges themselves.

Over the two years that EcoLink has been involved in the establishment of a new public finance system in the former USSR, the projects have become more definitive. For example, because the Soviet government has historically employed a large amount of its precious hard currency reserves to buy grain in international market, the capacity to increase its grain storage facilities represents a pressing requirement. The immediate advantage that new grain storage facilities can provide produces a return by preserving hard currently reserves. Indeed, the economic value of new grain storage facilities will allow the debt incurred for this purpose to be repaid within two years of amortization will apply in order to reduce financial pressures.

The project that has been given most attention has been the AIDS hospital planned for construction in the City of Moscow. The medical records compiled by the Soviet government have been perceived for many years as being very suspect. For example, in early 1991, the Soviets apparently reported to the World Health Organization that the country had only 48 cases of AIDs. According to our extensive discussions over the two years with credible health officials, the number of persons in the former USSR who were HIV positive equalled approximately three million people, or, on a comparable basis, a higher level than exists in the United States.

Proposed General Bond Structure

For the AIDS hospital and series of grain storage facilities, there will be different, but similar financing structures.

A series of recommendations has been considered for the AIDS hospital. One scenario has repeatedly been endorsed. Reflecting this scenario, an operating agreement was signed earlier this year among the City of Moscow, Republic of Russia and All-Union Government. In this agreement, it was anticipated that the City of Moscow would issue the equivalent of general obligation bonds in an amount approximating $110 million in hard currency dollars for the funding and construction of the AIDS hospital to be located in Moscow. In turn, debt service on these obligations would be paid through a combination of reimbursements by the Republic of Russia and the All-Union Government. Because of the major adjustments that have occurred with the increasing importance of republican governance, the role of the Republic of Russia has steadily increased. For example, two years ago, the All-Union Government would have been responsible for making virtually all capital reimbursement payments which would pay for debt service for the AIDS hospital. Steadily, the Republic of Russia has increased its budgetary importance, and Russia presumably now will be the primary source of reimbursement for the AIDS hospital financing.

For the series of grain storage facilities, they will be located in and about the Republic of Russia, and the Republic itself is expected to issue debt, on a project financing basis. In turn, the money saved as a result of a decrease in the use of hard currency for the purchase of grain will be employed for the payment of debt service on bonds.

While both project financing are expected to enjoy specific related revenues in an amount sufficient to secure the bonds that will be sold, the uncertainty and novelty surrounding these project financings will make it essential for some form of general purpose government support to be applied to the bonds.

Moreover, the maturity for the bonds to be issued for the AIDS hospital will be longer than those issued for the grain storage facilities. Because of the immediate financial return available from the grain storage facilities, the maturity on those securities will be quite short, possibly no more than five years. At the same time, based on research and advice from counterparts, it is the consensus that the maturity for the debt obligations to be sold for the

AIDS hospital should not extend beyond 10 to 12 years. While such a short maturity for a hospital would not be suitable in the U.S. domestic public finance market, since the capital reimbursement portion would be substantial and onerous, the use of a maturity structure of 10 to 12 years still will provide budgetary relief there, since normally a facility of the kind for the AIDS hospital would have been paid out of current revenues by the central government.

Distribution of the proposed bonds will be accomplished through a network arranged by existing banks, including savings banks. A question has arisen regarding the prospects for selling the debt for the initial projects to retail purchasers. EcoLink has advised that such an arrangement would create extensive complexity, and therefore, for the initial projects, commercial and savings banks, enterprises with excess rubles and the equivalent to our pension funds are the targeted investors for these projects.

