Hoover Daily Report

Capital Flight?

via russianeconomy.org
Thursday, March 15, 2001

For the past decade, foreign and domestic analysts of Russia’s economy have fretted over capital flight. Numerous analysts, for example, in the Bank of Finland Institute for Economies in Transition, have tried to quantify capital flight. The presence of large capital flight is presumed to reflect a poor investment climate in Russia. It is also said to be a contributing factor of Russia’s long-run contraction. Investing in villas on the Mediterranean cannot finance investments in industry that are required to increase productivity and output.

Shortly after the August 17, 1998, default and devaluation, the Central Bank of Russia imposed a 75% repatriation rule on export revenues. Exporters were required to repatriate 75% of their overseas earnings and sell them for rubles on the domestic market. We discussed this process at length in “The 100% Repatriation Rule: An Option for Russia.”

Despite concerns about capital flight and its presumed harmful effects, the Central Bank’s 75% repatriation policy is not popular. Critics fall into two camps. The first is opposed on ideological grounds. Financial liberalization, free movement of capital, is a standard view of the International Monetary Fund, other international financial institutions, the U.S. Treasury, and numerous scholars in think tanks and universities. Their Russian counterparts, who have read Western textbooks or studied in the West, agree that reducing or eliminating exchange controls on capital account transactions are a hallmark of a market economy. To the extent that the Central Bank restricts these transactions, Russia is seen to lag the West.

The second camp is opposed to the 75% repatriation rule on pragmatic grounds. Its members, who include bankers, owners and managers of exporting enterprises, lawyers, and investment analysts, argue that it is easy to circumvent capital controls, and, that as a matter of fact, the rule is only partly effective. Accordingly, they maintain, why not simply adjust policy with reality.

Before addressing these points, it is important to clarify some aspects of capital flight. Capital flight is both external and internal. It is external when exporters leave foreign currency earnings abroad. It is internal when Russian households buy dollars and stuff them in cookie jars and mattresses or use them as the medium of exchange. It is also internal when the Central Bank buys dollars and holds them as reserves. In every case, this portion of export revenues is not available to finance consumption or investment.

The absence of exchange controls on both current and capital account transactions is standard policy in Western market economies. Member nations of the OECD largely comply with this approach.

Proponents of relaxing or removing the Central Bank’s 75% repatriation rule argue that it is incompatible with Russia’s transition to a market economy. The flaw in this argument is that Russia has not evolved into a market economy. Rather, it has devolved into what we call Enterprise Network Socialism. We explained this phenomenon in Chapter 1 of From Predation to Prosperity: Breaking Up Enterprise Network Socialism in Russia. The enterprise network inherited from Soviet central planning effectively seized control of fiscal and monetary policy. During 1991–1998, the government was unable to enforce tax remittance. The Central Bank, during 1991–1995, was unable to control monetary policy or defend the ruble and, in 1998 again unable to defend the ruble.

Under enterprise network socialism, the 75% rule enables the government to more effectively enforce tax remittance. The repatriation rule increases internal cash flow, which, in turn, eases the payment jam, reduces the issue of excess invoices, facilitates payments, and thus fuels economic growth; and simultaneously reduces payroll and tax arrears. With the 75% rule, the Central Bank gains greater control over monetary policy and acquires reserves to maintain a stable exchange rate of the ruble. See our previous comment, “Is Financial Liberalization Good for Russia?

If the Russian government were willing and able to directly tax natural resource exporting enterprises, there would be no need for the 75% repatriation rule. But it has been unwilling and unable to do so. Before the 75% rule was imposed, the enterprise network determined the effective rate of tax it would pay.

Opponents of the 75% rule in the ideological camp thus misapply a policy suitable to market economies. Russia has yet to become a market economy. It will do so only after a proper policy set has been put in place.

Opponents of the 75% rule in the pragmatic policy camp misunderstand capital flight. Once the dollars have returned to Russia and been exchanged for rubles, any household or enterprise can buy dollars with rubles. Whether these dollars are stuffed in mattresses or shipped overseas through circuitous means is irrelevant. What matters is that the rubles ease the payment jam. Of course, it would be still better if the dollars could be invested in productive activity, but this requires a real banking system along the lines we set forth in Fixing Russia’s Banks, and making the dollar a legal tender along with the ruble. (On the latter point, see “It’s the Dollar”)

If and when Russia becomes a market economy and the government can directly tax resource exporting firms, the 75% rule will no longer be necessary. If the rule is prematurely abandoned, we can expect a rise in the issue of excess invoices and a rise of tax and payroll arrears and consequential defaults. Should world market prices for oil further decline and remain low, keeping the rule becomes even more important.