As a short vignette based on discussions with one of the enterprises demonstrates, the change in attitude toward privatization has occurred in a very short period of time. A newly created enterprise, through new legislation, created a board to govern. A former, high-level Communist party official had been appointed to the board. Pursuant to the legislation, the board was authorized to invite a member of the labor union that worked for the enterprise to serve on the board. In the midst of talks about the possibility that the enterprise would invest in public finance bonds, the discussion was interrupted by board consideration as to the possible addition of the labor union official. The former Communist party official was quite adamant that the labor union representative should not sit on the board for reasons that the labor union representative would not be sensitive to the need for optimizing profits and earnings for the enterprise. EcoLink representatives considered this quintessential irony and reflective of new institutional struggles.

While considering the prospective role that a trustee would provide in the context of the envisioned project financings, the issue of registration became critical for the Russians. It was their belief that bearer bond securities will not be politically acceptable to the citizens since so much attention has been paid by government officials and the populace at large to the need for control of black market profits. There has been fear that the use of bearer bonds will be a means by which profits from black market and underground sources can be laundered.

It should be emphasized at this point that a market economy is not expected to create the economic disparity in the former USSR that currently exists in Western nations among economic classes. Many in the Western world expect that the people of these republics will eventually become mirror images of Westerners. The attitudes and information received by EcoLink would suggest otherwise. A social contract that will limit the disparity among economic classes will continue to exist much more effectively than exists in the Western world.

Finally, as described above, the funds for these projects will be raised internally to establish a precedent on which future public finance projects can be accomplished without access to foreign markets.

Many Western observers have expressed the idea that there will be ready adaptation to the systematic checks and balances that exist in the Western debt issuance system. This conclusion does not reflect a realistic knowledge of the practices that have recently been put into place in former USSR for the privatization of securities' issuance. For example, at present, there is much less sensitivity and deference paid to potential conflicts of interst as privatization evolves out of the massive, centralized government that previously existed. Witness the chairman and chief executive officer of the Russian Commodity, Raw Material and Stock Exchange in Moscow, who is also chairman of the board of the Russian National Bank. This bank provides the equivalent of a line of credit and cash for brokers on the exchange to carry their positions, in effect, an arrangement that would be equivalent to the chairman of the New York Stock Exchange serving as chairman of a bank that had the monopolistic ability to provide banking services for brokerage firms that are active on the NYSE. The potential for conflict of interest of this type would not be tolerated in the American business environment. However, as the privatization momentum continues there, it is obvious that similar conflicts of interest will occur until a system with greater safeguards exists.

Investors in Moscow already have experienced a scandal in the financial markets. There have been no advertising prohibitions over the past 18 months that have limited the ability of companies offering stock for new enterprises and other private ventures. Indeed, one company did offer investment opportunities by extensive advertisement, and many Moscovites did, in fact, invest in the company. There was a mini-scandal about the proper management of the investment company when a large number of investors lost funds they had contributed. One does worry that the current environment, with the absence of appropriate checks on the activities of many new entrepreneurs, will create opportunities for securities fraud and manipulation as the momentum for privatization accelerates.

The Advisory Process

Participation by EcoLink in the emergence of a new public finance system has its roots in developments that occurred several years ago. Dr. Jeffrey A. Sachs, while he served as chief of staff for a congressman, attended an international conference in Stockholm where he had the opportunity to meet with certain Soviet officials involved in the reform process then operative in the USSR. Subsequent to these meetings, Dr. Sachs made several trips to Moscow and met with individuals deeply engaged in the economic reform movement there. These discussions resulte in protocol being signed in the fall of 1989 among the Commissioin on Economic Reform, the Institute for USA and Canada, and Dr. Sachs.

Dr. Sachs assembled a number of public finance experts to participate in implementation of the terms of the protocol, which, in part, established the goal of creating a new public finance system within the USSR. To codify the American advisory efforts, EcoLink was created as a nonprofit corporation in early 1990. To symbolize the role that EcoLink would provide to the new emerging economic environment in the Soviet Union, it was requested and EcoLink agreed to hold its first Board of Director's meeting at the offices of the Institute of the USA and Canada in Moscow on April 12, 1990.

During the first few months of 1990, numerous meetings were held in Moscow and in the United States to further refine the process by which the new public finance system could be established. In April, a new agreement was signed to implement the next steps toward this goal. An additional agreement was reached at that time and represented the first time that an individual American corporation had been a signatory to an agreement evidenced on Kremlin documents over the 70 years of Communist rule.

As part of the agreement, EcoLink was authorized to issue a request for proposals in the United States to investment banking firms and bond counsel firms to provide the necessary support to conclude the envisioned project financings. These requests for proposals were published in early summer 1990, in The Wall Street Journal and The New York Times. Nearly 100 responses were received from investment banking and financial advisory firms from U.S. and foreign-based companies. Five firms were selected. A list of law firms was developed, representing the largest and most active bond counsel firms in the American public finance field. This group of firms has been available to provide appropriate legal assistance to the endeavor.

In early 1991, a series of critical meetings were held in Moscow and a preliminary program for the funding of the AIDS hospital and grain storage facilities was prepared and structured with the following elements.

* For the AIDS hospital, the City of Moscow would issue debt as general obligation bonds, with debt service supported by a capital reimbursement from the All-Union Government and the Republic of Russia. The proceeds of the bond sale would replenish advance payments by the Ministry of Finance, which wished to move quickly to construct the facility. While the financing would be accomplished through the sale of securities internally, materials and certain expertise would be purchased on the international market through the hard currency advance. It should be emphasized that the normal period for hospital construction in the USSR is eight to 10 years, but through the use of hard currency purchases and a streamlined approval process, it was expected that the AIDS hospital could be opened within three years after funds were made available.

* For the series of grain storage facilities, the Republic of Russia would issue debt. The savings of hard currency reservers, by virtue of not having to buy grain on the open market, would be sufficient to repay the borrowed funds.

A series of meetings also was held with the state bank of the USSR, which had agreed to serve as both trustee and as principal distributor of the securities for the program. At the time when the initial structures were agreed upon--in early 1991--both sides expected that the financing would be accomplished by late summer 1991, and all parties worked independently for several months to develop the appropriate approaches and refinements for the funding of these two projects. Nonetheless, considerable political instability began to arise at the time culminating in the attemptd coup during the summer, which would presumably have eliminated further progress on economic reform of which the new public finance system and the demonstration projects were an important part.

Obstacles To Be Faced

An enormous amount of effort and expense has been incurred on both sides to accomplish the envisioned goal. The good will shown on both sides has been exceptional, and members of the working group for both sides are certain that the transactions will occur in the near future.

The principal obstacle that faces the full implementation of the program lies with the uncertain institutional and political climate existing in the areas that formerly constituted the USSR. In that respect, however, it is important to note that the AIDS hospital agreement has three signatories: the USSR, the Republic of Russia and the City of Moscow.

The educational process has been completed, and the benefits of the public finance system have become obvious. At the same time, the demands on resources over the next several months, particularly if food shortages and a severe winter are experienced, the technical advantages of long-term benefits derivative of the new public finance system will be much less important, as more critical political and governance issues are faced. In that set of circumstances, it will be increasingly difficult to receive the necessary commitments and attention of leaders who have been very supportive of the new public finance system through their principal advisors, as an ingredient to economic reform. As 1992 begins, EcoLink continues to work with the Republic of Russia, and as recently as early December 1991, representatives of the group were in Moscow meeting with officials of the Republic of Russia and the City of Moscow on the demonstration public finance projects.

J. CHESTER JOHNSON, president of Government Finance Associates, Inc., a leading independent public financial advisory firm, is a member of the Board of Directors and senior financial advisor to EcoLink. He is the 1988 recipient of the Distinguished Lifetime Contributions Award for Municipal Analysis, presented by the National Federation of Municipal Analysts.
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Title Annotation:Russia established a new public finance system to generate badly needed capital funds
Author:Johnson, J. Chester
Publication:Government Finance Review
Date:Feb 1, 1992
Words:4043
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